It’s Crunch Time, Ben! The Financial Accelerator

EH 447, 2008/9Week 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 :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

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

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

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

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 ) orJust reduce lending, even to solvent

customers, to reduce CCI

Baa Yield Spread Over Treasury Bonds

0

1

2

3

4

5

6

7

8

919

29:0

1

1929

:07

1930

:01

1930

:07

1931

:01

1931

:07

1932

:01

1932

:07

1933

:01

Bank of the United States Collapse, 12/1930

Deposits in Failed Banks (NBER m09039)

0

50

100

150

200

250

300

350

400

450

500

19

21

.01

19

22

.01

19

23

.01

19

24

.01

19

25

.01

19

26

.01

19

27

.01

19

28

.01

19

29

.01

19

30

.01

19

31

.01

19

32

.01

19

33

.01

mill

. US

$

Numbers of Business Failures

0

500

1000

1500

2000

2500

3000

3500

4000

1921

.01

1921

.07

1922

.01

1922

.07

1923

.01

1923

.07

1924

.01

1924

.07

1925

.01

1925

.07

1926

.01

1926

.07

1927

.01

1927

.07

1928

.01

1928

.07

1929

.01

1929

.07

1930

.01

1930

.07

1931

.01

1931

.07

1932

.01

1932

.07

1933

.01

Number of Business Failures

0

500

1000

1500

2000

2500

3000

3500

4000

1921

.01

1922

.01

1923

.01

1924

.01

1925

.01

1926

.01

1927

.01

1928

.01

1929

.01

1930

.01

1931

.01

1932

.01

1933

.01

1934

.01

1935

.01

1936

.01

1937

.01

1938

.01

Liabilities of Failed Businesses

0

20

40

60

80

100

1201

92

1.0

1

19

22

.01

19

23

.01

19

24

.01

19

25

.01

19

26

.01

19

27

.01

19

28

.01

19

29

.01

19

30

.01

19

31

.01

19

32

.01

19

33

.01

mill

US

$

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

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

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

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)

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

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

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

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