bernanke depression research by moredaze


									             Nonmonetary Effects of the Financial Crisis in the
                 Propagation of the Great Depression

                                             By BEN S. BERNANKE*

   During 1930-33, the U.S. financial system                        clines, and that sources of financial panics
experienced conditions that were among the                          unconnected with the fall in U.S. output
most difficult and chaotic in its history.                          have been documented by many writers. (See
Waves of bank failures culminated in the                            Section IV below.)
shutdown of the banking system (and of a                               Among explanations that emphasize the
number of other intermediaries and markets)                         opposite direction of causality, the most
in March 1933. On the other side of the                             prominent is the one due to Friedman and
ledger, exceptionally high rates of default                         Schwartz. Concentrating on the difficulties
and bankruptcy affected every class of bor-                         of the banks, they pointed out two ways in
rower except the federal government.                                which these worsened the general economic
   An interesting aspect of the general finan-                      contraction: first, by reducing the wealth of
cial crises—most clearly, of the bank failures                      bank shareholders; second, and much more
—was their coincidence in timing with ad-                           important, by leading to a rapid fall in the
verse developments in the macroeconomy.1                            supply of money. There is much support for
Notably, an apparent attempt at recovery                            the monetary view. However, it is not a
from the 1929-30 recession2 was stalled at                          complete explanation of the link between the
the time of the first banking crisis (Novem-                        financial sector and aggregate output in the
ber-December 1930); the incipient recovery                          1930's. One problem is that there is no the-
degenerated into a new slump during the                             ory of monetary effects on the real economy
mid-1931 panics; and the economy and the                            that can explain protracted nonneutrality.
financial system both reached their respec-                         Another is that the reductions of the money
tive low points at the time of the bank "holi-                      supply in this period seems quantitatively
day" of March 1933. Only with the New                               insufficient to explain the subsequent falls in
Deal's rehabilitation of the financial system                       output. (Again, see Section IV.)
in 1933—35 did the economy begin its slow                              The present paper builds on the Fried-
emergence from the Great Depression.                                man-Schwartz work by considering a third
   A possible explanation of these synchro-                         way in which the financial crises (in which
nous movements is that the financial system                         we include debtor bankruptcies as well as the
simply responded, without feedback, to the                          failures of banks and other lenders) may
declines in aggregate output. This is con-                          have affected output. The basic premise is
tradicted by the facts that problems of the                         that, because markets for financial claims are
financial system tended to lead output de-                          incomplete, intermediation between some
                                                                    classes of borrowers and lenders requires
                                                                    nontrivial market-making and information-
    * Stanford Graduate School of Business and Hoover               gathering services. The disruptions of 1930-
Institution. I received useful comments from too many               33 (as I shall try to show) reduced the ef-
people to list here by name, but I am grateful to each of           fectiveness of the financial sector as a whole
them. The National Science Foundation provided par-                 in performing these services. As the real costs
tial research support.
      This is documented more carefully in Sections I.C             of intermediation increased, some borrowers
and IV below.                                                       (especially households, farmers, and small
      This paper does not address the causes of the initial         firms) found credit to be expensive and dif-
1929-30 downturn. Milton Friedman and Anna                          ficult to obtain. The effects of this credit
Schwartz (1963) have stressed the importance of the                 squeeze on aggregate demand helped convert
Federal Reserve's "anti-speculative" monetary tight-
ening. Others, such as Peter Temin (1976), have pointed             the severe but not unprecedented downturn
out autonomous expenditure effects.                                 of 1929-30 into a protracted depression.
258                                    THE AMERICAN ECONOMIC REVIEW                                   JUNE 1983

    It should be stated at the outset that my               the real costs of credit intermediation, the
 theory does not offer a complete explanation               focus of the present work.
 of the Great Depression (for example, noth-                   The paper is organized as follows: Section
 ing is said about 1929-30). Nor is it neces-               I presents some background on the 1930-33
 sarily inconsistent with some existing ex-                 financial crisis, its sources, and its correspon-
 planations.3 However, it does have the virtues             dence with aggregate output movements.
 that, first, it seems capable (in a way in                 Section II begins the principal argument of
 which existing theories are not) of explaining             the paper. I explain how the runs on banks
 the unusual length and depth of the depres-                and the extensive defaults could have re-
 sion; and, second, it can do this without                  duced the efficiency of the financial sector in
 assuming markedly irrational behavior by                   performing its intermediary functions. Some
 private economic agents. Since the reconcili-              evidence of these effects is introduced.
 ation of the obvious inefficiency of the de-                  Possible channels by which reduced finan-
 pression with the postulate of rational private            cial efficiency might have affected output are
 behavior remains a leading unsolved puzzle                 discussed in Section III. Reduced-form
 of macroeconomics, these two virtues alone                 estimation results, reported in Section IV,
 provide motivation for serious consideration               suggest that augmenting a purely monetary
 of this theory.                                            approach by my theory significantly im-
    There do not seem to be any exact antece-               proves the explanation of the financial sec-
 dents of the present paper in the formal                   tor-output connection in the short run. Sec-
 economics literature.4 The work of Lester                  tion V looks at the persistence of these
 Chandler (1970, 1971) provides the best his-               effects.
 torical discussions of the general financial                  Some international aspects of the financial
 crisis extant; however, he does not develop                sector-aggregate output link are briefly dis-
very far the link to macroeconomic perfor-                  cussed in Section VI and Section VII con-
 mance. Beginning with Irving Fisher (1933)                 cludes.
 and A. G. Hart (1938), there is a literature
on the macroeconomic role of inside debt;                      I. The Financial Collapse: Some Background
 an interesting recent example is the paper by
 Frederic Mishkin (1978), which stresses                       The problems faced by the U.S. financial
household balance sheets and liquidity. Ben-                system between October 1930 and March
jamin Friedman (1981) has written on the                     1933 have been described in detail by earlier
relationship of credit and aggregate activity.              authors,6 but it will be useful to recapitulate
Hyman Minsky (1977) and Charles Kindle-                     some principal facts here. Given this back-
berger (1978) have in several places argued                 ground, attention will be turned to the more
for the inherent instability of the financial               central issues of the paper.
system, but in doing so have had to depart                     The two major components of the finan-
from the assumption of rational economic                    cial collapse were the loss of confidence in
behavior.5 None of the above authors has                    financial institutions, primarily commercial
emphasized the effects of financial crisis on               banks, and the widespread insolvency of
                                                            debtors. I give short discussions of each of
                                                            these components and of their joint relation
      See Karl Brunner (1981) for a useful overview of      to aggregate fluctuations.
contemporary theories of the depression. Also, see
Robert Lucas and Leonard Rapping's article in Lucas
(1981).                                                        A. The Failure of Financial Institutions
     This is especially true of the more recent work,
which tends to ignore the nonmonetary effects of the           Most financial institutions (even semipub-
financial crisis. Older writers often seemed to take the    lic ones, like the Joint Stock Land Banks)
disruptive impact of the financial breakdown for granted.   came under pressure in the 1930's. Some,
     I do not deny the possible importance of irrational-
ity in economic life; however, it seems that the best
research strategy is to push the rationality postulate as       See especially Chandler (1970, 1971) and Friedman
far as it will go.                                          and Schwartz.
VOL. 73 NO. 3                            BERNANKE: GREAT DEPRESSION                                                259

 such as the insurance companies and the                      petition between the state and national bank-
 mutual savings banks, managed to maintain                    ing systems for member banks also tended to
 something close to normal operations. Others,                keep the legal barriers to entry in banking
 like the building-and-loans (which, despite                  very low.10 In this sort of environment, a
 their ability to restrict withdrawals by de-                 significant number of failures was to be ex-
positors, failed in significant numbers) were                 pected and probably was even desirable.
greatly hampered in their attempts to carry                   Failures due to "natural causes" (such as the
on their business.7 Of most importance, how-                  agricultural depression of the 1920's upon
ever, were the problems of the commercial                     which many small, rural banks foundered)
banks. The significance of the banking diffi-                 were common.11
culties derived both from their magnitude                        Besides the simple lack of economic viabil-
and from the central role commercial banks                    ity of some marginal banks, however, the
played in the financial system.8                              U.S. system historically suffered also from a
    The great severity of the banking crises in               more malign source of bank failures; namely,
the Great Depression is well known to stu-                    financial panics. The fact that liabilities of
dents of the period. The percentages of oper-                 banks were principally in the form of fixed-
ating banks which failed in each year from                    price, callable debt (i.e., demand deposits),
 1930 to 1933 inclusive were 5.6, 10.5, 7.8,                  while many assets were highly illiquid,
and 12.9; because of failures and mergers,                    created the possibility of the perverse expec-
the number of banks operating at the end of                   tational equilibrium known as a "run" on
 1933 was only just above half the number                     the banks. In a run, fear that a bank may fail
that existed in 1929.9 Banks that survived                    induces depositors to withdraw their money,
experienced heavy losses.                                     which in turn forces liquidation of the bank's
    The sources of the banking collapse are                   assets. The need to liquidate hastily, or to
best understood in the historical context. The                dump assets on the market when other banks
first point to be made is that bank failures                  are also liquidating, may generate losses that
were hardly a novelty at the time of the                      actually do cause the bank to fail. Thus the
depression. The U.S. system, made up as it                    expectation of failure, by the mechanism of
was primarily of small, independent banks,                    the run, tends to become self-confirming.12
had always been particularly vulnerable.                         An interesting question is why banks at
(Countries with only a few large banks, such                  this time relied on fixed-price demand de-
as Britain, France, and Canada, never had                     posits, when alternative instruments might
banking difficulties on the American scale.)                  have reduced or prevented the problem of
The dominance of small banks in the United                    runs.13 An answer is provided by Friedman
States was due in large part to a regulatory                  and Schwartz: They pointed out that, before
environment which reflected popular fears of                  the establishment of the Federal Reserve in
large banks and "trusts"; for example, there                  1913, panics were usually contained by the
were numerous laws restricting branch bank-                   practice of suspending convertibility of bank
ing at both the state and national level. Com-                deposits into currency. This practice, typi-
                                                              cally initiated by loose organizations of urban
      Hart describes the problems of the building-and-
loans. An interesting sidelight here is the additional              Benjamin Klebaner (1974) gives a good brief his-
strain on housing lenders caused by the existence of the      tory of U.S. commercial banking.
Postal Savings System; see Maureen O'Hara and David                 Upham and Lamke, p. 247, report that approxi-
Easley(1979).                                                 mately 2-3 percent of all banks in operation failed in
      According to Raymond Goldsmith (1958), commer-          each year of the 1920's.
cial banks held 39.6 percent of the assets of all financial         Douglas Diamond and Philip Dybvig (1981) for-
intermediaries, broadly defined, in 1929. See his Table       malize this argument. For an alternative analysis of the
11.                                                           phenomenon of runs, see Robert Flood and Peter Garber
      Cyril Upham and Edwin Lamke (1934, p. 247).             (1981).
Since smaller banks were more likely to fail, the fraction          For example, equity-like instruments, such as those
of deposits represented by suspended banks was some-          used by modern money-market mutual funds, could
what less. Eventual recovery by depositors was about 75       have been used as the transactions medium. See Ken-
percent; see Friedman and Schwartz, p. 438.                   neth Cone (1982).
260                               THE AMERICAN ECONOMIC REVIEW                                      JUNE 1983

banks called clearinghouses, moderated the            insolvency. Given that debt contracts were
dangers of runs by making hasty liquidation           written in nominal terms,15 the protracted
unnecessary. In conjunction with the suspen-          fall in prices and money incomes greatly
sion of convertibility practice, the use of           increased debt burdens. According to Evans
demand deposits created relatively little in-         Clark (1933), the ratio of debt service to
stability.14                                          national income went from 9 percent in 1929
   However, with the advent of the Federal            to 19.8 percent in 1932-33. The resulting
Reserve (according to Friedman-Schwartz),             high rates of default caused problems for
this roughly stable institutional arrangement         both borrowers and lenders.
was upset. Although the Federal Reserve in-              The "debt crisis" touched all sectors. For
troduced no specific injunctions against the          example, about half of all residential proper-
suspension of convertibility, the clearing-           ties were mortgaged at the beginning of the
houses apparently felt that the existence of          Great Depression; according to the Financial
the new institution relieved them of the re-          Survey of Urban Housing (reported in Hart),
sponsibility of fighting runs. Unfortunately,         as of January 1, 1934,
the Federal Reserve turned out to be unable
or unwilling to assume this responsibility.                  The proportion of mortgaged
   No serious runs occurred between World                 owner-occupied houses with some in-
War I and 1930; but the many pieces of bad                terest or principal in default was in
financial news that came in from around the               none of the twenty-two cities [surveyed]
world in 1930-32 were like sparks around                  less than 21 percent (the figure for
tinder. Runs were clearly an important part               Richmond, Virginia); in half it was
                                                          above 38 percent; in two (Indianapolis
of the banking problems of this period. Some              and Birmingham, Alabama) between 50
evidence emerges from contemporary ac-                    percent and 60 percent; and in one
counts, including descriptions of specific                (Cleveland), 62 percent. For rented
events precipitating runs. Also notable is the            properties, percentages in default ran
fact that bank failures tended to occur in                slightly higher. [p. 164]
short spasms, rather than in a steady stream
(see Table 1, col. 2, for monthly data on the            Because of the long spell of low food
deposits of failing banks). The problem was           prices, farmers were in more difficulty than
not arrested until government intervention            homeowners. At the beginning of 1933,
became important in late 1932 and early               owners of 45 percent of all U.S. farms, hold-
1933.                                                 ing 52 percent of the value of farm mortgage
   We see, then, that the banking crises of the       debt, were delinquent in payments (Hart, p.
early 1930's differed from earlier recorded           138). State and local governments—many of
experience both in magnitude and in the               whom tried to provide relief for the unem-
degree of danger posed by the phenomenon              ployed—also had problems paying their
of runs. The result of this was that the behav-       debts: As of March 1934, the governments of
ior of almost the entire system was adversely         37 of the 310 cities with populations over
affected, not just that of marginal banks. The        30,000 and of three states had defaulted on
bankers' fear of runs, as I shall argue below,        obligations (Hart, p. 225).
had important macroeconomic effects.                     In the business sector, the incidence of
                                                      financial distress was very uneven. Aggregate
         B. Defaults and Bankruptcies                 corporate profits before tax were negative in
                                                      1931 and 1932, and after-tax retained earn-
   The second major aspect of the financial           ings were negative in each year from 1930 to
crisis (one that is currently neglected by            1933 (Chandler, 1971, p. 102). But the subset
historians) was the pervasiveness of debtor
                                                            Finding an explanation for the lack of indexed debt
     Diamond and Dybvig derive this point formally,   during the deflationary 1930's—as in the inflationary
with some caveats.                                    1970's—is a point on which I stumble.
VOL. 73 NO. 3                    BERNANKE: GREAT DEPRESSION                                            261

of corporations holding more than $50 mil-         facilitated by the monthly data in Table 1.
lion in assets maintained positive profits         Column 1 is an index of real industrial pro-
throughout this period, leaving the brunt to       duction. Columns 2 and 3 are the (nominal)
be borne by smaller companies. Solomon             liabilities of failing banks and nonbank com-
Fabricant (1935) reported that, in 1932 alone,     mercial businesses, respectively.
the losses of corporations with assets of             The industrial production series reveals
$50,000 or less equalled 33 percent of total       that a recession began in the United States
capitalization; for corporations with assets in    during 1929. By late 1930, the downturn,
the $50,000-$100,000 range, the comparable         although serious, was still comparable in
figure was 14 percent. This led to high rates     magnitude to the recession of 1920-22; as
of failure among small firms.                      the decline slowed, it would have been rea-
   Although the deflation of the 1930's was       sonable to expect a brisk recovery, just as in
unusually protracted, there had been a simi-       1922.
lar episode as recently as 1921-22 which had          With the first banking crisis, however, there
not led to mass insolvency. The seriousness       came what Friedman and Schwartz called a
of the problem in the Great Depression was        "change in the character of the contraction"
due not only to the extent of the deflation,      (p. 311). The economy first flattened out,
but also to the large and broad-based expan-      then went into a new tailspin just as the
sion of inside debt in the 1920's. Charles        banks began to fail again in June 1931.
Persons surveyed the credit expansion of the          A lengthy slide of both the general econ-
predepression decade in a 1930 article: He        omy and the financial system followed. The
reported that outstanding corporate bonds         banking situation calmed in early 1932, and
and notes increased from $26.1 billion in         nonbank failures peaked shortly thereafter.
1920 to $47.1 billion in 1928, and that non-      A new recovery attempt began in August,
federal public securities grew from $11.8 bil-    but failed within a few months.16 In March
lion to $33.6 billion over the same period.       1933, the bottom was reached for both the
(This may be compared with a 1929 national        financial system and the economy as a whole.
income of $86.8 billion.) Perhaps more sig-       Measures taken after the banking holiday
nificantly, during the 1920's, small bor-         ended the bank runs and greatly reduced the
rowers, such as households and unincor-           burden of debt. Simultaneously aggregate
porated businesses, greatly increased their       output began a recovery that was sustained
debts. For example, the value of urban real       until 1937.
estate mortgages outstanding increased from           The leading explanation of the correlation
$11 billion in 1920 to $27 billion in 1929,       between the conditions of the financial sec-
while the growth of consumer installment          tor and of the general economy is that of
debt reflected the introduction of major con-     Friedman and Schwartz, who stressed the
sumer durables to the mass market.                effects of the banking crises on the supply of
   Like the banking crises, then, the debt        money. I agree that money was an important
crisis of the 1930's was not qualitatively a      factor in 1930-33, but, because of reserva-
new phenomenon; but it represented a break        tions cited in the introduction, I doubt that it
with the past in terms of its severity and        completely explains the financial sector-
pervasiveness.                                    aggregate output connection. This motivates

    C. Correlation of the Financial Crisis           16
                                                       Judging by Table 1. the failure of this recovery
       with Macroeconomic Activity                seems to be unrelated to financial sector difficulties.
                                                  However, accounts from the time suggest that the bank-
   The close connection of the stages of the      ing crisis of late 1932 and early 1933 (which ended in
financial crisis (especially the bank failures)   the banking holiday) was in fact quite severe; see Susan
                                                  Kennedy (1973). The relatively low reported rate of
with changes in real output has been noted        bank failures at this time may be an artifact of state
by Friedman and Schwartz and by others.           moratoria, restrictions on withdrawals, and other in-
An informal review of this connection is          terventions.
262                                   THE AMERICAN ECONOMIC REVIEW                                   JUNE 1983

                         TABLE 1—SELECTED MACROECONOMIC DATA, JULY 1 9 2 9 - M A R C H    1933

Month              IP               Banks             Fails             L/IP             L/DEP        DIF

 1929J             114               60.8             32.4               .163              .851      2.31
      A            114                 6.7            33.7               .007              .855      2.33
      S            112                 9.7            34.1               .079              .860      2.33
      O            110                12.5            31.3               .177              .865      2.50
      N            105               22.3             52.0               .121              .854      2.68
      D            100                15.5            62.5             -.214               .851      2.59
 1930J             100               26.5             61.2             -.228               .837      2.49
      F            100               32.4             51.3             -.102               .834      2.48
      M            98                23.2             56.8               .076              .835      2.44
      A            98                31.9             49.1               .058             .826       2.33
      M            96                19.4             55.5             -.028              .820       2.41
      J            93                57.9             63.1               .085             .818       2.53
      J            89                29.8             29.8             -.055              .802       2.52
      A            86                22.8             49.2             -.027              .800       2.47
      S            85                21.6             46.7               .008             .799       2.41
      O            83                19.7             56.3             -.010              .791       2.73
      N            81               179.9             55.3             -.067              .111       3.06
      D            79               372.1             83.7             -.144              .775       3.49
 1931J             78                75.7             94.6             -.187              .763       3.21
      F            79                34.2             59.6             -.144              .747       3.08
      M            80                34.3             60.4             -.043              .738       3.17
      A            80                41.7             50.9             -.104              .722       3.45
      M            80                43.2             53.4             -.133              .706       3.99
      J            77               190.5             51.7             -.120              .707       4.23
      J            76                40.7             61.0             -.013              .704       3.93
      A            73               180.0             53.0             -.103              .706       4.29
      S            70               233.5             47.3             -.050              .713       4.82
      O            68               471.4             70.7             -.310              .716       5.41
      N            67                67.9             60.7             -.101              .726       5.30
      D            66               277.1             73.2             -.120              .732       6.49
1932J              64               218.9             96.9             -.117              .745       4.87
      F            63                51.7             84.9             -.138              .757       4.76
      M            62                10.9             93.8             -.183              .744       4.91
      A            58                31.6            101.1             -.225              .718       6.78
      M            56                34.4             83.8             -.154              .696       7.87
      J            54               132.7             76.9             -.170              .689       7.93
      J            53                48.7             87.2             -.219              .677       7.21
      A            54                29.5             77.0             -.130              .662       4.77
      S            58                13.5             56.1             -.091              .641       4.19
      0            60                20.1             52.9             -.095              .623       AM
      N            59                43.3             53.6             -.133              .602       4.79
      D            58                70.9             64.2             -.039              .596       5.07
1933J              58               133.1             79.1             -.139              .576       4.79
      F            57                62.2             65.6             -.059              .583       4.09
      M            54              3276.3a            48.5             -.767a             .607 a     4.03

Notes: IP = seasonally adjusted index of industrial production, 1935-39 = 100; Federal Reserve Bulletin.
    Banks = deposits of failing banks, $millions; Federal Reserve Bulletin.
     Fails = liabilities of failing commercial businesses, $millions; Survey of Current Business.
    L/PI= ratio of net extensions of commercial bank loans to (monthly) personal income; from Banking and
             Monetary Statistics and National Income.
     L/D= ratio of loans outstanding to the sum of demand and time deposits, weekly reporting banks; Banking and
            Monetary Statistics.
      DIF= difference (in percentage points) between yields on Baa corporate bonds and long-term U.S. government
            bonds; Banking and Monetary Statistics.
    A national bank holiday was declared in March 1933.
VOL. 73 NO. 3                         BERNANKE: GREAT DEPRESSION                                            263

my study of a nonmonetary channel through               governments or corporations on well-orga-
which an additional impact of the financial             nized exchanges. One of the options savers
crisis may have been felt.                              have is to lend resources to a banking sys-
                                                        tem. The banks also have a menu of different
        II. The Effect of the Crisis on the Cost        assets to choose from. Assume, however, that
               of Credit Intermediation                 banks specialize in making loans to small,
                                                        idiosyncratic borrowers whose liabilities are
   This paper posits that, in addition to its           too few in number to be publicly traded.
effects via the money supply, the financial             (Here is where the complete-markets as-
crisis of 1930-33 affected the macroeconomy             sumption is dropped.)
by reducing the quality of certain financial               The small borrowers to whom the banks
services, primarily credit intermediation. The          lend will be taken, for simplicity, to be of
basic argument is to be made in two steps.              two extreme types, "good" and "bad." Good
First, it must be shown that the disruption of          borrowers desire loans in order to undertake
the financial sector by the banking and debt            individual-specific investment projects. These
crises raised the real cost of intermediation           projects generate a random return from a
between lenders and certain classes of bor-             distribution whose mean will be assumed
rowers. Second, the link between higher in-             always to exceed the social opportunity cost
termediation costs and the decline in aggre-            of investment. If this risk is nonsystematic,
gate output must be established. I present              lending to good borrowers is socially desir-
here the first step of the argument, leaving            able. Bad borrowers try to look like good
the second to be developed in Sections III-V.           borrowers, but in fact they have no "project."
   In order to discuss the quality of perfor-           Bad borrowers are assumed to squander any
mance of the financial sector, I must first             loan received in profligate consumption, then
describe the real services that the sector is           to default. Loans to bad borrowers are so-
supposed to provide. The specification of               cially undesirable.
these services depends on the model of the                 In this model, the real service performed
economy one has in mind. We shall clearly               by the banking system is the differentiation
not be interested in economies of the sort              between good and bad borrowers.18 For a
described by Eugene Fama (1980), in which               competitive banking system, I define the cost
financial markets are complete and informa-             of credit intermediation (CCI) as being the
tion/transactions costs can be neglected. In            cost of channeling funds from the ultimate
such a world, banks and other intermediaries            savers/lenders into the hands of good bor-
are merely passive holders of portfolios.               rowers. The CCI includes screening, moni-
Banks' choice of portfolios or the scale of the         toring, and accounting costs, as well as the
banking system can never make any dif-                  expected losses inflicted by bad borrowers.
ference in this case, since depositors can              Banks presumably choose operating proce-
offset any action taken by banks through                dures that minimize the CCI. This is done by
private portfolio decisions.17                          developing expertise at evaluating potential
   As an alternative to the Fama complete-              borrowers; establishing long-term relation-
markets world, consider the following stylized          ships with customers; and offering loan con-
description of the economy. Let us suppose              ditions that encourage potential borrowers to
that savers have many ways of transferring              self-select in a favorable way.19
resources from present to future, such as                  Given this simple paradigm, I can describe
holding real assets or buying the liabilities of        the effects of the two main components of

   17                                                      18
     It should be noted that the phenomena emphasized         To concentrate on credit intermediation, I neglect
by Friedman and Schwartz—the effects of the contrac-    the transactions and other services performed by banks.
tion of the banking system on the quantity of the             See Dwight Jaffee and Thomas Russell (1976) and
transactions medium and on real output—are also im-     Joseph Stiglitz and Andrew Weiss (1981) on the way
possible in a complete-markets world.                   banks induce favorable borrower self-selection.
264                                 THE AMERICAN ECONOMIC REVIEW                                       JUNE 1983

the financial crisis on the efficiency of the           bank credit, the monthly change in bank
credit allocation process (i.e., on the CCI).           loans outstanding, normalized by monthly
                                                        personal income.22 One might have expected
  A. Effect of the Banking Crises on the CCI            the loan-change-to-income ratio to be driven
                                                        primarily by loan demand and thus by the
   The banking problems of 1930-33 dis-                 rate of production. Comparison with the first
rupted the credit allocation process by creat-          two columns of Table 2 shows, however, that
ing large, unplanned changes in the channels            the banking crises were as important a de-
 of credit flow. Fear of runs led to large              terminant of this variable as output. For
withdrawals of deposits, precautionary in-              example, except for a brief period of liquida-
creases in reserve-deposit ratios, and an in-           tion of speculation loans after the stock
creased desire by banks for very liquid or              market crash, credit outstanding declined
rediscountable assets. These factors, plus the          very little before October 1930—this despite
actual failures, forced a contraction of the            a 25 percent fall in industrial production that
banking system's role in the intermediation             had occurred by that time. With the first
of credit.20 Some of the slack was taken up             banking crisis of November 1930, however, a
by the growing importance of alternative                long period of credit contraction was ini-
channels of credit (see below). However, the            tiated. The shrinkage of credit shared the
rapid switch away from the banks (given the             rhythm of the banking crises; for example, in
banks' accumulated expertise, information,              October 1931, the worst month for bank
and customer relationships) no doubt im-                failure before the bank holiday, net credit
paired financial efficiency and raised the              reduction was a record 31 percent of per-
CCI.21                                                  sonal income.23
   It would be useful to have a direct mea-                The fall in bank loans after November
sure of the CCI; unfortunately, no really               1930 was not simply a balance sheet reflec-
satisfactory empirical representation of this           tion of the decline in deposits. Column 5 in
concept is available. Reported commercial               Table 1 gives the monthly ratio of outstand-
loan rates reflect loans that are actually made,        ing bank loans to the sum of demand and
not the shadow cost of bank funds to a                  time deposits. This ratio declined sharply as
representative potential borrower; since                banks switched out of loans and into more
banks in a period of retrenchment make only             liquid investments.
the safest and highest-quality loans, mea-                 The perception that the banking crises and
sured loan rates may well move inversely to             the associated scrambles for liquidity exerted
the CCI. I obtained a number of interesting             a deflationary force on bank credit was
results using the yield differential between            shared by writers of the time. A 1932 Na-
Baa corporate bonds and U.S. government                 tional Industrial Conference Board survey of
bonds as a proxy for the CCI; however, the
use of the Baa rate is not consistent with my
story that bank borrowers are those whose                  22
                                                              In the construction of the bank loans series, data
liabilities are too few to be publicly traded.          from weekly reporting member banks (which held about
   While we cannot observe directly the ef-             40 percent of all bank loans) were used to interpolate
                                                        between less frequent aggregate observations. N o t e that,
fects of the banking troubles on the CCI, we            for our purposes, looking at the change in loans is
can see their impact on the extension of bank           preferable to considering the stock of real loans out-
credit: Table 1 gives some illustrative data.           standing: In a regime of nominally contracted debt and
Column 4 gives, as a measure of the flow of             sharp unanticipated deflation, stability of the stock of
                                                        real debt does not signal a comfortable situation for
   20                                                      23
      For an interesting contemporary account of this         The effect of bank failures o n credit outstanding is
process, see the article by Eugene H. Burris in the     somewhat exaggerated by the fact that the credit con-
American Banker, October 15, 1931.                      traction measure includes the loans of suspending banks
      Since intermediation resources could have been    that were not transferred to other banks; however, I
shifted out of the beleaguered banking sector (given    estimate that this accounting convention is responsible
enough time), mine is basically a costs-of-adjustment   for less than one-eighth of the total (measured) credit
argument.                                               contraction between October 1930 and February 1933.
VOL. 73 NO. 3                    BERNANKE: GREAT DEPRESSION                                   265

credit conditions reported that "During 1930,      creditor and defaulted debtor make the pay-
the shrinkage of commercial loans no more          ments to third parties (lawyers, administra-
than reflected business recession. During          tors) that these proceedings entail, instead of
 1931 and the first half of 1932 (the period       somehow agreeing to divide those payments
studied), it unquestionably represented pres-      between themselves? In a complete-markets
sure by banks on customers for repayment of        world, bankruptcy would never be observed;
loans and refusal by banks to grant new            this is because complete state-contingent loan
loans" (p. 28). Other contemporary sources         agreements would uniquely define each
tended to agree (see, for example, Chandler,       party's obligations in all possible circum-
1971, pp. 233-39, for references).                 stances, rendering third-party arbitration un-
   Two other observations about the contrac-       necessary. That we do observe bankruptcies,
tion of bank credit can be made. First, the        in our incomplete-markets world, suggests
class of borrowers most affected by credit         that creditors and debtors have found the
reductions were households, farmers, unin-         combination of simple loan arrangements
corporated businesses, and small corpora-          and ex post adjudication by bankruptcy
tions; this group had the highest direct or        (when necessary) to be cheaper than attempt-
indirect reliance on bank credit. Second, the      ing to write and enforce complete state-con-
contraction of bank credit was twice as large      tingent contracts.
as that of other major countries, even those          To be more concrete, let us use the "good
which experienced comparable output de-            borrower-bad borrower" example. In writing
clines (Klebaner, p. 145).                         a loan contract with a potential borrower,
   The fall in bank loans outstanding was          the bank has two polar options. First, it
partly offset by the relative expansion of         might try to approximate the complete
alternative forms of credit. In the area of        state-contingent contract by making the bor-
consumer finance, retail merchants, service        rower's actions part of the agreement and by
creditors, and nonbank lending agencies im-        allowing repayment to depend on the out-
proved their position relative to banks and        come of the borrower's project. This con-
primarily bank-supported installment fi-           tract, if properly written and enforced, would
nance companies (Rolf Nugent, 1939, pp.            completely eliminate the possibility of either
114-16). Small firms during this period sig-       side not being able to meet its obligations;
nificantly reduced their traditional reliance      its obvious drawback is the cost of monitor-
on banks in favor of trade credit (Charles         ing which it involves. The bank's other op-
Merwin, 1942, pp. 5 and 75). But, as argued        tion is to write a very simple agreement
above, in a world with transactions costs and      ("payment of such-amount to be made on
the need to discriminate among borrowers,          such-date"), then to make the loan only if it
these shifts in the loci of credit intermedia-     believes that the borrower is likely to repay.
tion must have at least temporarily reduced        The second approach usually dominates the
the efficiency of the credit allocation process,   first, of course, especially for small bor-
thereby raising the effective cost of credit to    rowers.
potential borrowers.                                  A device which makes the cost advantage
                                                   of the simpler approach even greater is the
  B. The Effect of Bankruptcies on the CCI         use of collateral. If the borrower has wealth
                                                   that can be attached by the bank in the event
                                                   of nonpayment, the bank's risk is low. More-
  I turn now to a brief discussion of the          over, the threat of loss of collateral provides
impact of the increase in defaults and bank-       the right incentives for borrowers to use loans
ruptcies during this period on the cost of         only for profitable projects. Thus, the combi-
credit intermediation.                             nation of collateral and simple loan contracts
  The very existence of bankruptcy proceed-        helps to create a low effective CCI.
ings, rather than being an obvious or natural         A useful way to think of the 1930-33 debt
phenomenon, raises deep questions of eco-          crisis is as the progressive erosion of bor-
nomic theory. Why, for example, do the             rowers' collateral relative to debt burdens.
266                             THE AMERICAN ECONOMIC REVIEW                             JUNE 1983

As the representative borrower became more          bonds (Table 1, column 6). Because this vari-
and more insolvent, banks (and other lenders        able contains no adjustment for the reclassi-
as well) faced a dilemma. Simple, noncontin-        fication of firms into higher risk categories, it
gent loans faced increasingly higher risks of       tends to understate the true difference in
default; yet a return to the more complex          yields between representative risky and safe
type of contract involved many other costs.        assets. Nevertheless, this indicator showed
Either way, debtor insolvency necessarily          some impressive shifts, going from 2.5 per-
raised the CCI for banks.                          cent during 1929-30 to nearly 8 percent in
   One way for banks to adjust to a higher         mid-1932. (The differential never exceeded
CCI is to increase the rate that they charge       3.5 percent in the sharp 1920-22 recession.)
borrowers. This may be counterproductive,          The yield differential reflected changing per-
however, if higher interest charges increase       ceptions of default risk, of course; but note
the risk of default. The more usual response       also the close relationship of the differential
is for banks just not to make loans to some        and the banking crises (a fact first pointed
people that they might have lent to in better      out by Friedman and Schwartz). Bank crises
times. This was certainly the pattern in the       depressed the prices of lower-quality invest-
1930's. For example, it was reported that the      ments as the fear of runs drove banks into
extraordinary rate of default on residential       assets that could be used as reserves or for
mortgages forced banks and life insurance          rediscounting. This effect of bank portfolio
companies to "practically stop making mort-        choices on an asset price could not happen in
gage loans, except for renewals" (Hart, p.         a Fama-type, complete-markets world.
163). This situation precluded many bor-               Finally, it is instructive to consider the
rowers, even with good projects, from getting      experience of a country that had a debt crisis
funds, while lenders rushed to compete for         without a banking crisis. Canada entered the
existing high-grade assets. As one writer of       Great Depression with a large external debt,
the time, D. M. Frederiksen, put it:               much of it payable in foreign currencies. The
                                                   combination of deflation and the devalua-
      We see money accumulating at the             tion of the Canadian dollar led to many
   centers, with difficulty of finding safe        defaults. Internally, debt problems in agri-
   investment for it; interest rates drop-         culture and in mortgage markets were as
   ping down lower than ever before;               severe as in the United States, while major
   money available in great plenty for             industries (notably pulp and paper) expe-
   things that are obviously safe, but not         rienced many bankruptcies (A. E. Safarian,
   available at all for things that are in         1959, ch. 7). Although Canadian bankers did
   fact safe, and which under normal con-          not face serious danger of runs, they shifted
   ditions would be entirely safe (and there       away from loans to safer assets. This shift
   are a great many such), but which are           toward safety and liquidity, though less pro-
   now viewed with suspicion by lenders.           nounced than in the U.S. case, drew criticism
                              [1931, p. 139]       from all facets of Canadian society. The
                                                   American Banker of December 6, 1932, re-
As this quote suggests, the idea that the low      ported the following complaint from a non-
yields on Treasury or blue-chip corporation        populist Canadian politician:
liabilities during this time signalled a general
state of "easy money" is mistaken; money
was easy for a few safe borrowers, but dif-              The chief criticism of our present
ficult for everyone else.                             system appears to be that in good times
                                                      credit is expanded to great extremes...
   An indicator of the strength of lender             but, when the pinch of hard times is
preferences for safe, liquid assets (and hence        first being felt, credit is suddenly and
of the difficulty of risky borrowers in ob-           drastically restricted by the banks... At
taining funds) is the yield differential be-          the present time, loans are only being
tween Baa corporate bonds and Treasury                made when the banks have a very wide
VOL. 73 NO. 3                     BERNANKE: GREAT DEPRESSION                                               267

   margin of security and every effort is               These arguments are reminiscent of some
   being made to collect outstanding loans.          ideas advanced by John Gurley and E. S.
   All our banks are reaching out in an              Shaw (1955), Ronald McKinnon (1973), and
   endeavor to liquefy their assets....              others in an economic development context.
                                      [p.l]          The claim of this literature is that immature
                                                     or repressed financial sectors cause the
Canadian lenders other than banks also tried         "fragmentation" of less developed econo-
to retrench: According to the Financial Post,        mies, reducing the effective set of production
May 14, 1932, "Insurance, trust, and loan           possibilities available to the society.
companies were increasingly unwilling to               Did the financial crisis of the 1930's turn
lend funds with real estate and rental values        the United States into a " temporarily under-
falling, a growing number of defaults of            developed economy" (to use Bob Hall's felic-
interest and principal, the increasing burden       itous phrase)? Although this possibility is
of property taxes, and legislation which            intriguing, the answer to the question is
adversely affected creditors" (quoted in            probably no. While many businesses did
Safarian, p. 130).                                  suffer drains of working capital and invest-
   More careful study of the Canadian expe-         ment funds, most larger corporations entered
rience in the Great Depression would be             the decade with sufficient cash and liquid
useful. However, on first appraisal, that ex-       reserves to finance operations and any de-
perience does not seem to be inconsistent           sired expansion (see, for example, Friedrich
with the point that even good borrowers may         Lutz, 1945). Unless it is believed that the
find it more difficult or costly to obtain          outputs of large and of small businesses are
credit when there is extensive insolvency.          not potentially substitutes, the aggregate
The debt crisis should be added to the bank-        supply effect must be regarded as not of
ing crises as a potential source of disruption      great quantitative importance.
of the credit system.                                  The reluctance of even cash-rich corpora-
                                                    tions to expand production during the de-
    III. Credit Markets and Macroeconomic           pression suggests that consideration of the
                 Performance                        aggregate demand channel for credit market
                                                    effects on output may be more fruitful. The
   If it is taken as given that the financial       aggregate demand argument is in fact easy to
crises during the depression did interfere with     make: A higher cost of credit intermediation
the normal flows of credit, it still must be        for some borrowers (for example, households
shown how this might have had an effect on          and smaller firms) implies that, for a given
the course of the aggregate economy.                safe interest rate, these borrowers must face
   There are many ways in which problems in         a higher effective cost of credit. (Indeed, they
credit markets might potentially affect the         may not be able to borrow at all.) If this
macroeconomy. Several of these could be             higher rate applies to household and small
grouped under the heading of "effects on            firm borrowing but not to their saving (they
aggregate supply." For example, if credit           may only earn the safe rate on their savings),
flows are dammed up, potential borrowers in         then the effect of higher borrowing costs is
the economy may not be able to secure funds         unambiguously to reduce their demands for
to undertake worthwhile activities or invest-       current-period goods and services. This pure
ments; at the same time, savers may have to         substitution effect (of future for present con-
devote their funds to inferior uses. Other          sumption) is easily derived from the classical
possible problems resulting from poorly             two-period model of savings.24
functioning credit markets include a reduced
feasibility of effective risk sharing and greater
difficulties in funding large, indivisible proj-       24
                                                          The classical model may be augmented, if the
ects. Each of these might limit the economy's       reader desires, by considerations of liquidity constraints,
productive capacity.                                bankruptcy costs, or risk aversion; see my 1981 paper.
268                            THE AMERICAN ECONOMIC REVIEW                                      JUNE 1983

   Assume that the behavior of borrowers           have related national income to measures
unaffected by credit market problems is un-        of "unanticipated" changes in money or
changed. Then the paragraph above implies          prices.25
that, for a given safe rate, an increase in the       The most familiar way of constructing a
cost of credit intermediation reduces the total    proxy for unanticipated components of a
quantity of goods and services currently de-       variable is the two-step method of Robert
manded. That is, the aggregate demand curve,       Barro (1978), in which the residuals from a
drawn as a function of the safe rate, is           first-stage prediction equation for (say) mon-
shifted downward by a financial crisis. In         ey are employed as the independent variables
any macroeconomic model one cares to use,          in a second-stage regression. I experimented
this implies lower output and lower safe in-       with both the Barro approach and some
terest rates. Both of these outcomes char-         alternatives.26 Since my conclusions were
acterized 1930-33, of course.                      unaffected by choice of technique, I report
   Some evidence on the magnitude of the           here only the Barro-type results.
effect of the financial market problems on            In the spirit of the Lucas-Barro analysis, I
aggregate output is now presented.                 considered the effects of both "money
                                                   shocks" and "price shocks" on output. Mon-
      IV. Short-Run Macroeconomic Impacts          ey shocks (M—Me) were defined as the
              of the Financial Crisis              residuals from a regression of the rate of
                                                   growth of Ml on four lags of the growth
   This section studies the short-run or "im-      rates of industrial production, wholesale
pact" effects of the financial crisis. For this    prices, and Ml itself; price shocks (P - Pe)
purpose, I use only monthly data on the            were defined symmetrically.27I used ordinary
relevant variables. In addition, rather than       least squares to estimate the effects of money
consider the 1929-33 episode outside of its        and price shocks on the rate of growth of
context, I have widened the sample to in-          industrial production, relative to trend.
clude the entire interwar period (January             The basic regression results for the inter-
 1919-December 1941).                              war sample period are given as equations (1)
   Section I.C above has already given some        and (2) in Table 2. These two equations are
evidence of the relationship between the           of interest, independently of the other results
troubles of the financial sector and those of      of this paper. The estimated "Lucas supply
the economy as a whole. However, support           curve," equation (2), shows an effect of price
for the thesis of this paper requires that         shocks on output that is statistically and
nonmonetary effects of the financial crisis on     economically significant. As such, it comple-
output be distinguished from the monetary          ments the results of Thomas Sargent (1976),
effects studied by Friedman and Schwartz.         who found a similar relationship for the
My approach will be to fit output equations       postwar. The relationship of output to mon-
using monetary variables, then to show that        ey surprises, equation (1), is a bit weaker.
adding proxies for the financial crisis sub-      The fact that we discover a smaller role for
stantially improves the performance of these      money in the monthly data than does Paul
equations. Comparison of financial to totally      Evans (1981) is primarily the result of our
nonfinancial sources of the Great Depres-         inclusion of lagged values of production on
sion, such as those suggested by Temin, is        the right-hand side. This inclusion seems
left to future research.                          justified both on statistical grounds and for
   To isolate the purely monetary influences
on the economy, one needs a structural ex-           25
                                                        A notable exception is Mishkin (1982).
planation of the money-income relationship.          26
                                                        Principal alternatives tried were 1) the use of antic-
Lucas (1972) has presented a formal model         ipated as well as unanticipated quantities as explanatory
in which monetary shocks affect production        variables; and 2) reestimation of some equations by the
                                                  more efficient but computationally more complex
decisions by causing confusion about the          method of Andrew Abel and Mishkin (1981).
price level. Influenced by this work, most           27
                                                        The first-stage regressions were unsurprising and,
recent empirical studies of the role of money     for the sake of space, are not reported.
VOL. 73 NO. 3                       BERNANKE: GREAT DEPRESSION                                              269

                                   TABLE 2—ESTIMATED OUTPUT EQUATIONS

Notes: Yt= rate of growth of industrial production (Federal Reserve Bulletin), relative to exponential trend.
( M - Me)t = rate of growth of M1, nominal and seasonally adjusted (Friedman and Schwartz, Table 4-1), less
             predicted rate of growth.
  (P - Pe)t= rate of growth of wholesale price index (Federal Reserve Bulletin), less predicted rate of growth.
  DBANKSt= first difference of deposits of failing banks (deflated by wholesale price index).
   DFAILSt= first difference of liabilities of failing businesses (deflated by wholesale price index).
Data are monthly; t-statistics are shown in parentheses.

the economic reason that costs of adjusting              are used to perform dynamic simulations of
production can be presumed to create a serial            the path of output between mid-1930 and the
dependence in output. Like Evans, I was not              bank holiday of March 1933, they capture no
able to find effects of money (or prices)                more than half of the total decline of output
lagged more than three months.                           during the period. This is the basis of the
   While these regression results exhibit sta-           comment in the introduction that the de-
tistical significance and the expected signs             clines in money seem "quantitatively insuffi-
for coefficients, they are disappointing in the          cient" to explain what happened to output in
following sense: When equations (1) and (2)              1930-33.
270                                    THE AMERICAN ECONOMIC REVIEW                          JUNE 1983

    Given the basic regressions (1) and (2), the       increasing the amount of importance attrib-
 next step was to examine the effects of in-           uted to the March 1933 crisis raises the
 cluding proxies for the nonmonetary finan-            magnitude and statistical significance of the
 cial impact as explanators of output. Based           measured effects of the financial crises on
 on the earlier analysis of this paper, the most       output. (It is in this sense that the 15 percent
 obvious such proxies are the deposits of fail-        figure is conservative.) However, the bank
 ing banks and the liabilities of failing busi-        failure coefficients in the regressions retained
 nesses.                                               high significance even when less weight was
    A preliminary problem with the bank de-            given to March 1933.
posits series that needs to be discussed is the           I turn now to the results of adding (real)
value for March 1933, the month of the bank            deposits of failing banks and liabilities of
holiday. As can be seen in Table 1, the                failing businesses to the output equations
deposits of banks suspended in March 1933              (see equations (3) and (4) in Table 2). The
is seven times that of the next worse month.           sample period begins in 1921 because of the
The question arises if any adjustment should          unavailability of data on monthly bank
be made to that figure before running the              failures before then. In both regressions, cur-
regressions.                                          rent and lagged first differences of the added
   We believe that it would be a mistake to           variables enter the explanation of the growth
eliminate totally the bank holiday episode            rate of industrial production (relative to
from the sample. According to contemporary            trend) with the expected sign and, taken
accounts, rather than being an orderly and            jointly, with a high level of statistical signifi-
planned-in-advance policy, the imposition of          cance. The magnitudes and significance of
the holiday was a forced response to the              the coefficients of money and price shocks
most panicky and chaotic financial condi-             are not much changed. This provides at least
tions of the period. The deposits of sus-             a tentative confirmation that nonmonetary
pended banks figure for March, as large as it         effects of the financial crisis augmented
is, reflects not all closed banks but only            monetary effects in the short-run determina-
those not licensed to reopen by June 30,              tion of output.
 1933. Of these banks, most were liquidated               Some alternative proxies for the nonmone-
or placed in receivership; less than 25 per-          tary component of the financial crisis were
cent had been licensed to reopen as of De-            also tried. For the sake of space, only a
cember 31, 1936.28 Qualitatively, then, the           summary of these results is given. 1) To
March 1933 episode resembled the earlier              examine the direct effects of the contraction
crises; it would be throwing away informa-            of bank credit on the economy, I began by
tion not to include in some way the effects of        regressing the rate of growth of bank loans
this crisis and of its resolution on the econ-        on current and lagged values of suspended
omy.                                                  bank deposits and of failing business liabili-
   On the other hand, the mass closing of             ties. (This regression indicated a powerful
banks by government action probably created           negative effect of financial crisis on bank
less confusion and fear of future crises than         loans.) The fitted series from this regression
would have a similar number of suspensions            was used as a proxy for the portion of the
occurring without government intervention.            credit contraction induced by the financial
As a conservative compromise, I assumed               crisis. In the presence of money or price
that the "supervised" bank closings of March          shocks, the effect of a decline in this variable
1933 had the same effect as an "unsuper-              on output was found to be negative for two
vised" bank crisis involving 15 percent as            months, positive for the next two months,
much in frozen deposits. This scales down             then strongly negative for the fifth and sixth
the March 1933 episode to about the size of           months after the decline. For the period from
the events of October 1931. The sensitivity of        1921 until the bank holiday, and with mone-
the results to this assumption is as follows:         tary variables included, the total effect of
                                                      credit contraction on output (as measured by
      Federal Reserve Bulletin, 1937, pp. 866-67.     the sum of lag coefficients in a polynomial
VOL. 73 NO. 3                     BERNANKE: GREAT DEPRESSION                                             271

  distributed lag) was large (comparable to the      nificance of the coefficients on bank and
 monetary effect), negative, and significant at      business failures. Finally, the economic sig-
  the 95 percent level. For the entire interwar      nificance of the results was tested by using
 sample, however, the statistical significance       the various estimated equations to run dy-
 of this variable was much reduced. This last        namic simulations of monthly levels of in-
 result is due to the fact that the recovery of      dustrial production (relative to trend) for
  1933-41 was financed by nonbank sources,           mid-1930 to March 1933. Relative to the
 with bank loans remaining at a low level.           pure money-shock and price-shock simula-
    2) Another proxy for the financial crisis        tions described above, the equations includ-
 that was tried was the differential between         ing financial crisis proxies did well. Equa-
 Baa corporate bond yields and the yields on         tions (3) and (4) reduced the mean squared
 U.S. bonds. As described in Section I.C, this       simulation error over (1) and (2) by about 50
 variable responded strongly to both bank            percent. The other (nonreported) equations
 crises and the problems of debtors, and as          did better; for example, those using the yield
 such was a sensitive indicator of financial         differential variable reduced the MSE of
 market conditions. The yield differential           simulation from 90 to 95 percent.
 variable turned out to enter very strongly as          These results are promising. However, a
 an explanator of current and future output          caveat must be added: To conclude that the
 growth, overall and in every subsample. As          observed correlations support the theory out-
 much of this predictive power was no doubt          lined in this paper requires an additional
 due to pure financial market anticipations of       assumption, that failures of banks and com-
 future output declines, I also put the dif-         mercial firms are not caused by anticipations
 ferential variable through a first-stage regres-    of (future) changes in output. To the extent
 sion on the liabilities of bank and business        that, say, bank runs are caused by the receipt
 failures. Assuming that these latter variables      of bad news about next month's industrial
 themselves were not determined by anticipa-        production, the fact that bank failures tend
tions of future output declines (see below),         to lead production declines does not prove
the use of the fitted series from this regres-      that the bank problems are helping to cause
sion "purged" the differential variable of its      the declines.29
pure anticipatory component. The fitted                 While it may not be possible to convince
series entered the output equations less            the determined skeptic that bank and busi-
strongly than the raw series, but it retained       ness failures are not purely anticipatory phe-
the right sign and statistical significance at      nomena, a good case can be made against
the 95 percent confidence level.                    that position. For example, while in some
    In almost every case, then, the addition of     cases a bad sales forecast may induce a firm
proxies for the general financial crisis im-        to declare bankruptcy, more often that op-
proved the purely monetary explanation of           tion is forced by insolvency (a result of past
short-run (monthly) output movements. This          business conditions). For banks, it might well
finding was robust to the obvious experi-           be argued that not only are failures relatively
ments. For example, with the above-noted            independent of anticipations about output,
exception of the credit variable in 1933-41,        but that they are not simply the product of
coefficients remained roughly stable over           current and past output performance either:
subsamples. Another experiment was to in-           First, banking crises had never previous to
clude free dummy variables for each quarter         this time been a necessary result of declines
from 1931:1 to 1932:IV in the above re-             in output.30 Second, Friedman and Schwartz,
gressions. The purpose of this was to test the      as well as other writers, have identified
suggestion that our results are only a reflec-
tion of the fact that both the output and              29
financial crisis variables "moved a lot" dur-             Actually, a similar criticism might be made of
                                                    Barro's work and my own money and price regressions.
ing 1930-33. The rather surprising discovery           30
                                                          Philip Cagan (1965) makes this point; see pp. 216,
was that the inclusion of the dummies               227-28. The 1920-22 recession, for example, did not
increased the magnitude and statistical sig-        generate any banking problems.
272                              THE AMERICAN ECONOMIC REVIEW                                 JUNE 1983

specific events that were important sources          course, plausibility is not enough; some evi-
of bank runs during 1930-33. These include           dence on the speed of financial recovery
the revelation of scandal at the Bank of the         should be adduced.
United States (a private bank, which in De-            After struggling through 1931 and 1932,
cember 1930 became the largest bank to fail          the financial system hit its low point in March
up to that time); the collapse of the Kredit-        1933, when the newly elected President
anstalt in Austria and the ensuing financial         Roosevelt's "bank holiday" closed down
panics in central Europe; Britain's going off       most financial intermediaries and markets.
gold; the exposure of huge pyramiding                March 1933 was a watershed month in several
schemes in the United States and Europe;             ways: It marked not only the beginning of
and others, all connected very indirectly (if       economic and financial recovery but also the
at all) with the path of industrial production      introduction of truly extensive government
in the United States.                               involvement in all aspects of the financial
   If it is accepted that bank suspensions and      system.31 It might be argued that the federally
business bankruptcies were the product of           directed financial rehabilitation—which took
factors beyond pure anticipations of output         strong measures against the problems of both
decline, then the evidence of this section          creditors and debtors—was the only major
supports the view that nonmonetary aspects          New Deal program that successfully pro-
of the financial crisis were at least part of the   moted economic recovery.32 In any case, the
propagatory mechanism of the Great De-              large government intervention is prima facie
pression. If it is further accepted that the        evidence that by this time the public had lost
financial crisis contained large exogenous          confidence in the self-correcting powers of
components (there is evidence for this in the       the financial structure.
case of the banking panics), then there are            Although the government's actions set the
elements of causality in the story as well.         financial system on its way back to health,
                                                    recovery was neither rapid nor complete.
      V. Persistence of the Financial Crisis        Many banks did not reopen after the holi-
                                                    day, and many that did open did so on a
   The claim was made in the introduction           restricted basis or with marginally solvent
that my theory seems capable, unlike the            balance sheets. Deposits did not flow back
major alternatives, of explaining the unusual       into the banks in great quantities until 1934,
length and depth of the Great Depression. In        and the government (through the Recon-
the previous section, I attempted to deal with      struction Finance Corporation and other
the issue of depth; simulations of the esti-        agencies) had to continue to pump large
mated regressions suggested that the com-           sums into banks and other intermediaries.
bined monetary and nonmonetary effects of           Most important, however, was a noticeable
the financial crisis can explain much of the        change in attitude among lenders; they
severity of the decline in output. In this          emerged from the 1930-33 episode chas-
section, the question of the length of the          tened and conservative. Friedman and
Great Depression is addressed.                      Schwartz (pp. 449-62) have documented the
   As a matter of theory, the duration of the       shift of banks during this time away from
credit effects described in Section II above        making loans toward holding safe and liquid
depends on the amount of time it takes to 1)        investments. The growing level of bank
establish new or revive old channels of credit      liquidity created an illusion (as Friedman
flow after a major disruption, and 2) re-           and Schwartz pointed out) of easy money;
habilitate insolvent debtors. Since these
processes may be difficult and slow, the per-
sistence of nonmonetary effects of financial            31
                                                          See Chandler (1970), ch. 15, and Friedman and
crisis has a plausible basis. (In contrast, per-    Schwartz, ch. 8.
sistence of purely monetary effects relies on              E. Carey Brown (1956) has argued that New Deal
                                                    fiscal policy was not very constructive. A paper by
the slow diffusion of information or unex-          Michael Weinstein in Brunner (1981) points out coun-
plained stickiness of wages and prices.) Of         terproductive aspects of the N.R.A.
VOL. 73 NO. 3                   BERNANKE: GREAT DEPRESSION                                         273

however, the combination of lender reluc-         of their high ratings by a standard commer-
tance and continued debtor insolvency in-         cial rating agency." Even within the elite
terfered with credit flows for several years      sample, 45 percent of the firms reported
after 1933.                                       difficulty in securing funds for working
   Evidence of postholiday credit problems is     capital purposes during this period; and 75
not hard to find. For example, small busi-       percent could not obtain capital or long-term
nesses, which (as I have noted) suffered dis-    loan requirements through regular markets.
proportionately during the Contraction, had      (See Stoddard.)
continuing difficulties with credit during re-       The reader may wish to view the American
covery. Lewis Kimmel (1939) carried out a         Bankers Association and Small Business Re-
survey of credit availability during 1933-38     view Committee surveys as lower and upper
as a companion to the National Industrial        bounds, with the Hardy-Viner study in the
Conference Board's 1932 survey. His conclu-      middle. In any case, the consensus from
sions are generally sanguine (this may reflect    surveys, as well as the opinion of careful
the fact that the work was commissioned by       students such as Chandler, is that credit dif-
the American Bankers Association). How-          ficulties for small business persisted for at
ever, his survey results (p. 65) show that, of   least two years after the bank holiday.33
responding manufacturing firms normally              Home mortgage lending was another im-
dependent on banks, refusal or restriction of    portant area of credit activity. In this sphere,
bank credit was reported by 30.2 percent of      private lenders were even more cautious after
very small firms (capitalization less than        1933 than in business lending. They had a
$50,000); 14.3 percent of small firms            reason for conservatism; while business
($50,001-$500,000); 10.3 percent of medium       failures fell quite a bit during the recovery,
firms ($500,001-$1,000,000); and 3.2 percent     real estate defaults and foreclosures con-
of the largest companies (capital over $1        tinued high through 1935.34 As has been
million). (The corresponding results from the    noted, some traditional mortgage lenders
 1932 NICB survey were 41.3, 22.2, 12.5, and     nearly left the market: life insurance compa-
9.7 percent.)                                    nies, which made $525 million in mortgage
   Two well-known economists, Hardy and          loans in 1929, made $10 million in new loans
Viner, conducted a credit survey in the Sev-     in 1933 and $16 million in 1934.35 During
enth Federal Reserve District in 1934-35.        this period, mortgage loans that were made
Based on "intensive coverage of 2600 indi-       by private institutions went only to the very
vidual cases," they found "a genuine             best potential borrowers. Evidence for this is
unsatisfied demand for credit by solvent bor-    the sharp drop in default rates of loans made
rowers, many of whom could make economi-         in the early 1930's as compared to loans
cally sound use of working capital.... The       made in earlier years (see Carl Behrens, 1952,
total amount of this unsatisfied demand for      p. 11); this decline was too large to be ex-
credit is a significant factor, among many       plained by the improvement in business con-
others, in retarding business recovery." They    ditions alone.
added, "So far as small business is con-            To the extent that the home mortgage
cerned, the difficulty in getting bank credit    market did function in the years immediately
has increased more, as compared with a few       following 1933, it was largely due to the
years ago, than has the difficulty of getting    direct involvement of the federal govern-
trade credit." (These passages are quoted in     ment. Besides establishing some important
W. L. Stoddard, 1940.)                           new institutions (such as the FSLIC and the
   Finally, another credit survey for the        system of federally chartered savings and
1933-38 period was done by the Small Busi-       loans), the government "readjusted" existing
ness Review Committee for the U.S. Depart-       debts, made investments in the shares of
ment of Commerce. This study surveyed
6,000 firms with between 21 and 150 em-            33
                                                      See Chandler (1970), pp. 150-51.
ployees. From these they chose a special           34
                                                      U.S. Department of Commerce (1975), series N301.
sample of 600 companies "selected because          35
                                                      U.S. Department of Commerce (1975), N282.
274                              THE AMERICAN ECONOMIC REVIEW                                 JUNE 1983

thrift institutions, and substituted for re-         overseas markets. Thus we need not look to
calcitrant private institutions in the provision     the domestic financial system as an im-
of direct credit. In 1934, the government-           portant cause in every case.
sponsored Home Owners' Loan Corporation                   2) The countries in which banking crises
made 71 percent of all mortgage loans ex-            occurred (the United States, Germany,
tended.36                                            Austria, Hungary, and others) were among
   Similar conditions obtained for farm credit       the worst hit by the depression. Moreover,
and in other markets, but space does not             these countries held a large share of world
permit this to be pursued here. Summarizing          trade and output. The United States alone
the reading of all of the evidence by                accounted for almost half of world industrial
economists and by other students of the              output in 1925-29, and its imports of basic
period, it seems safe to say that the return of      raw materials and foodstuffs in 1927-28
the private financial system to normal condi-        made up almost 40 percent of the trade in
tions after March 1933 was not rapid; and            these commodities.37 The reduction of im-
that the financial recovery would have been         ports as these economies weakened exerted
more difficult without extensive government          downward pressure on trading partners.
intervention and assistance. A moderate                   3) There were interesting parallels be-
estimate is that the U.S. financial system           tween the troubles of the domestic financial
operated under handicap for about five years         system and those of the international system.
(from the beginning of 1931 to the end of           One of the Federal Reserve's proudest
1935), a period which covers most of the            accomplishments had been the establish-
time between the recessions of 1929-30 and          ment, during the 1920's, of an international
1937-38. This is consistent with the claim          gold-exchange standard. Unfortunately, like
that the effects of financial crisis can help       domestic banking, the gold-exchange stan-
explain the persistence of the depression.          dard had the instability of a fractional-
                                                    reserve system. International reserves
            VI. International Aspects               included not only gold but also foreign cur-
                                                    rencies, notably the dollar and the pound;
   The Great Depression was a worldwide             for countries other than the United States
phenomenon; banking crises, though occur-           and the United Kingdom, foreign exchange
ring in a number of important countries             was 35 percent of total reserves.
besides the United States, were not so                 In 1931, the expectations that the interna-
ubiquitous. A number of large countries had         tional financial system would collapse be-
no serious domestic banking problems, yet           came self-fulfilling. A general attempt to
experienced severe drops in real income in          convert currencies into gold drove one cur-
the early 1930's. Can this be made consistent       rency after another off the gold-exchange
with the important role we have ascribed to         standard. Restrictions on the movement of
the financial crisis in the United States? A        capital or gold were widely imposed. By 1932,
complete answer would require another               only the United States and a small number
paper; but I offer some observations:               of other countries remained on gold.
      1) The experience of different countries         As the fall of the gold standard parallelled
and the mix of depressive forces each faced         domestic bank failures, the domestic in-
varied significantly. For example, Britain,         solvency problem had an international ana-
suffering from an overvalued pound, had             logue as well. Largely due to fixed exchange
high unemployment throughout the 1920's;            rates, the deflation of prices was worldwide.
after leaving gold in 1931, it was one of the       Countries with large nominal debts, notably
first countries to recover. The biggest prob-       agricultural exporters (the case of Canada
lems of food and raw materials exporters            has been mentioned), became unable to pay.
were falling prices and the drying up of            Foreign bond values in the United States
                                                    were extremely depressed.
     U.S. Department of Commerce (1975), N278 and
N283.                                                     U.S. Department of Commerce (1947), pp. 29-31.
VOL. 73 NO. 3                     BERNANKE: GREAT DEPRESSION                                  275

   As in the domestic economy, these prob-             August 1978, 86, 549-80.
lems disrupted the worldwide mechanism of          Behrens, Carl, Commercial Bank Activities in
credit. International capital flows were re-           Urban Mortgage Financing, New York:
duced to a trickle. This represented a serious         National Bureau of Economic Research,
problem for many countries.                            1952.
   To summarize these observations: the fact       Bernanke, Ben, "Bankruptcy, Liquidity, and
that the Great Depression hit countries which          Recession," American Economic Review
did not have banking crises does not pre-              Proceedings, May 1981, 71, 155-59.
clude the possibility that banking and debt        Brown, E. Carey, "Fiscal Policy in the Thir-
problems were important in the United States           ties: A Reappraisal," American Economic
(or, for that matter, that countries with strong       Review, December 1956, 46, 857-79.
banks had problems with debtor insolvency).        Brunner, Karl, The Great Depression Revisited,
Moreover, my analysis of the domestic finan-           Boston: Martinus Nijhoff, 1981.
cial system may be able to shed light on           Cagan, Philip, Determinants and Effects of
some of the international financial difficul-          Changes in the Stock of Money, 1875-1960,
ties of the period.                                   New York: National Bureau of Economic
                                                       Research, 1965.
                VII. Conclusion                    Chandler, Lester, America's Greatest Depres-
                                                      sion, New York: Harper & Row, 1970.
   Did the financial collapse of the early                   , American Monetary Policy, 1928-
 1930's have real effects on the macroecon-            1941, New York: Harper & Row, 1971.
omy, other than through monetary channels?         Clark, Evans, The Internal Debts of the United
The evidence is at least not inconsistent with        States, New York: Macmillan Co., 1933.
this proposition. However, a stronger reason       Cone, Kenneth, "Regulation of Depository
for giving this view consideration is the one         Financial Intermediaries," unpublished
stated in the introduction: this theory has           doctoral dissertation, Stanford University,
hope of achieving a reconciliation of the              1982.
obvious suboptimality of this period with the      Diamond, Douglas and Dybvig, Philip, "Bank
postulate of reasonably rational, market-con-         Runs, Deposit Insurance, and Liquidity,"
strained agents. The solution to this paradox         mimeo., University of Chicago, 1981.
lies in recognizing that economic institutions,    Evans, Paul, "An Econometric Analysis of the
rather than being a "veil," can affect costs of       Causes of the Great Depression in the
transactions and thus market opportunities            U.S.," mimeo., Stanford University, 1981.
and allocations. Institutions which evolve and     Fabricant, Solomon, Profits, Losses, and Busi-
perform well in normal times may become               ness Assets, 1929-1934, Bulletin 55, Na-
counterproductive during periods when ex-             tional Bureau of Economic Research, 1935.
ogenous shocks or policy mistakes drive the        Fama, Eugene, "Banking in the Theory of
economy off course. The malfunctioning of             Finance," Journal of Monetary Economics,
financial institutions during the early 1930's        January 1980, 6, 39-57.
exemplifies this point.                            Fisher, Irving, "The Debt-Deflation Theory of
                                                      Great Depressions," Econometrica, Oc-
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