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Ben S. Bernanke, 1983

American Economic Review

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

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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

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Syllabus

I: Historical background of the Great Depression II: The monetary channel by Friedman and Schwartz

III: The nonmonetary channel• A) Effect of the Banking Crises & Bankruptcies on the Cost of

Intermediation (CCI)• B) Link of higher CCI to output decline

IV: Empirical testing

V: Further research possibilities

VI: Discussion and relation with the current crisis

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I. Historical BackgroundI. Historical Background

The Great Depression in the U.S., 1929 - 1941

Migrant Mother, Dorothea Large, 1936

http://de.wikipedia.org/wiki/Florence_Owens_Thompson#Migrant_Mother

• 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?)

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I. Historical Background: Two components of the financial collapse

A) Failure of Financial Institutions

Bank failures are nothing new in the U.S.• System made up of small, independent banks• Failures due to „natural causes“ were common• Another source of failure: No deposit insurance (est. 1933). Possibility of

bad expectional equilibria = bank runs

What is new? The extent and length of the banking crises• Biggest problem: widespread failures of commercial banks that hold a

central role in the financial system• In 1933, only half the number of banks that existed in 1929• Surviving banks experience heavy losses• Severe loss of confidence in financial institutions

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I. Historical Background: Two components of the financial collapse

B) Defaults and Bankruptcies

Widespread debtor insolvency due to „debt deflation“• Large deflation = Debt burden increases because debt contracts were

written in nominal terms• Large expansion of inside debt in the 20‘s („bubble“), especially by small

borrowers

Result: high rates of default• Main victims: farmers, small households, small firms

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II. The monetary channel by Friedman and Schwartz, 1963

Why now this close connection of the financial crisis with output?Main driving factor of economic recession here: Money Supply

The FED tightened monetary policy and raised interest rates to defend the dollar in response to speculative attacks: fall in money supply

Additionally, bank failures caused Reduced wealth of the bank shareholders Rapid fall in money supply (bank failures lead to a withdrawal of currency

from the financial system)

Deflationary spiral: Low prices lead to lower production, that leads to lower wages and demand, ultimately to a further decrease in prices

But this explanation seems to be quantitatively insufficient to explain the Great Depression What about long-term neutrality of money?

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III. The nonmonetary channel

Banking sector fullfills the function of intermediator between lenders and borrowers.

Consider the following economy:• One option for savers to transfer ressources from present to future is

lending to banks.• Borrowers have two types, „good“ or „bad“. Lending to good borrowers

with projects of random return is socially desirable. Lending to bad borrowers that only spend the loan for consumption to default afterwards is undesirable.

• Service performed by banks: Differentiation between good and bad borrowers = screening, monitoring, accounting costs.

Main hypothesis: If this service of credit intermediation becomes more costly for banks (CCI increases), loans are more difficult to realize and aggregate output suffers. Two steps of prove:

Financial crisis leads to higher CCI Higher CCI leads to decline in output

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III. The nonmonetary channel. A) Effect of the Banking Crises & Bankruptcies on the Cost of Intermediation (CCI)

Banking Crisis: Fear of runs lead to Withdrawal of deposits Increase in reserve-deposit ratio Higher bank demand for very liquid assets

Banks refuse to grant new loans and push constumers into quick repayment. CCI increases.

Bankruptcies and defaults: Progressive erosion of borrowers collateral relative to debt burdens. More and more insolvent borrowers increase the risk of default to newly

granted loans CCI increases

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III. The nonmonetary channel. A) Effect of the Banking Crises & Bankruptcies on the Cost of Intermediation (CCI)

What does a bank do when facing higher CCI? Possibilities: Increase interest rate. BUT: higher interest rates = higher risk of

default. Suspending loans to some people that might have gotten the loan

in better times. During the Great Depression, only a very few safe borrowers

had access to loans.

Main victims: households, farmers, unincorporated businesses, small corporations. Highest reliance on bank credit

Partly offset by alternative forms of credit This quick shift away from the banks having great expertise and

ressources must have resulted in a temporarily reduced efficiency.

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III. The nonmonetary channelB) Link of higher CCI to output decline

How does then a higher CCI (=a disrupted credit flow) affect output?

Effects on aggregate supply• No funds to undertake investments• Reduced effective risk sharing• Greater difficulties to fund large, indivisible projects

BUT: Most large corporations entered the crisis with sufficient cash reserves to tackle the temporal credit disruption

Effects on aggregate demand• Limited borrowing possibilities lead to reduction of demand for goods and

services.• Think of it as a substitution effect (current borrowing is expensive, this

leads to a substitution of future for present consumption).

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IV. Empirical Testing

1) Regress price and money shocks on output (the monetary channel)

2) Find that this quantitatively only accounts for ca. 50% of the change in output

1) Include proxies for the nonmonetary channel in the regression: deposits of failing banks and liabilities of failing businesses

2) Improves the explanatory power of the regression

3) Robust to:- Coefficients are stable for

subsamples- Dummies for quarters

Caveat: Assumption that causality is not reversed i.e. that proxies are not caused by anticipations of changes in output.

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IV. Empirical Testing

These findings, according to Bernanke, show the „depth“ of the crisis that the nonmonetary channel can explain

What about the „length“?

It takes time to Establish new or revive old channels of credit flow after a big

disruption Rehabilitate insolvent debtors

VS. In the monetary channel Slow diffusion of information Stickiness of wages and prices

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V. Further research possibilities / Gaps

• Using these two financial channels to test for non-financial causes of the Great Depression (Temin, 76)

• Green and Whiteman (1992) regarding the regression: spikes in commercial and banking failures in 31 and 32 could function as dummy variables, picking up forces that caused the U.S. Depression to sharpen in that period.

• Bernanke (1993): Influence of the Gold Standard

• Parallels / Discrepancies to today‘s crisis.

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IV. Discussion

• The inevitable comparison with today‘s crisis (keep in mind, Ben S. Bernanke has been Chairman of the FED since 2006)

• „Lesson“ of his paper seems to be that, if possible, banks should not be allowed to go under in times of financial crises, as this worsens the credit disruption and increases the impact of the non-monetary channel.

• Bernanke mentions in his paper that the U.S., as a system of small, independent banks, was more vulnerable to bank failures than the UK or France, having bigger banks, and thus suffered a lot from the non-monetary channel

• Importance of money supply expansion to avoid a high impact of the monetary channel.

• Again: Deposit insurance equivalence for the „shadow banking sector“?

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“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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Thank you for your attention!!

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