Financial Factors in the Great Depression

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Point of paper: Cost of financing for firms rose during the Great Depression due to debt deflation and “flight” to quality (which contributes to the asymmetric information).

The paper is VERY BORING and LONG and he jumps ALL OVER THE PLACE: I do apologize for such a long summary but there is no other way I can summarize all this because if Jones asks something beyond what’s on the study guide then hopefully this will give a little more insight.

  • Financial Factors in the Great Depression:

A central, neglected theoretical piece of the story for financial factors was the allocative effects of imperfections in capital markets, which can imply links between disruptions in financial markets and subsequent economic activity. Also, the increasing emphasis on learning and "path-dependence" in economics has helped to explain why financial shocks during the 1930s were so severe and why policy-makers failed to prevent the Depression.

  • The Monetarist Revolution and the Great Depression:

In their monumental Monetary History of the United States (1963), Milton Friedman and Anna Schwartz provided a simple and potentially powerful explanation of the origins of the Great Depression that depended on exogenous changes in the money supply (including elements such as the co-movements of nominal GNP and the money stock, the movements of prices, and changes in the relative size of various components of the money stock.)

Friedman and Schwartz were less interested in explaining the beginnings of the recession of 1929 and the October stock market crash than in the question of how an initial downturn in 1929 became transformed into the Great Depression

  • A Change in Paradigm, New Questions, and Old Answers:

Economists began to formulate theoretical arguments of why conditions in financial markets might not be accurately captured by the aggregate value of capital in the stock market, the supply of money, and "the" real or nominal interest rate.

Theoretical models of credit allocation under asymmetric information imply that access to external finance may be inhibited because of information costs faced by sources of outside funding. Under these circumstances, "insiders”-firm managers and financial intermediaries with an ongoing relationship with the firm-can supply funds at lower cost than "outsiders”-relatively uninformed stockholders and bondholders. An important implication of this literature is that changes in the allocation of wealth in the economy can increase the cost of outside finance if they reduce the available supply of "insider" funding

Mishkin (1978) was the first to apply the new literature on imperfect capital markets to the Great Depression. Mishkin (1976) presents a model of consumer "distress" to analyze the role of debt deflation in reducing consumer durables demand. He argues that consumers valued "liquidity" (that is, holding wealth in assets that do not suffer distress-sale discounts due to asymmetric information about their true value). Exogenous shocks to consumer liquidity will lead consumers to reduce their demand for illiquid consumer durables as they try to rebuild their stock of liquid assets. This framework served as the basis for Mishkin's (1978) study of the effects of changes in the household balance sheet and consumer expenditures during the Depression. Mishkin (1978) argued that in addition to the depressive effect of aggregate wealth reduction on consumption in the 1930s, the debt deflation (a reallocation of wealth away from indebted consumers) reduced aggregate consumption demand

Bernanke argued that in the presence of capital market imperfections, the destruction of intermediaries and the reduction in borrowers' net worth-both the results of debt deflation-reduced investment in the 1930s by increasing the marginal cost of funding. Reductions in firm net worth increase credit costs for firms because as debt deflation erodes the equity stake of firm "insiders," the ratio of external to internal claims on the firm rises. Under asymmetric information this increases the marginal cost of external finance. Debt deflation also erodes the net worth of banks, causing some banks to fail, and others to tighten their credit standards to avoid runs by depositors. Thus access to "inside" debt from relatively well-informed banks is also curtailed. The financial devastation of 1929 to 1933 had always been given prominence in accounts of the Depression.

Bernanke's (1983) contribution was to combine theory and empirical evidence to argue that financial collapse was more than a symptom of economic decline; financial collapse deepened the Depression by hampering the efficient allocation of capital.

As shown in Figure 2, the quality spread in bond market yields jumped dramatically during the Depression, and real liabilities of failed businesses tripled. Nominal liabilities of failed businesses ros from a monthly average of $40 million for January 1928 through December 1929 to a monthly average of $63 million for January 1930 through June 1933.

According to Bernanke, the decline in the efficiency of the economy's financial allocation mechanism induced by the reduction of banks' lending capabilities and the collapse of producers' and consumers' net worth should be thought of as long-lived shocks to financial technology, and therefore, can explain the persistent decline in output through a rise in the "cost of credit intermediation."

Bernanke cited (and likely was motivated by) the writings of several 1930s chroniclers of credit market conditions and economists who emphasized persistent disruption to financial markets as one of the main continuing problems of the Depression after 1933, and who viewed deflation as a destabilizing influence. The economists on this list include Irving Fisher (1933), whose classic statement of the debt-deflation cycle mirrors many of Bernanke's arguments.

In his empirical work, Bernanke showed that both shocks to firms' and banks' net worth were significant (statistically and economically) for explaining the fall in output during the 1930s, even after taking account of monetary shocks. Indicators of declining net worth of banks and firms-including deflation, corporate failures, bank failures, and the bond risk spread-all were important as predictors of economic decline over and above monetary shocks.

The "new view" of Bernanke and others was not a rejection of Friedman and Schwartz's argument that monetary shocks were important. Its main contribution was to show that monetary shocks, and other disturbances during the early phase of the Depression, had long-run effects largely because they affected the institutional structure of credit markets and the balance sheets of borrowers.

Mishkin (1991a, 1991b) argued that reductions in stock prices and increases in quality spreads in bond markets are best viewed as the result of changes in "lemons" discounts on securities prices under asymmetric information, which signal financial-market disruption and reductions in internal funds available to firms.' Financial market disruption has a larger impact on certain firms, and thus reduces their creditworthiness and the value of their securities in the market. Mishkin (1991a) analyzed yield spreads for bonds and stock price movements during historical financial panics and confirmed a "flight to quality" (that is, an increased penalty for firms whose prospects suffer an asymmetric-information discount). He applied this analysis to bond and stock markets in 1930, and argued for a similar "flight to quality" at the beginning of the recession of 1937. Mishkin's analysis of securities markets provides a theoretical explanation for time variation in the risk premium of stocks and bonds by linking these changes to exogenous disruptions in financial markets throughout U.S. history.

  • Implications of the "New View":

First, the financial-propagation view of the Depression implies that a money-supply shock of a given magnitude will have a larger effect if it occurs at a time of high leverage, or in an economy with a poorly diversified, geographically fragmented banking system like that of the United States.

However, the unprecedented debt burden, which continued to rise during the deflation of the early 1930s (as shown in Figure 3), reduced the creditworthiness of many borrowers through drastic redistributions of wealth. The extent to which the Depression's severity was a consequence of the financial boom that preceded it remains an interesting question for future research.

Second, once the character of financial market influences is broadened to include non-monetary channels, earlier monetarist arguments that restoring the money supply to earlier levels through open market operations in 1931-1933 could have reversed the course of the Depression and prevented bank failure, borrower insolvency, and economic decline must be qualified. Because the financial system is path-dependent, disturbances to the allocation of wealth and the viability of financial intermediaries caused by open market operations cannot in general be reversed by open market operations that restore the money supply. Borrowers or bankers who have already suffered large losses due to increased debt burdens and costs of financial distress will not regain lost wealth as the result of subsequent open market operations.

Thus, according to the new view, even if Friedman and Schwartz and their supporters were entirely correct about the importance of monetary shocks in precipitating the Depression, it does not follow that open market operations to restore the money supply would have had offsetting effects in promoting recovery from the Depression.

Third, different methods of increasing the money supply-say, expansionary open market operations vs. reductions in the discount rate-might have had very different consequences for recovery (contrary to Friedman and Schwartz, 1986, p. 201). The discount window could have been used to provide focused assistance to the banking system and decrease the relative cost of bank credit, while the benefits of expansionary open market operations would have been confined to increases in the aggregate supply of money, increased prices, and reduced interest rates on riskless short-term securities.

However, one of the implications of the new financial view is that open market operations may be a blunt and insufficient instrument for reversing the effects of bad previous policy compared to other policies.

  • Was Deflation Unanticipated?:

A central element of the new financial view is that deflationary shocks from 1929 to 1933 were largely unanticipated (otherwise, they would not have produced financial distress).

While there is some continuing disagreement between these authors and Cecchetti (1992) over precisely how much of the deflation was anticipated at short time horizons, all parties agree that there was substantial unanticipated deflation even at quarterly frequencies.

They find that agents systematically overestimated the probability of a return to a zero-inflation regime rather than continuing deflation. Given that debt contracts often were written with durations greater than several months, the rise in the real value of long-term debt that occurred must have been unanticipated.

  • New Challenges and Interpretations:

The new view's emphasis on deflation prompted several cross-country comparisons of the role and transmission of deflation. In notable recent work, Haubrich's (1990) study of financial-real interactions during the Depression applies empirical methods similar to Bernanke (1983) to Canada. He finds that measures of financial distress have no economic or statistical significance for predicting economic activity in Canada.

There are at least four reasons to doubt the general proposition that macroeconomic financial distress depends on widespread bank failures, and the application of this proposition to the 1930s.

First, Canada and the United States were not equally vulnerable to financial disturbances at the time of the Depression. According to theoretical models of the allocative effects of wealth redistribution, the effects on economic activity of deflation-induced reductions in net worth are nonlinear and depend on the initial balance sheet position of the firm, and its initial composition of inside and outside funding (Bernanke and Gertler, 1989, 1990; Calomiris and Hubbard, 1990) While the United States and Canada suffered similar deflations from 1929 to 1933, Canadian real debt burdens started lower and never reached levels comparable to the United States. .

Second, in Canada the money stock may have been a better indicator of the outstanding volume of short-term credit than in the United States where non-bank forms of credit (like commercial paper) were much more important.

Third, Canada's relative reliance on banks as sources of short-term credit, and the concentration of the banking industry, may have reduced the costs of managing financial distress in Canada relative to the United States.

Fourth, Haubrich's interpretation of his findings implies that exogenous variation in "inside equity" has smaller allocative consequences than similar variation in the availability of "inside debt" (bank loans). It is difficult to justify this distinction between inside debt and inside equity as a theoretical proposition. The central point of the asymmetric-information approach to corporate finance is that outside funds, whether debt or equity, entail greater costs than funds supplied by relatively informed stockholders/managers and their bankers.

For these reasons I do not think Haubrich's findings support his general conclusion (and his suggested interpretation of Bernanke, 1983) that bank failures are a necessary precondition for the transmission of financial distress.

Temin (1989) challenges the importance of unanticipated deflation and Bernanke's financial transmission mechanism for the United States. Temin argues that the anticipated component of the deflation (post-1930) must have been more important, particularly downward rigidity of nominal interest rates (which keeps the cost of borrowing high), and the Mundell-Tobin portfolio reallocation effect.

(11The Mundell-Tobin efFect relies on portfolio allocation toward money when the inflation rate is low (Mundell, 1963; Tobin, 1965). For example, in Tobin's dynamic framework, expected deflation reduces the attractiveness of holding real capital and thus reduces equilibrium economic activity.)

Temin constructs a test of this proposition and rejects it. He divides the economy into industries and asks whether industries with low concentration ratios suffered unusually severe contractions relative to other industries compared to other cyclical downturns. Finding no such pattern, he rejects the importance of increases in the cost of credit as the propagator of deflation.

I would raise three objections to Temin's test. First, differences across firms in costs of finance may not show up in industry-level aggregation. Second, concentration ratios at the industry level may be a very poor indicator of cross-industry variation in external finance costs. Third, cross-sectional differences in industry performance may be hard to observe during a massive disturbance like the Depression that substantially affects all borrowers, particularly if there is feedback in demand across industries.

Hunter groups firms by size categories and examines differences in firms' balance sheet changes during the Depression. She argues that corporate liquidity preference increased substantially during the Depression, but increases in liquidity were confined mainly to large firms. Large firms were the only ones capable of improving their liquidity positions because of their superior access to financial markets.

This evidence provides more direct support for Bernanke's position using standards of comparison suggested by Temin (1989).

The costs of external finance were quite high during the Depression, these costs were particularly high for small, growing enterprises. High finance costs reflected both the reduced creditworthiness of firms as well as a contraction in the availability of "inside" bank debt.

While financial factors can explain persistent reductions in the efficiency of capital allocations and economic activity, one must combine financial influences with other factors to explain protracted underutilization of resources (that is, unemployment and excess capacity).

Depression brought endogenous responses in technological choice, the composition of consumption demand, and demands for labor skills, which had important effects on aggregate production, capacity utilization, and employment.

Financial factors are unlikely to provide the entire explanation for how early adverse shocks were transformed into the Great Depression.

A final lesson from the Depression for modern macroeconomics is the peril of assuming that shocks to technology (including changes in the cost of credit intermediation) are independent of shocks to monetary policy or other influences on "aggregate demand."

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