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It’s Crunch Time, Ben! The Financial Accelerator

It’s Crunch Time, Ben! The Financial Accelerator. EH 447, 2008/9 Week 4-2 Albrecht Ritschl. “The Great Depression is the Holy Grail of Macroeconomics”. Ben Bernanke, Essays on the Great Depression (2000). Key economic concepts. Yield differentials / credit spread :

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It’s Crunch Time, Ben! The Financial Accelerator

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  1. It’s Crunch Time, Ben! The Financial Accelerator EH 447, 2008/9 Week 4-2 Albrecht Ritschl

  2. “The Great Depression is the Holy Grail of Macroeconomics” Ben Bernanke, Essays on the Great Depression (2000)

  3. Key economic concepts • Yield differentials / credit spread : interest rate differential between two bonds of same maturity. • This type of spread measures credit default risk (if both bonds in same country and currency)  Yield spread between corporate bonds and Treasury bonds

  4. Key economic concepts (cont’d) • Cost of Credit Intermediation (CCI) • Information asymmetries between borrowers and lenders (Stiglitz & Weiss, 1981, extensive literature) • “Bad” mimic “good” borrowers • Credit rationing as an attempt to minimize incentive problems • CCI as result of monitoring, building long term relationships, enforcement cost etc

  5. Key economic concenpts (cont’d) • Debt deflation, Irving Fisher (1933) Debt contracts written in nominal units [$, £ etc., w/o price index clauses] Price fall of underlying asset • causes negative equity • may cause firesale in case of debt default • Feeds back on price declines of underlying asset

  6. Debt deflation (cont’d) • But if nominal debt is so bad, then why are such contracts written in the first place (instead e.g. of a profit share)? Gale and Hellwig (1985): because of high cost of / difficulties in verifying debtor’s true profits • Even easier if debtor provides collateral

  7. Bernanke (1983) Great Depression aggravated by financial market problems • Debt deflation of values of collateral (much like 2007-? housing slump) • Nominal debt contract more risky, CCI  • Resort to complicated risk sharing contracts (then again, CCI ) or • Just reduce lending, even to solvent customers, to reduce CCI

  8. Bank of the United States Collapse, 12/1930

  9. Some finer points • Financial channel is not about 1929 • Most banking problems not endogenous to fall in output • Instead caused by exogenous events  This is most important for comparison to 2008 • Output may be endogenous to banking

  10. U.S. crisis 1929: a timeline • Since 1928: NYSE stock market boom • August 1929: Upswing in real investment stops • 24 and 29 October 1929: stock market crash • Towards end of 1929: • Decline in output, price levels • Stock market quite resilient after initial shock • Bold steps by Fed to lower interest rates

  11. U.S. crisis 1930: a timeline • Throughout 1930: further slide into depression, very low interest rates • June 1930: protectionist Hawley/Smoot tariff • December 1930: Bank of U.S. fails, increased failures of rural banks

  12. U.S. crisis 1931-32: a timeline • Mid-1931: renewed banking panics (banking troubles also in Ctrl Europe) • Sept 1931: another wave of panic (after UK’s departure from Gold Standard) • Dec 1932: yet another panic (after UK, F default on wartime credits, F withdrawal of gold from NY)

  13. U.S. crisis 1933: a timeline • March 1933: Emergency Banking Act (Bank Holidays, reopening of banks after federal inspection) • June 1933: (2nd) Glass-Steagall Act (separation of deposit and investment banking, federal deposit insurance, state banking system, far-reaching regulation) • Steep upswing sets in

  14. International banking crisis 1931 • Austrian Creditanstalt crisis in May • German banking crisis in July • Bank run / bank holidays • Forced merger of two of top 5 banks • Part nationalisation of top 5 banks • Run on currency / capital controls • Hoover 1-year moratorium on reparations and foreign debt

  15. Consequences of 1931 banking crisis • UK loans frozen in Austria, Germany • Contributed to UK departure from Gold Standard in September • US loans frozen • German reparations suspended • Sent France, Belgium into depression • 1932: UK, F default on WW1 loans from US • Causal for renewed U.S. banking crisis of early 1933

  16. Conclusions on 1929/32 • Causes not so clear • Catastrophic depression and deflation • Banking crisis only towards the end of depression • Strong European element in banking crisis • Special features: Gold Standard, reparations

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