Consequences of Bank Distress During the Great Depression

The consequences of bank distress for the economy during the Depression remain an area of unresolved controversy. Since John M. Keynes (1931) and Irving Fisher (1933), macroeconomists have argued that bank distress magnified the extent of the economic decline during the Depression. As the intermediaries controlling money and credit, banks were in a special position to transmit their distress to other sectors. But the mechanism through which banking distress mattered for the economy has been hotly contested. Milton Friedman and Anna J. Schwartz (1963) saw the contraction in the money multiplier—driven, in their view, by panicked depositors’ withdrawals of deposits—as the primary mechanism through which banking distress affected the real economy. They described the mechanism transmitting banking distress to the real sector as operating at the national level through changes in the aggregate supply of money and interest rates. Bank distress reduced the money supply available to the public either through the closure of banks and the consequent freezing of bank deposits, or the withdrawals of deposits by depositors that feared bank failure. Ben S. Bernanke (1983), building on Fisher (1933), emphasized the transmission of monetary shocks via their effects on the balance sheets of borrowers and on the supply of credit by banks. Borrowers’ balance sheets were worsened by debt deflation as the result of fixed dollar debt obligations—borrowers’ net worth and cash flow declined with the rising value of debt service costs relative to income. Borrowers with positive net present value projects, but weak balance sheets, had less internally generated retained earnings to invest and could not qualify for credit. Furthermore, Bernanke argued that the contraction of the money supply produced contraction of nominal income and prices relative to fixed debt service, which weakened borrowers’ balance sheets, and in turn, weakened banks. Not only did firms’ financial distress reduce the number of qualified borrowers, the contraction in banks’ net worth forced a reduction in the supply of bank loans to qualified borrowers. Many firms and individuals relied on banks for credit, and as those banks suffered losses of capital (due to asset value declines) and contractions in deposits (as depositors reacted to bank weakness by withdrawing their funds), even borrowers with viable projects and strong balance sheets experienced a decrease in the effective supply of loanable funds. Bernanke termed the combined weakening of borrowers’ balance sheets and the contraction in bank credit supply a rise in the “cost of credit intermediation. ” The scarcity of perfect substitutes for the positive net present value investments of firms with weak balance sheets, and for the credit supplied by existing banks, implies that the weakening of firms’ and banks’ balance sheets, the disappearance of banks, and the contraction in surviving banks’ lending made it more difficult for the economy to channel funds to their best use. Thus, what began as a contraction in aggregate demand became a contraction in aggregate supply, which magnified adverse economic shocks and prolonged and deepened the Depression. The financial distress of firms and banks, and the decline in bank lending, were not only symptoms of the Depression, but means for magnifying the shocks that caused the Depression. Bernanke’s statistical evidence in support of this story is derived from time-series analysis at the national level, in * Calomiris: Graduate School of Business, 601 Uris Hall, Columbia University, 3022 Broadway, New York, NY 10027, and National Bureau of Economic Research (e-mail: cc374@columbia.edu); Mason: Department of Finance, Drexel University, 3141 Chestnut Street, Philadelphia, PA 19104 (e-mail: joe.mason@drexel.edu). We thank Valerie Ramey, David Wheelock, Charles Himmelberg, Steve Zeldes, Gary Gorton, two referees, and seminar participants at Columbia University, Wharton, Northwestern University and the 2001 Economic History Association Meetings for helpful comments on an earlier draft. We gratefully acknowledge support from the National Science Foundation, the University of Illinois, and the Federal Reserve Bank of St. Louis.