Credit Markets and Macroeconomic Performance in the Great Depression

Given all the discussion recently about the relationship between credit flows and the macroeconomy, it seemed worthwhile to review what Ben Bernanke says about this topic with respect to the Great Depression. Bernanke's analysis concludes that the effects work through aggregate demand, not aggregate supply, i.e. that the problem was not one of "greater difficulties in funding large, indivisible projects." Instead, the "reluctance of even cash-rich corporations to expand production during the depression suggests ... consideration of the aggregate demand channel for credit market effects":

Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, by Ben bernanke, American Econonomic Review, June 1983: During 1930-33, the U.S. financial system experienced conditions that were among the most difficult and chaotic in its history. Waves of bank failures culminated in the shutdown of the banking system (and of a number of other intermediaries and markets) in March 1933. On the other side of the ledger, exceptionally high rates of default and bankruptcy affected every class of borrower except the federal government.

An interesting aspect of the general financial crises - most clearly, of the bank failures - was their coincidence in timing with adverse developments in the macroeconomy.[l] Notably, an apparent attempt at recovery from the 1929-30 recession[2] was stalled at the time of the first banking crisis (November- December 1930); the incipient recovery degenerated into a new slump during the mid-1931 panics; and the economy and the financial system both reached their respective low points at the time of the bank" holiday" of March 1933. Only with the New Deals rehabilitation of the financial system in 1933-35 did the economy begin its slow emergence from the Great Depression. A possible explanation of these synchronous movements is that the financial system simply responded, without feedback, to the declines in aggregate output. This is contradicted by the facts that problems of the financial system tended to lead output declines, and that sources of financial panics unconnected with the fall in U.S. output have been documented by many writers. (See Section IV below.)

Among explanations that emphasize the opposite direction of causality, the most prominent is the one due to Friedman and Schwartz. Concentrating on the difficulties of the banks, they pointed out two ways in which these worsened the general economic contraction: first, by reducing the wealth of bank shareholders; second, and much more important, by leading to a rapid fall in the supply of money. There is much support for the monetary view. However, it is not a complete explanation of the link between the financial sector and aggregate output in the 1930's. One problem is that there is no theory of monetary effects on the real economy that can explain protracted nonneutrality. Another is that the reductions of the money supply in this period seems quantitatively insufficient to explain the subsequent falls in output. (Again, see Section IV.)

The present paper builds on the Friedman- Schwartz work by considering a third way in which the financial crises (in which we include debtor bankruptcies as well as the failures of banks and other lenders) may have affected output. The basic premise is that, because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial market-making and information gathering services. The disruptions of 1930-33 (as I shall try to show) reduced the effectiveness of the financial sector as a whole in performing these services. As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression. ...

III. Credit Markets and Macroeconomic Performance If it is taken as given that the financial crises during the depression did interfere with the normal flows of credit, it still must be shown how this might have had an effect on the course of the aggregate economy. There are many ways in which problems in credit markets might potentially affect the macroeconomy. Several of these could be grouped under the heading of "effects on aggregate supply." For example, if credit flows are dammed up, potential borrowers in the economy may not be able to secure funds to undertake worthwhile activities or investments; at the same time, savers may have to devote their funds to inferior uses. Other possible problems resulting from poorly functioning credit markets include a reduced feasibility of effective risk sharing and greater difficulties in funding large, indivisible projects. Each of these might limit the economy's productive capacity.

These arguments are reminiscent of some ideas advanced by John Gurley and E. S. Shaw (1955), Ronald McKinnon (1973), and others in an economic development context. The claim of this literature is that immature or repressed financial sectors cause the "fragmentation" of less developed economies, reducing the effective set of production possibilities available to the society.

Did the financial crisis of the 1930's turn the United States into a "temporarily underdeveloped economy" (to use Bob Hall's felicitous phrase)? Although this possibility is intriguing, the answer to the question is probably no. While many businesses did suffer drains of working capital and investment funds, most larger corporations entered the decade with sufficient cash and liquid reserves to finance operations and any desired expansion (see, for example, Friedrich Lutz, 1945). Unless it is believed that the outputs of large and of small businesses are not potentially substitutes, the aggregate supply effect must be regarded as not of great quantitative importance.

The reluctance of even cash-rich corporations to expand production during the depression suggests that consideration of the aggregate demand channel for credit market effects on output may be more fruitful. The aggregate demand argument is in fact easy to make: A higher cost of credit intermediation for some borrowers (for example, households and smaller firms) implies that, for a given safe interest rate, these borrowers must face a higher effective cost of credit. (Indeed, they may not be able to borrow at all.) If this higher rate applies to household and small firm borrowing but not to their saving (they may only earn the safe rate on their savings), then the effect of higher borrowing costs is unambiguously to reduce their demands for current-period goods and services. This pure substitution effect (of future for present consumption) is easily derived from the classical two-period model of savings.[24]

Assume that the behavior of borrowers unaffected by credit market problems is unchanged. Then the paragraph above implies that, for a given safe rate, an increase in the cost of credit intermediation reduces the total quantity of goods and services currently demanded. That is, the aggregate demand curve, drawn as a function of the safe rate, is shifted downward by a financial crisis. In any macroeconomic model one cares to use, this implies lower output and lower safe interest rates. Both of these outcomes characterized 1930-33, of course.

Some evidence on the magnitude of the effect of the financial market problems on aggregate output is now presented. [From Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression, by Ben bernanke, American Econonomic Review, June 1983.]

Update: I probably shouldn't have left it there. Here are more recent thoughts from Bernanke on this topic, including a discussion of the financial accelerator and the bank lending channel for monetary policy:

...Market Frictions and the Real Effects of Financial and Credit Conditions Economists have not always fully appreciated the importance of a healthy financial system for economic growth or the role of financial conditions in short-term economic dynamics. As a matter of intellectual history, the reason is not difficult to understand. During the first few decades after World War II, economic theorists emphasized the development of general equilibrium models of the economy with complete markets; that is, in their analyses, economists generally abstracted from market "frictions" such as imperfect information or transaction costs. But without such frictions, financial markets have little reason to exist. For example, with complete markets (and if we ignore taxes), we know that whether a corporation finances itself by debt or equity is irrelevant (the Modigliani-Miller theorem).

The blossoming of work on asymmetric information and principal-agent theory, led by Nobel laureates Joseph Stiglitz and George Akerlof and with contributions from many other researchers, gave economists the tools to think about the central role of financial markets in the real economy. ...

My own first job as an academic was at Stanford University, where I arrived as an assistant professor in the Graduate School of Business in 1979. At the time, Stanford was a hotbed of work on asymmetric information, incentives, and the principal-agent problem; and even though my field was macroeconomics, I was heavily influenced by that intellectual environment. I became particularly interested in how this perspective on financial markets could help explain why financial crises--that is, extreme disruptions of the normal functioning of financial markets--seem often to have a significant impact on the real economy. Putting the issue in the context of U.S. economic history, I laid out, in a 1983 article, two channels by which the financial problems of the 1930s may have worsened the Great Depression (Bernanke, 1983).

The first channel worked through the banking system. As emphasized by the information-theoretic approach to finance, a central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems. By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop "informational capital." The widespread banking panics of the 1930s caused many banks to shut their doors; facing the risk of runs by depositors, even those who remained open were forced to constrain lending to keep their balance sheets as liquid as possible. Banks were thus prevented from making use of their informational capital in normal lending activities. The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction.

The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers. In general, the availability of collateral facilitates credit extension. The ability of a financially healthy borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender. However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments. Borrowers' cash flows and liquidity were also impaired, which likewise increased the risks to lenders. Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit. Incidentally, this information-based explanation of how the sharp deflation in prices in the 1930s may have had real effects was closely related to, and provided a formal rationale for, the idea of "debt-deflation," advanced by Irving Fisher in the early 1930s (Fisher, 1933).

The External Finance Premium and the Financial Accelerator Both real and monetary shocks produced the Great Depression, and in my 1983 paper I argued that banking and financial markets propagated both types of impulses, without distinguishing sharply between the two. My subsequent research and that of many others looked separately at the role of financial conditions in amplifying both monetary and nonmonetary influences.

On the nonmonetary side, Mark Gertler and I showed how, in principle, the effects of a real shock (such as a shock to productivity) on financial conditions could lead to persistent fluctuations in the economy, even if the initiating shock had little or no intrinsic persistence (Bernanke and Gertler, 1989). A key concept in our analysis was the external finance premium, defined as the difference between the cost to a borrower of raising funds externally and the opportunity cost of internal funds. External finance (raising funds from lenders) is virtually always more expensive than internal finance (using internally generated cash flows), because of the costs that outside lenders bear of evaluating borrowers' prospects and monitoring their actions. Thus, the external finance premium is generally positive. Moreover, the theory predicts that the external finance premium that a borrower must pay should depend inversely on the strength of the borrower's financial position, measured in terms of factors such as net worth, liquidity, and current and future expected cash flows. Fundamentally, a financially strong borrower has more "skin in the game," so to speak, and consequently has greater incentives to make well-informed investment choices and to take the actions needed to ensure good financial outcomes. Because of the good incentives that flow from the borrower's having a significant stake in the enterprise and the associated reduction in the need for intensive evaluation and monitoring by the lender, borrowers in good financial condition generally pay a lower premium for external finance.[1]

The inverse relationship of the external finance premium and the financial condition of borrowers creates a channel through which otherwise short-lived economic shocks may have long-lasting effects. In the hypothetical case that Gertler and I analyzed, an increase in productivity that improves the cash flows and balance sheet positions of firms leads in turn to lower external finance premiums in subsequent periods, which extends the expansion as firms are induced to continue investing even after the initial productivity shock has dissipated. This "financial accelerator" effect applies in principle to any shock that affects borrower balance sheets or cash flows. The concept is useful in that it can help to explain the persistence and amplitude of cyclical fluctuations in a modern economy.

Although the financial accelerator seems intuitive--certainly financial and credit conditions tend to be procyclical--nailing down this mechanism empirically has not proven entirely straightforward. ...

Financial accelerator effects need not be confined to firms and capital spending but may operate through household spending decisions as well.[3] Household borrowers, like firms, presumably face an external finance premium, which is lower the stronger their financial position. For households, home equity is often a significant part of net worth. Certainly, households with low mortgage loan-to-value ratios can borrow on relatively favorable terms through home-equity lines of credit, with the equity in their home effectively serving as collateral. If the financial accelerator hypothesis is correct, changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect because changes in homeowners' net worth also affect their external finance premiums and thus their costs of credit. If true, this hypothesis has various interesting implications. For example, unlike the standard view based on the wealth effect, this approach would suggest that the distribution of housing wealth across the population matters because the effect on aggregate consumption of a given decline in house prices is greater, the greater the fraction of consumers who begin with relatively low home equity. Another possible implication is that the structure of mortgage contracts may matter for consumption behavior. In countries like the United Kingdom, for example, where most mortgages have adjustable rates, changes in short-term interest rates (whether induced by monetary policy or some other factor) have an almost immediate effect on household cash flows. If household cash flows affect access to credit, then consumer spending may react relatively quickly. In an economy where most mortgages carry fixed rates, such as the United States, that channel of effect may be more muted. I do not think we know at this point whether, in the case of households, these effects are quantitatively significant in the aggregate. Certainly, these issues seem worthy of further study.

Monetary Policy and the Credit Channel ...Some evidence suggests that the influence of monetary policy on real variables is greater than can be explained by the traditional "cost-of-capital" channel, which holds that monetary policy affects borrowing, investment, and spending decisions solely through its effect on the level of market interest rates. This finding has led researchers to look for supplementary channels through which monetary policy may affect the economy. One such supplementary channel, the so-called credit channel, holds that monetary policy has additional effects because interest-rate decisions affect the cost and availability of credit... The credit channel, in turn, has traditionally been broken down into two components or channels of policy influence: the balance-sheet channel and the bank-lending channel (Bernanke and Gertler, 1995). The balance-sheet channel of monetary policy is closely related to the idea of the financial accelerator that I have already discussed. ... For example, according to this view, a tightening of monetary policy that reduces the net worth and liquidity of borrowers would increase the effective cost of credit by more than the change in risk-free rates and thus would intensify the effect of the policy action.

In the interest of time I will confine the remainder of my remarks to the bank-lending channel. The theory of the bank-lending channel holds that monetary policy works in part by affecting the supply of loans offered by depository institutions. This concept is a cousin of the idea I proposed in my paper on the Great Depression, that the failures of banks during the 1930s destroyed "information capital" and thus reduced the effective supply of credit to borrowers. Alan Blinder and I adapted this general idea to show how, by affecting banks' loanable funds, monetary policy could influence the supply of intermediated credit (Bernanke and Blinder, 1988). ...