currency to enable depositors to withdraw their deposits without forc-
ing banks to liquidate loans and other assets.
In the long run, money creation by the Fed was still constrained by
the gold standard since the government’s paper currency, or Federal Re-
serve notes, promised to pay a fixed amount of gold. But in the short
run, the Federal Reserve was free to create money as long as it did not
threaten the convertibility of Federal Reserve notes to gold at the ex-
change rate of $20.67 per ounce. Yet the Fed was never given any guid-
ance by Congress or by the Federal Reserve Act on how to conduct
monetary policy and determine the right quantity of money.
THE FALL OF THE GOLD STANDARD
This lack of guidance had disastrous consequences just two decades
later. In the wake of the stock crash of 1929, the world economies entered
a severe downturn. Falling asset prices and failing businesses made de-
positors suspicious of banks’ assets. When word was received that a few
banks were having problems meeting depositors’ withdrawals, this
started a bank panic.
In an astounding display of institutional ineptitude, the Federal Re-
serve failed to provide extra reserves in order to stem the banking panic
and prevent a crash of the financial system, even though the Fed had the
explicit power to do so under the Federal Reserve Act. In addition, those
depositors who did receive their money sought even greater safety by
turning their notes back to the Treasury in exchange for gold, a process
that put extreme pressure on the government’s gold reserves. The bank-
ing panic soon spread from the United States to Great Britain and Conti-
nental Europe.
To prevent a steep loss of gold, Great Britain took the first step and
abandoned the gold standard on September 20, 1931, suspending the
payment of gold for sterling. Eighteen months later, on April 19, 1933,
the United States also suspended the gold standard as the Depression
and financial crisis worsened.
The financial markets loved the government’s new-found flexibil-
ity, and the reaction of the U.S. stock market to gold’s overthrow was
even more enthusiastic than that in Great Britain. Stocks soared over 9
percent on April 19 and almost 6 percent the next day. This constituted
the greatest two-day rally in stock market history. Investors felt the gov-
ernment could now provide the extra liquidity needed to stabilize com-
modity prices and stimulate the economy, which they regarded as a
boon for stocks. Bonds, however, fell, as investors feared the inflationary
192 PART 3 How the Economic Environment Impacts Stocks