The Great Depression may be ancient history but interest in the subject is enjoying a revival, including at the Federal Reserve, now chaired by self-described “Great Depression buff” Ben Bernanke.

 

A new research paper by staff economist Mark Carlson tackles a seemingly esoteric topic that could have useful lessons for the current crisis. In his working paper, recently posted on the Fed’s Web site, he investigates whether some of the thousands of banks that failed in the Great Depression could have survived if only they hadn’t been sucked down in a panic.

 

Previous research has found that banks that failed during the Depression started out weaker than banks that survived, suggesting a lot of the bank failures may have been unavoidable. But Mr. Carlson finds that “many of the banks that failed during the panics appear to have been at least as financially sound as banks that were able to use alternative resolution strategies,” such as merging, or suspending and recapitalizing.

 

When a failed bank was liquidated, its “assets [were] taken out of the banking system and frozen for extended periods. During a bank merger, the assets stay in the banking system continuously. For banks that suspended temporarily, the median length of suspension in this sample was about 5 months… Thus, to the extent that the panics prevented banks from pursuing less disruptive resolution strategies, then the panics of the early 1930s may well have played a role in prolonging and deepening the Great Depression.”

 

Mr. Carlson defines a panic as a period in which statewide bank failures are relatively elevated and there is “some clustering of failure-at least three failures or suspensions in the same county or more than one county with at least two suspensions or failures.” Using that method he finds 20 panic periods from 1930 to 1933 in the 21 states for which he has data. Almost a quarter of the more than 6,000 banks in those states failed in that period, and about a fifth of those failures occurred during panics. Comparing the banks that failed during panics to banks that found some other way to survive he found that the two groups were of roughly similar financial health. The reason the first group failed and the second group didn’t was that they were swept under by the panic. “The financial turbulence associated with the panics may have resulted in some banks being placed in receiverships and liquidated instead of being able to resolve their troubles less disruptively.” These banks represented 30% of all failed banks’ assets -– a sizable portion.

 

If any of this sounds familiar to Bernanke watchers, it’s because these issues were central to his own groundbreaking research on the Great Depression, which is duly cited in Mr. Carlson’s paper.

Mr. Carlson draws no explicit lessons from his research for the present, but it’s easy to imagine some. Despite their woes, banks are reasonably well capitalized today and a panic seems pretty unlikely, especially with federal deposit insurance covering most of depositors’ money. But large swathes of the financial system are outside the deposit insurance safety net – some of it in other parts of banking conglomerates, some of it outside the banks altogether, in mortgage companies, hedge funds, and asset-backed securitization pools. Much like a run on a bank, a generalized investor flight from such institutions could cause some to fail, even if their assets were fundamentally sound.

 

In fact, they don’t even have to fail to affect the economy: they only have to see their capital impaired, or stretched, enough to shut down further lending. That could cause further economic weakness, which feeds back into greater stress on the institutions. Mr. Bernanke and his colleagues have made ever increasing reference to such negative feedback loops. (Actually, they are technically positive feedback loops, in that the initial stress produces responses in the same direction; in a negative feedback loop, the initial stress is followed by a response in the opposite direction, causing it to rapidly peter out. But that’s semantics.)

 

The newfound urgency to Fed rate cuts is driven largely by a belief that, if timely and aggressive enough, such cuts can short-circuit such a feedback loop, and preventing far greater, and unnecessary, economic damage. — Greg Ip

 

 

Money Supply:

 

contracted by 25%  :  http://www.capitaleconomics.com/clientarea/articles/Great%20Depression.pdf

 

 

Comparison:

 

* before the Great Depression, oil and cotton prices were falling (prior)

 

• There is still no universally accepted single cause of the Great Depression. But our analysis

suggests that the main culprit for the role of catalyst was the bursting of the bubbles in the equity

and commodity markets, accompanied by falling house prices. This undermined the ability of

banks to lend and, interacting with other recessionary forces in a symbiotic way, caused

widespread bank failures.

 

• This ties in with the argument put forward by Friedman and Bernanke that the large contraction in

the global money supply was the critical factor. It may have been. But the key point is that the

majority of banks failed due to insolvency most likely caused by the sharp falls in commodity,

housing and equity prices and the resulting rapid rise in bad loans.

 

• We have no doubt that other factors exacerbated the Depression. The US Federal Reserve and

Presidents Hoover and Roosevelt all pursued deflationary policies (the latter in contrast to the widely

held belief that his actions ended the Depression). But their actions were a response to the

downturn in the real economy that was already in place, meaning that they cannot be the cause.

 

• The same is true of the lurch towards protectionism. That said, protectionism surely made things

worse, and together with the Gold Standard, spread the pain around the world.

 

• All this suggests that the causes of the Great Depression were worryingly similar to the causes of

today’s credit crisis. Admittedly, this time round the response of those in charge of both interest

rates and fiscal policy has been quicker and more aggressive. What’s more, governments have not

let large numbers of banks fail. Moreover, key currencies have been allowed to depreciate, in

contrast to conditions under the Gold Standard.

 

• However, much depends on whether these actions work. In particular, a lot depends upon the

preparedness of the authorities on both sides of the Atlantic to pursue money-financed fiscal

expansion as much as is necessary. At the moment, a repeat of the Great Depression does not look

like a central case. But the risk is significant. And the severity of the implications means that this is

a risk worth taking very seriously.

Read more from Roger Bootle and Paul Dales here: http://www.capitaleconomics.com/clientarea/articles/Great%20Depression.pdf

 

 

 

Voodoo Economics

 

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