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

1. NonmonetaryEffectsofthe Financial Crisis in the Propagation ofthe Great Depression Ben S. Bernanke, 1983 American Economic Review

2. Key message of the paper • How do financial crises affect the real economy and output? • Traditional explanation by Friedman and Schwartz, 1963: Monetary channel (fall in money supply due to banking crises) • Bernanke’s contribution: Nonmonetary channel: Financial crises reduce the quality of certain financial services, primarily credit intermediation. This leads to increased costs of intermediation and, ultimately, to a credit squeeze. • Why is this new channel important? • Explaining the unusual length and depth of the Great Depression

3. Syllabus • I: Historical backgroundofthe Great Depression • II: The monetarychannelby Friedman and Schwartz • III: The nonmonetarychannel • A) Effectofthe Banking Crises & Bankruptcies on theCostof Intermediation (CCI) • B) Link ofhigher CCI tooutputdecline • IV: Empiricaltesting • V: Further researchpossibilities • VI: Discussionandrelationwiththecurrentcrisis

4. I. Historical Background The Great Depression in the U.S., 1929 - 1941 • Black Thursday, 24 October 1929 • Waves of bank failures resulting in a complete shutdown of the banking system in March 1933 • Accompanied by a deep macroeconomic recession that only slowed down with the New Deal 1933 – 35 • Synchronous movements of crises in the financial system and declines in aggregate output/macroeconomic depression (Direction of causality?) Migrant Mother, Dorothea Large, 1936 http://de.wikipedia.org/wiki/Florence_Owens_Thompson#Migrant_Mother

5. I. Historical Background: Two components of the financial collapse • Failureof Financial Institutions • Bank failuresarenothingnew in the U.S. • System madeupofsmall, independentbanks • Failures due to „naturalcauses“ werecommon • Anothersourceoffailure: Nodepositinsurance (est. 1933). Possibilityofbadexpectionalequilibria = bankruns • Whatisnew? The extentandlengthofthebankingcrises • Biggestproblem: widespreadfailuresofcommercialbanksthat hold a centralrole in thefinancialsystem • In 1933, only half thenumberofbanksthatexisted in 1929 • Survivingbanksexperience heavy losses • Severelossofconfidence in financialinstitutions

6. I. Historical Background: Two components of the financial collapse • B) Defaults andBankruptcies • Widespreaddebtorinsolvency due to „debtdeflation“ • Large deflation = Debtburdenincreasesbecausedebtcontractswerewritten in nominal terms • Large expansionofinsidedebt in the 20‘s („bubble“), especiallybysmallborrowers • Result: high ratesofdefault • Main victims: farmers, smallhouseholds, smallfirms

7. II. The monetary channel by Friedman and Schwartz, 1963 • Whynowthiscloseconnectionofthefinancialcrisiswithoutput? • Main drivingfactorofeconomicrecessionhere: Money Supply • The FED tightenedmonetarypolicyandraisedinterestratestodefendthedollar in responsetospeculativeattacks: fall in moneysupply • Additionally, bankfailurescaused • Reducedwealthofthebankshareholders • Rapid fall in moneysupply (bankfailuresleadto a withdrawalofcurrencyfromthefinancialsystem) • Deflationary spiral: Low pricesleadtolowerproduction, thatleadstolowerwagesanddemand, ultimatelyto a furtherdecrease in prices • But thisexplanationseemstobequantitativelyinsufficienttoexplainthe Great Depression • Whataboutlong-term neutralityofmoney?

8. III. The nonmonetary channel • Banking sectorfullfillsthefunctionofintermediatorbetweenlendersandborrowers. • Considerthefollowingeconomy: • Oneoptionforsaverstotransferressourcesfrompresenttofutureislendingtobanks. • Borrowershavetwotypes, „good“ or „bad“. Lendingtogoodborrowerswithprojectsofrandomreturnissociallydesirable. Lendingtobadborrowersthatonlyspendtheloanforconsumptiontodefaultafterwardsisundesirable. • Service performedbybanks: Differentiation betweengoodandbadborrowers = screening, monitoring, accountingcosts. • Main hypothesis: Ifthisserviceofcreditintermediationbecomesmorecostlyforbanks (CCI increases), loansaremoredifficulttorealizeandaggregateoutputsuffers. Twostepsofprove: • Financial crisisleadstohigher CCI • Higher CCI leadstodecline in output

10. III. The nonmonetary channel. A) Effect of the Banking Crises & Bankruptcies on the Cost of Intermediation (CCI) • Banking Crisis: Fear ofrunsleadto • Withdrawalofdeposits • Increase in reserve-depositratio • Higher bankdemandforvery liquid assets • Banks refusetograntnewloansand push constumersinto quick repayment. CCI increases. • Bankruptciesanddefaults: • Progressive erosionofborrowerscollateral relative todebtburdens. • More andmore insolvent borrowersincreasetheriskofdefaulttonewlygrantedloans • CCI increases

11. III. The nonmonetary channel. A) Effect of the Banking Crises & Bankruptcies on the Cost of Intermediation (CCI) • Whatdoes a bank do whenfacinghigher CCI? Possibilities: • Increaseinterest rate. BUT: higherinterestrates = higherriskofdefault. • Suspendingloanstosomepeoplethatmighthavegottentheloan in bettertimes. • Duringthe Great Depression, only a veryfewsafeborrowershadaccesstoloans. • Main victims: households, farmers, unincorporatedbusinesses, smallcorporations. Highestreliance on bankcredit • Partlyoffsetby alternative formsofcredit • This quick shiftawayfromthebankshavinggreatexpertiseandressources must haveresulted in a temporarilyreducedefficiency.

12. III. The nonmonetary channelB) Link of higher CCI to output decline • Howdoesthen a higher CCI (=a disruptedcreditflow) affectoutput? • Effects on aggregatesupply • Nofundstoundertakeinvestments • Reducedeffectiverisksharing • Greaterdifficultiestofund large, indivisibleprojects • BUT: Most large corporationsenteredthecrisiswithsufficient cash reservestotacklethe temporal creditdisruption • Effects on aggregatedemand • Limited borrowingpossibilitiesleadtoreductionofdemandforgoodsandservices. • Think ofitas a substitutioneffect (currentborrowingis expensive, thisleadsto a substitutionoffutureforpresentconsumption).

13. IV. Empirical Testing • Regress priceandmoneyshocks on output (themonetarychannel) • Find thatthisquantitativelyonlyaccountsfor ca. 50% ofthechange in output • Includeproxiesforthenonmonetarychannel in theregression: depositsoffailingbanksandliabilitiesoffailingbusinesses • Improvestheexplanatory power oftheregression • Robust to: • Coefficientsarestableforsubsamples • Dummiesforquarters Caveat: Assumption that causality is not reversed i.e. that proxies are not caused by anticipations of changes in output.

14. IV. Empirical Testing • These findings, accordingtoBernanke, showthe„depth“ ofthecrisisthatthenonmonetarychannelcanexplain • Whataboutthe „length“? • Ittakes time to • Establishneworreviveoldchannelsofcreditflow after a bigdisruption • Rehabilitate insolvent debtors • VS. In themonetarychannel • Slow diffusionofinformation • Stickinessofwagesandprices

15. V. Further research possibilities / Gaps • Usingthesetwofinancialchannelstotestfor non-financialcausesofthe Great Depression (Temin, 76) • Green and Whiteman (1992) regardingtheregression: spikes in commercialandbankingfailures in 31 and 32 couldfunctionasdummy variables, pickingupforcesthatcausedthe U.S. Depression tosharpen in thatperiod. • Bernanke (1993): Influenceofthe Gold Standard • Parallels / Discrepanciestotoday‘scrisis.

16. IV. Discussion • The inevitablecomparisonwithtoday‘scrisis (keep in mind, Ben S. Bernankehasbeen Chairman ofthe FED since 2006) • „Lesson“ ofhispaperseemstobethat, ifpossible, banksshould not beallowedtogounder in timesoffinancialcrises, asthisworsensthecreditdisruptionandincreasestheimpactofthe non-monetarychannel. • Bernankementions in hispaperthatthe U.S., as a systemofsmall, independentbanks, was more vulnerable tobankfailuresthanthe UK or France, havingbiggerbanks, andthussuffered a lotfromthe non-monetarychannel • Importanceofmoneysupplyexpansiontoavoid a high impactofthemonetarychannel. • Again: Depositinsuranceequivalenceforthe „shadowbankingsector“?

17. “Federal Reserve Chairman Ben S. Bernanke, initially criticized for being too academic and slow to respond to market worries, has presided over some of the most interventionist and controversial Fed actions since the central bank's founding in 1913. He has also plunged into the public spotlight to an extent that none of his predecessors would have contemplated, in a profound departure from the central bank's tradition as an aloof and secretive temple of economic policy. Mr. Bernanke … opened the Fed's discount window to a new range of financial institutions, helped conceive and pushed for the $700 billion federal bailout of the financial system, and tripled the Fed's balance sheet, to about $2.3 trillion, as he used a wide range of tools to pump money into a staggering economy. … Mr. Obama praised Mr. Bernanke for his "bold action and out-of-the-box thinking," saying it had helped avoid a repeat of the Great Depression, but his nomination encountered an unexpectedly high level of opposition. Mr. Bernanke found himself the target of anger from both the left and the right over the Fed's extraordinary interventions in the market in 2008 — which have been lumped together with the huge bailouts of big financial institutions — and over the perceived regulatory failings of the Fed in the years preceding the crisis.” NY Times online, Oct. 4 2011

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