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Nonmonetary Effects of the Financial Crisis in
the Propagation of the Great Depression
Ben S. Bernanke, 1983
American Economic Review
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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 Background
The Great Depression in the U.S., 1929 - 1941
Migrant Mother, Dorothea Large, 1936
• 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?)
http://de.wikipedia.org/wiki/Florence_Owen
s_Thompson#Migrant_Mother
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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 channel
B) 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 nonmonetary 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 outof-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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