Banking Panics During the Great Depression
Project Background
Research about Financial Panics During the Great Depression
A short primer by Professor Richardson
The causes, consequences, and possibilities of preventing the banking panics of the Great Depression have been debated for seven decades. The debate’s factual foundations rest upon data published in the Federal Reserve Bulletin. The September 1937 issue contains the only comprehensive collection of statistics on suspended banks; it is the sole source of aggregate bank failure rates (Board of Governors 1937, hereafter FRB’37).1 Scholars studying the contraction continuously redefine, reinterpret, and reveal new correlations between the FRB’37 data and measures of industrial, commercial, and financial activity.2
The scholarship addresses three key questions. Why did bank suspensions surge at particular points in time? How did bursts of bank suspensions affect commercial and industrial activity? Could Federal Reserve intervention have prevented (or did its actions trigger) these crises? Debate persists about the answer to each inquiry.
Concerning causes of the banking crises, some scholars conclude that banks failed because the economy contracted. Droughts disrupted the economies of grain growing states. Loan default rates rose. Bond prices declined. Stock values fell when the securities market crashed. These fundamentals forced banks into insolvency, continuing a process of consolidation and liquidation that began during the 1920s.3 Other scholars conclude that a contagion of fear, a flight to cash holdings, and withdrawals en masse drained deposits from banks and pushed financial markets towards collapse. Illiquidity of assets and Federal Reserve inaction exacerbated the credit crunch.4
Concerning the consequences of the banking crises, some scholars see bank failures as symptoms of ongoing events with no special role in the propagation of the downturn.5 Other scholars believe that banking panics had monetary effect. Panics eroded depositors’ confidence, induced further withdrawals, forced banks to liquidate assets at deep discounts, lowered asset prices, encourage banks to hold excess reserves, and reduced the money multiplier. This vicious cycle reduced the money supply and turned what would have been a typical recession into a great contraction.6 Another set of scholars maintains that bank panics influenced economic activity by disrupting financial intermediation. Bank failures increased the cost of credit intermediation, dislocated the financing of small and medium firms, disrupted current production, and curtailed investment spending. This financial acceleration lowered the economy deeper into depression.7
Concerning the possibilities of preventing the banking panics, some scholars argue the Federal Reserve could have done little to aid ailing banks. Fundamental forces pushed banks into insolvency; monetary intervention could not pull them out. Liquidity assistance could not eliminate loan losses. Open-market expansion – even on a massive scale – could not lift the economy out of the liquidity trap (Temin 1976). Other scholars argue that the Federal Reserve could not aid ailing banks directly, since illiquidity and contagion caused few banks failures, but that massive open-market expansions, such as those that the Roosevelt administration implemented after abandoning the gold standard, could (and did) reignite economic expansion, and thus, indirectly alleviate the banking situation (Calomiris and Mason 2003, Eichengreen and Sachs 1985, Romer 1992, Temin 1989). Another set of scholars argue that even limited assistance from the Federal Reserve might have mitigated banking panics. By acting as a lender of last resort and extending loans to solvent but illiquid institutions, the Federal Reserve could have kept ailing institutions afloat. A credible commitment to do so might have calmed consumers, reassured bankers, raised the money multiplier, alleviated the credit crunch, and eased the economic situation (Richardson and Troost 2005). A final and influential set of scholars concludes that the Federal Reserve’s sins were of commission as well as omission. The Federal Reserve not only neglected to aid ailing banks, but by raising interest rates, reducing the monetary base, and restricting discount lending, the Federal Reserve weakened all banks, forced many into insolvency, and created conditions conducive to panics. As evidence, these scholars highlight the Federal Reserve’s monetary contraction in 1928 and the Federal Reserve’s defense of the gold standard in 1931 (Friedman and Schwartz 1963, Meltzer 2003).
Economists hold positions across this spectrum of beliefs. One reason for the diversity of opinion may be the single source of evidence. FRB’37’s statistical series are imperfect indicators of bank distress. The data do not distinguish temporary suspensions from permanent suspensions. The data do not distinguish institutions afflicted by illiquidity from banks suffering insolvency. Neither the categories nor the causes of suspensions are indicated. The smallest period of aggregation at the national level is the month and at the Federal Reserve district level is the year. Key terms remain undefined, leaving much open to interpretation.8 Scholars strive to fill these voids by analyzing samples of national banks (Eugene White 1984) or panels of banks from within individual cities, states, or Federal Reserve districts (Charles Calomris and Joseph Mason 1997, Mark A. Carlson 2004). The most recent and comprehensive work (Calomiris and Mason 2003) analyzes a panel of data for all Federal Reserve member banks.9 These studies question conclusions predicated solely upon the FRB’37 series, suggesting that the old series require reconstruction.
