Friday, March 21, 2008

What Many of the Great Depression Comparisons Miss

There seems to be many observers comparing the current economic crisis to that of the Great Depression. Amity Shales does a good job reviewing and correcting some of the comparisons. Following her lead, I want to briefly comment on Paul Krugman's latest NY Times piece titled "Partying Like It's 1929." Krugman makes the case that we have forgotten an important lesson learned from this period: regulating the financial system. One of the main contributors to the Great Depression was the massive collapse of the banking system--about 9000 banks fell. Krugman believes this development turned what would have been a normal recession into the Great Depression. While some economists would debate whether this was the most important factor, no one disputes that it turned a bad situation into something worse. Here is Krugman:

What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.

As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.


Krugman fails to mention some important details about the banking system in the 1920s and 1930s that undermines his thesis that it was "unregulated, unsupervised financial markets" that caused the banking crisis of the 1930s. First, there is a huge literature that shows a key reason for the massive banking collapse was the unit banking laws of the time--laws preventing banks from having more than one branch. The absence of interstate, and sometimes intrastate, branch banking meant bank assets were poorly diversified. For example, a bank in Kansas would hold loans mostly from farmers, making it susceptible to swings in the agricultural market. Now imagine if that same Kansas bank had branches throughout the nation. It's balance sheet would now include loans to sectors of the economy other than just farming. Simply put, its balance sheet would more diversified and better insulated from negative economic shocks.

A second advantage of branch banking is that even if a non-rational, panic-driven bank run starts it can be nipped in the bud at the onset. Imagine now the panic erupts at the bank in Kansas. People rush to bank and a big line forms outside. Instead of running out of reserves, the bank in Kansas can now pull in reserves from its branch bank in the next county. This will stem the panic and prevent it from becoming systemic.

Now, are these ideas merely theoretical? No; one needs to look no further than Canada during the Great Depression. Canada, unlike the United States, had nationwide branch banking. Guess how many banks shut down in Canada during the Great Depression? Zero. Yes, you read that correctly, zero banks shut down in Canada while around 9000 shut down in the United States. Oh, did I mention that Canada did not have a central bank during the worst part of the Great Depression? And yes, the real economy was hit just as hard in Canada as it was in the United States.

A good survey of the branch banking literature is found in Charles Calomiris' book, U.S. Bank Deregulation in Historical Perspective. It is also worth noting that some researchers such as David Wheelock also point out that experiments by state governments with deposit insurance in the 1920s also contributed to the problem. His research finds that deposit insurance "caused more entry and encouraged greater risk-taking than would have otherwise occurred and, hence, the banking systems of states with insurance might have been more vulnerable to a decline in economic activity." (source here)

So Krugman's claim that it was the "unregulated, unsupervised financial markets" that caused the bank runs misses some important details. If I were writing Krugman's column I would say it was the "poorly designed banking system aided by a poorly run Federal Reserve" that contributed to the collapse of the banking system.

So if this is the season for making comparisons to the Great Depression, what is the relevant comparison for financial markets today? Are the financial market as poorly designed today as they were back then?

2 comments:

  1. There seems to be a pattern doesn't there: regulation is introduced in response to a financial crisis; the economy evolves and the regulatory framework is seen as outmoded and inefficient and the "regulatory dialectic" plays itself out; financial liberalization occurs and financial entrepreneurs push their new freedom to its limits, resulting in a crash....and so it goes on. Cycles are endogenous to capitalism.
    But we have at least learned something from the Great Depression:we seem better able to insulate the real economy from the pathologies of the financial sector, through automatic stabilizers and discretionary policy.

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  2. Krugman performs what is essentially bait and switch. He claims with hindsight that regulators could have prevented both this crises and the crises in the early thirties.

    The switch is, going forward we don't have the benefit of hindsight. Regulators would be and are running just as blind as anyone else.

    He also ignores the government's complicit role in creating this crises to begin with.

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