The Credit Crunch of 1966: An Instructive 50th Anniversary

It's the 50th anniversary of the Credit Crunch of 1966, which roiled financial markets in August and September of that year. Group financial memory fades, so if you don't know or remember that there was such a crunch, searing at the time, you are not alone. Yet it taught an essential lesson, again being re-learned right now, 50 years later: the Federal Reserve, and central banks in general, simply do not know what the right interest rate is.

Central to the events of 1966 was that the Federal Reserve set the maximum interest rates that banks could pay on their deposits. This was the Fed's now long gone but then critical "Regulation Q" authority, at the time considered an essential part of the banking system.

As of July, 1966, the Fed had set the interest rate ceiling on savings deposits at 4%. For so-called "multiple maturity" time deposits (where withdrawal was at the depositor's notice) it was 4% for a minimum maturity of up to 89 days, and 5% for 90 days or more. For fixed maturity date time deposits, the ceiling was 5.5%. In September, that was dropped to 5%, except that deposits of more than $100,000 (that's $743,000 in 2016 dollars) could still get 5.5%.

How did the Fed know those numbers were right? They didn't-- as events demonstrated. Most of the time over the preceding decades they had set the ceilings higher than market interest rates, so it generally hadn't been an issue.

But in 1966, there was strong credit demand from an extended economic expansion plus inflationary pressure from the Vietnam War and "Great Society" deficits. Interest rates in the open market went up a lot more than before. Three-month Treasury bill yields got to 5.59%, federal funds to 5.77%, commercial paper rates to 6%. Market rates on negotiable CDs went over the ceilings. "The prime rate briefly reached the then unheard of level of 6%," wrote financial economist Albert Wojnilower. [link: "The Central Role of Credit Crunches in Recent Financial History," 1980] A 6% prime rate was the highest it had been in more than 30 years.

This time the Fed refused to raise the ceilings in line with the market. This in part reflected political pressure to limit competition for deposits in order to favor savings and loan institutions, which were stuck with long-term mortgages at low fixed rates. Lending long and borrowing short was already dangerous in 1966.

Naturally, in response, people took their money out of both banks and savings and loans and put it into higher-yielding conservative investments, a perfectly sensible thing to do. This process had a cumbersome name at the time: "disintermediation"-a problem created entirely by regulation. Unable to expand their funding, the banks cut back on their loans. The savings and loans cut way back on their mortgage loans. "For most people, residential mortgage money was unobtainable...there was a sharp slump in mortgage loans and housing starts," said The New York Times.

Banks also cut back on their previously expanding investments, notably in municipal bonds. Both banks and savings and loans worried about their ability to fund their existing balance sheets. "There was distress liquidation and extreme pressure on the money market," wrote Sidney Homer in his History of Interest Rates. The theoretician of financial crises, Hyman Minsky, summed it up: "By the end of August, the disorganization in the municipals market, rumors about the solvency and liquidity of savings institutions, and the frantic [funding] efforts by money-center banks generated what can be characterized as a controlled panic." Not allowed to bid competitive rates for deposits, according to the St. Louis Fed's history of the crunch, "Banks had never before experienced a large outflow of time deposits."

So the Fed fixed prices and the result was the credit crunch. Following Wojnilower's colorful account: "Lending to all but the most established and necessitous customers was halted abruptly. Chief executives of leading banks reportedly were humbled to the point of pleading with their counterparts in industry to renew their CDs." Further, in order to the raise needed funds there was "the apparent inevitability of massive distress sales of long-term assets into a paralyzed marketplace."

Who came to the rescue? The cause of the problem. "The gravity of the situation penetrated to an initially incredulous Federal Reserve," Wojnilower continued, and banks were invited to borrow at the discount window in the face of "the very lively fears that major banks might have to close their doors."

The shock of the unexpected credit crunch led the Fed into "a long-lasting series of private and public reassurances that no such crisis would ever be permitted to recur." But it did recur, and soon. The next credit crunch, more severe, came in 1969, only three years later. As another St. Louis Fed paper observed at the time, "market interest rates have soared to levels never before reached in this country," but "rates on deposits at banks and other financial institutions have been held much lower." By the Fed, of course. The authors of Regulation Q had a really bad idea, based on the false assumption that the Fed would somehow know the right answer.

But the Fed did not know what the right interest rate was in 1966, or 1969-nor do they know it now. They never have and cannot know it. Put not your faith in their demonstrably dubious "expertise."