Authored By: Prof B.
Fellow business colleagues, investors, past students and friends,
For more than fifteen years now I have shared a passion for teaching that has allowed me to meet a great number of incredibly bright and ambitious young people. After numerous competitions, my dreaded twenty-four hour case studies and endless laughs over lunches; many of you have gone on to achieve wonderful things in life beyond just fame or fortune. It was always my intention during those years to open your eyes beyond the confines of a textbook to the world of opportunity that surrounded you.
It is indeed a great pleasure to have the opportunity to be welcomed here today by Brad to this online community. I have always enjoyed following the careers of past students and as many of you know I continue to stay in touch. My intention today is to put into perspective the historical significance of recent events with those of the past in the hope that something is learnt from all of this. Remember that nothing is ever as it appears and there are angles that you must interpret in order to see the whole picture accurately.
In 1983 a work was published by the American Economic Review titled Nonmonetary Effects on the Financial Crisis in the Propagation of the Great Depression that has received attention recently in light of the current problems plaguing the credit markets. Over the past twenty-five years few would take notice of the significance of this paper and the subsequent appointment by the author to Chairman of the Federal Reserve in February of 2006. The paper provides meaningful insight into the sustained financial crisis that existed during the Great Depression and what factors played a role in this collapse. It also provides meaningful insight into the actions of the Federal Reserve in recent months and their focus on maintaining lending between institutions through various means.
The three themes presented throughout the paper revolve around the failure of financial institutions, defaults & bankruptcies and a high correlation between the financial crisis and macro economic activity during that period. Firstly, the author does not attempt to explain reasons for the initial downturn in the markets found during 1929-1930, but it is common knowledge that events were perpetuated by a banking crisis and household insolvency that contributed to the depth and extent of the period. Secondly, Bernanke builds upon a Friedman-Schwartz work (1963) that provides an alternative view of the financial crisis where the prior belief was that the depression was due to propagation in monetary and price shocks. Thirdly, Bernanke provides an argument that the service of gathering information, between borrowers and lenders, cost more than previously charged and those increased costs impacted the ability of then borrowers to secure funding from financial institutions. This disruption when compounded with the reduced ability of the financial markets to provide funding in part due to high costs of obtaining funds had a real impact on aggregate demand of the macro economy.
The two main contributors to the financial collapse of the Great Depression presented by the author were a loss of confidence in financial institutions (regional commercial banks) and the spread of insolvency among debtors (Bernanke, 1983).
The failure of financial institutions peaked during the 1930’s although some corporations such as insurance companies and mutual savings banks survived with minimal impact to their operations. Institutions focused on lending to borrowers were the ones to suffer the most significant collapses. Between 1930 and 1933 the average rate of bank failure was 9.2% with only half of all banks in 1927 continuing operations in late 1929. When placed into today’s context these facts are indeed quite significant. Failures at the time of the depression were not new or unheard of since the US banking system was made up of many small, regional banks exposed to higher levels of risk. The dominance of small institutions at this time was largely due to the regulatory environment where large banks were feared and laws restricted branch banking at the national and state levels (Bernanke, 1983). Although many regional banks suffered failures due in part to agricultural pressures seen in the 1920’s, others were more vulnerable to panics in financial markets compounded by highly illiquid assets and fixed-price liabilities that created a run on the bank perpetuated by deposits withdrawn increasingly as panic grew. The significance of these events was compounded by responsible institutions experiencing runs, a large number of banks experiencing difficulties and the period of time through which these panics lasted.
Of course the effect of deflation wasn’t the only major factor for this economic period. The overall increase in indebtedness was significant as corporate bonds increased from $26.1B to $47.1B from 1920-1928, public securities increased from $11.8B to $33.6B and mortgages increased from $11B to $27B during the same period (Bernanke, 1983). This debt crisis sent housing into a tailspin as half of all mortgages were financed during the start of the depression with default rates ranging anywhere from 21% to 62% in many areas of the country. To put this into context: as of August 2007 the default rate stated on adjustable-rate subprime mortgages was only 8% and rising. The impact of deflation was also much more severe than it had been in 1921-1922 where insolvency had not been as large of an issue. The problems seen throughout the Great Depression were not solely responsible by rampant deflation, but more so from the massive expansion of credit during the 1920’s and its contraction beyond 1929. As household and small firm incomes declined during this period the debt service/income ratio increased from 9% in 1929 to nearly 20% in 1933. Add to this that aggregate corporate profits (before tax) were negative in 1932-1933 and after-tax retained earnings were negative in 1930-1933 and the extent of declines for this period are well expressed.
Into 1930 the economic downturn was viewed by many as comparable to the recessionary period of 1920-1922 with the recession that began in 1929 expected to be met with an equally brisk recovery. As the economy flattened out and anticipation of a recovery was created the markets tumbled as banks began to fail by mid-1931. In 1932 the banking system appeared to stabilize for a period of time only to experience another fall in August of that year with subsequent failures. It was only in March of 1933, after the banking holiday, that the bottom was reached and runs on the banks were ended by reducing the burden of debt (Bernanke, 1983) and a recovery was prolonged until 1937. The failures of banks during this earlier period prevented the economy from experiencing a sustained recovery in the early part of 1930. Due to these events, Bernanke was motivated to examine the link between a nonmonetary channel and reduction in real activity.
The financial crisis seen in 1930-1933 had a direct effect on the macro economy through its effect on the money supply and reducing the quality of certain financial services such as credit intermediation with a focus on paper. The disruption in the system by runs on the bank and debt crises increased the cost of intermediation between lenders and certain groups of borrowers, already highlighted above, and these higher costs lead to a decline in the economy (Bernanke, 1983). Some economists argue that financial markets are complete and information and transaction costs can be negated due to banks and other institutions being passive holders of assets. But the trouble lies with the actions of depositors who can adversely affect these holdings by quickly demanding liquidity of their holdings that might be otherwise illiquid. Financial services and information can therefore not be assumed to be perfect markets.
Banks traditionally have always made loans to two groups of borrowers: good & bad. A good borrower takes a loan and invests in an individualized investment or project, which will generate some random return along the mean that is assumed to exceed the opportunity cost of the investment. In the absence of non-systematic risk lending to a good borrower is socially desirable. Bad borrowers on the other hand are assumed to misuse money provided through a loan and are therefore socially undesirable. Bernanke defines the cost of credit intermediation (CCI) as the cost of moving monies from high quality savers into the hands of good borrowers. The CCI includes transactional, monitoring, accounting costs and expected losses due to bad borrowers (Bernanke, 1983).
The financial crisis of the Great Depression was directly due to the disruption of the credit allocation process when significant alterations to credit flow occurred. As fear of continued runs on the banks led to withdrawals of deposits in banks of highly liquid assets, this caused banks to begin looking towards precautionary measures by increasing reserve ratios and holding liquid assets (i.e. non-mortgage). These actions by the banks inevitably increased the CCI and many good borrowers did not receive financing or funds on loans. As the CCI increased banks only took on loans of the highest quality in reaction to the current environment. As the depression deepened throughout 1931-1933 the number of commercial loans continued to decrease as banks made fewer & fewer loans with the largest impact being felt by households, farmers and small businesses who rely heavily on bank credit for financing and operations.
Banks at that time chose between two types of contracts. The first was a state contingent contract that required high monitoring costs and information over each future state and the second was a simple contract that specified a date and amount of money to be repaid that required the use of collateral. In the current environment of decreasing available liquidity banks choose to utilize simple contracts because collateral helped to lower CCI. Simple non-contingent loans became very risky of default and banks stopped making mortgage loans and good borrowers were unable to secure any funds. These actions saw the spread between government and Baa (investment grade) bonds widen significantly as banks demanded very liquid and safe government bonds. Bernanke further on makes the link between CCI, the interest rate spread and industrial production.
The effects on credit markets and macro economic activity demonstrated that many potential borrowers (firms) were unable to secure funds for safe and low risk-investments for use in their corporate infrastructures. Since many large corporations held substantial levels of cash, assets and reserves prior to this period of time they were able to proceed with capital investments on their own. Yet even if firms had the liquid capital many were reluctant to expand production due to low economic demand and monetary shortfalls. These firms (viewed as good borrowers) faced higher interest rates on borrowing of funds, but not on their savings which decreased the demands for consumption through banks who sought high quality forms of liquidity.
We now see that the effects on contraction in bank credit caused the rate of growth of loans to slow on failing business liabilities and failing bank deposits due to depositors retrieving funds that led to a large negative effect on the economy as a whole. The discussion of persistence by Bernanke becomes slightly more complex and raises the questions of whether financial crises are able to explain the depth and extent of the depression but possibly not the length. The length of time depends upon the amount of time it takes a financial crisis to establish new and renew existing channels of credit after any major disruption (ex: CCI) and rehabilitate insolvent debtors which for this period was slow to develop.
The banking holiday of 1933 was an attempt by the banks to revive the financial system and introduce new regulation that took stronger measures against the problems experienced in the past with creditors and debtors. Yet even after, the banks were largely reluctant to make loans and instead chose to hold safe liquid investments for their own security. Debtor insolvency continued from 1933-1938 largely due to many banks reluctance to make loans. There is evidence that a surplus of funds were available since residential mortgages were slow to adjust and residential defaults continued through 1935 due to this stonewalling.
The financial crisis we’ve encountered today has parallels and dissimilarities to those of past periods with unique characteristics that have evolved over time. Yet the complexity at this time is likely one which is unprecedented and needs further study in order to accurately establish its mechanics. What is known is that statistical modeling combined with a failure to correctly recognize risk and ambition for ever improving margins led many financial institutions to suffer considerable losses in the past twelve months due to increasing and uncertain credit obligations. Although these may seem to be manageable obstacles the question of other more significant challenges should be addressed.
The question of moral hazard has been discussed extensively by the media and social settings in reaction to the near failure of Bear Stearns. Moral hazard, by definition, arises when an individual or institution fails to realize the true consequences of their actions. This often leads to an increased tendency to act less conservatively in the face of risk than they might otherwise operate. This is clearly seen in the behaviour of many corporate leaders at a time when repercussions for the actions of their firms are lenient and responsibilities to shareholders are largely ignored. This produces a situation where asymmetrical information runs rampant and without direction or control. From the principal-agent problems of asset backed commercial paper to the abundance and chronic addiction to poor quality credit in the subprime mortgage market; many of these corporations pushed risk onto lenders who pulled investors inwards with greater amounts of even higher pre-packaged obligations filled with now obvious opaque perils.
Today we see the interest rate spread (the difference between interest rates banks pay on deposits vs. rates they charge for loans) at levels highlighting historical distress. Although interest rates have fallen significantly in the US and may continue to fall, lending institutions remain inflexible in their lowering of lending rates in the face of uncertainty. This creates problems not only in the consumer debt markets but for counter-party trading that many financial institutions require in order to service short-term debt obligations between each other. In some cases this counter-party effect has virtually swollen up to a point where the system has run the potential for failure as solvency erodes. In a system where one large institution is a counterparty to many others the ripple effects of a failure would pose a significant systemic risk to the entire market.
What is evident now, expressed by the irrational swings and volatility within the markets, is that few investors realize the true jeopardy that the financial system faced with the potential failure of Bear Stearns and the domino effect that it may have been responsible for initiating. Complex computer networks often utilize redundancy as a form of protection against system failure; if one server fails there are others which can pick up the slack to prevent a system-wide crash. In the financial system very few (if any) of these preventative measures are present due to the lack of regulation requiring transparency of risk.
Nearly anywhere you look within the system are direct and obvious conflicts of interest that continue to expose the system to continued risk. Whether you mark criticism towards federal agencies, financial institutions, insurers or rating agencies the need for reform is now more apparent than ever before. It will take years for the complexities of these debt instruments to unravel and gain the transparency that they require in order to protect both institutions and independent investors from unnecessary risk, but only if the system is forced to expose their dirty laundry and accept that these practices are critically flawed. Any failure to do so continues to put the system at risk from systematic failure in a similar fashion to that experienced from past credit collapses and the period of the early 1930’s.
It is important to note that I am not a fortune teller or someone who holds an ability to achieve clairvoyance in his teachings; simply an intrigued student of history and its impact on many events that might otherwise go unnoticed. The mistake to discount the true fundamental causes of the Great Depression is a failure within a system that boasts adequate bureaucratic oversight responsible for maintaining the mechanics of liquidity. Bernanke and his deputies have focused appropriately within the financial system on the flow of liquidity to stave off disaster. As I look back to his appointment as chairman of the Federal Reserve only a short while ago I smile at the possibility that few others would handle this crisis as well as it appears he has. For all of the criticism directed of late towards the Fed and its handling and reaction to interest rates and lending structures, very few likely recognize just what they have managed to do in the face of chaos, fear and an environment in which financial desire significantly outweighed the rational realization of risk. It is my belief that his appointment was with significant consideration of the looming bubble and his demonstrated knowledge of the inner workings of significant past events.
The Fed is currently focused on lending today, but on inflation tomorrow. The easiest part may be over, but the difficulties definitively do not end here.
Bernanke, Ben, “Non-monetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review, 73, (1983), 257-276.
Friedman, Milton and Schwartz, Anna, “A Monetary History of the United States, 1867-1960,” Princeton: Princeton University Press, 1963.