George Selgin on the New Deal and the History of Banking Crises

Episode Summary

Executive Summary: George Selgin argues that the Fed’s ample-reserve/floor system was a legal and policy mistake that failed to deliver promised efficiencies, weakened markets, and politicized the balance sheet. He also says the Fed’s Main Street lending facility was an expensive failure, and he pushes back on panic-based banking myths, blaming many crises on bad regulation rather than inherent instability.

Main Topics: Fed balance sheet and operating system (Priority: 5/5): Selgin criticizes the post-2008 floor/ample-reserve framework as inefficient, legally questionable, and inferior to a corridor system with scarce reserves and interest on reserves below the policy rate. Fed task force and balance-sheet shrinkage (Priority: 5/5): He welcomes Kevin Warsh’s task force, saying a serious review of the balance sheet, asset composition, and operating framework is overdue and politically important. Discount window, interbank lending, and market design (Priority: 4/5): Selgin supports reducing reserve demand and improving liquidity tools, but argues the interbank market is preferable to relying on a more accessible discount window; he also proposes broader, auction-based open market operations. Main Street Lending Facility evaluation (Priority: 5/5): He revisits both the 1930s and COVID-era Main Street programs and concludes they mainly proved ordinary banks can already lend to worthy businesses in crises, while Fed lending to firms produced large losses. Myths about banking panics and Diamond-Dybvig (Priority: 4/5): Selgin argues that many bank failures stem from insolvency and bad regulation, not pure panic, and that Diamond-Dybvig is a useful but limited model often misused as proof for deposit insurance or lender-of-last-resort policies. Historical causes of U.S. banking instability (Priority: 5/5): He points to unit banking, bond-backed note restrictions, and inelastic currency supply before the Fed as key regulatory distortions that made the pre-Fed U.S. system fragile.

Key Arguments: The Fed’s current floor system was not what the 2006 interest-on-reserves legislation intended; Selgin says the Fed has effectively violated the statute by paying reserves at or above market rates. The floor system has not delivered its promised benefits: it did not remain efficient with only a few hundred billion in reserves, did not simplify policy, and required added facilities like ON RRP and standing repo. Shrinking reserve demand is a worthwhile goal, but revival of unsecured interbank lending is a better long-run objective than expanding discount-window use. Making the discount window easier to use can reduce reserve demand, but it is a second-best substitute compared with restoring competitive interbank lending. Open market operations are not inherently more market-friendly than discount lending; institutional design matters, and Selgin favors broader multi-asset auction-based operations. The COVID Main Street facility mirrored the disappointing 1930s experience: banks were not ignoring large numbers of worthy businesses, and the Fed’s entry mostly increased risk and losses. Banking crises are usually driven by insolvency and bad regulations, not by random panic among solvent banks. The Diamond-Dybvig model is mathematically elegant but often overstated; it does not by itself prove the need for deposit insurance or central-bank backstops. Pre-Fed U.S. instability was worsened by unit banking, note-issuance restrictions, and the artificial scarcity of currency caused by bond-collateral requirements. Canada and Scotland are cited as examples of more stable systems with freer branching and note issuance, suggesting alternative institutional arrangements can work better.

Data Points: Book title: Faustian: The New Deal and the Promise of Recovery, 1933 through 1947 - Selgin discusses the reception of his book on New Deal recovery Publication era for floor-system critique: 2014 (book written shortly after he joined Cato in 2014) - He references his early critique of the ample-reserve/floor system in Floored! Interest on reserves implementation: October 2008 - Selgin says the Fed began violating the legal rate condition when it implemented IOR 1930s Main Street loan losses: about 3% of advances - Historical Main Street program under 13B COVID-era Main Street loss rate so far: 12% of advances - Selgin cites quarterly reports as loans matured Expected eventual COVID-era Main Street losses: about 15% of advances - His projection based on provisions and emerging losses Harvest-season currency demand: seasonal spike - He uses this to explain why inelastic note supply caused crises in the late 19th century Canadian banking crises period: No major bank failures from the 1880s to the Home Bank failure in the 1920s - Used as evidence of stability under freer banking arrangements Scottish stability period: No important Scottish bank failure from 1772 into the 1800s/early 1880s - Cited as another example of robust free banking Main Street facility uptake: Initially very limited, later increased as standards were loosened - Described as evidence the facility had to take on more risk to generate lending

Pivotal Quotes: "it was a mistake to introduce interest on reserves in the first place" — George Selgin: His critique of the Fed’s post-2008 operating framework "it was also arguably necessary... in the heat and wake of the great financial crisis" — Selgin quoting a paper he disputes: He rejects the claim that IOR was justified by the crisis "the banks weren't overlooking good lending prospects" — George Selgin: His assessment of why the Main Street lending facilities underperformed

Implications: The episode reinforces pressure to shrink the Fed’s balance sheet, rethink reserve frameworks, and avoid turning emergency lending into a routine substitute for private markets. It also challenges standard panic-based justifications for Fed intervention.