Ben S. Bernanke Nonmonetary Effects of the F inancial Crisis in the Propagation of the Great Depression American Econom

1. Ben S. Bernanke Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression American Economic Review, June 1983 Why was the Great Depression so deep? Why did it last so long? The credit channel: a career is launched!

2. Why was the Great Depression so deep?Why did it last so long? • Friedman and Schwartz: monetary contraction. • Bernanke: true, but there’s more. Financial crisis – bank failures – reduced borrower net worth • Increased Cost of Credit Intermediation (CCI) (A “rational” credit squeeze) • Opposed to Keynes, Minsky, Kindleberger, Shiller: Animal spirits/Irrational exuberance  Inherent instability of financial capitalism • Bernanke: “push rationality postulate as far as it will go.”

3. Cost of Credit Intermediation • Intermediaries separate “good” from “bad” borrowers • Screening costs • Monitoring costs • Accounting costs • Bad loan losses • Debt build-up in Roaring ‘20s • Erosion of collateral values Either write more complex debt contracts or bear higher bad loan losses Either way, CCI rises and lending is reduced. • Banks liquidate loans/rush to quality assets (T-bonds) • Observe low interest rate…but money isn’t easy.

4. Aside: Bernanke and GertlerAgency Costs, Net Worth and Business Fluctuations Lender costs of “auditing” borrowers put a wedge between the costs of inside capital and outside capital. The higher an entrepreneur’s net worth (saving), the easier it is to attract credit and to undertake investment projects. Positive productivity shocks increase income, increase entrepreneur saving, reduce agency costs of securing credit, increase current investment…and increase capital stock making for greater future output and investment. Negative shocks push some entrepreneurs out of a “good” category  greater negative effects on investment and future output. Redistribution “shocks” from borrowers (entrepreneurs) to lenders reduce borrower net worth and reduce investment. Debt-deflation shocks reduce borrower net worth and similarly reduce investment.

5. Garrett Jones’ (GMU) Summary of Bernanke and Gertler • Two kinds of people: Entrepreneurs (E) and Savers (S) • Technology shocks • Variations in Output, Income, Saving (E Net Worth) • Entrepreneurs don’t have enough saving to reap full benefits of their ideas • Savers could lend to entrepreneurs who could tell them their projects failed even when they were successful • Lenders incur auditing costs (“costly state verification”) Set audit probability so E won’t lie when his project succeeds • S’s willing to lend more when the future is promising • Less chance they’ll incur auditing costs

6. Normal times • S does some lending to E though some projects not funded • Some E are unlucky, fail to repay S, and might get audited Negative aggregate shock • E have less collateral (net worth) to back their ideas • S can’t trust E as much: Less trust  Less Lending  Less Investment  Less future Y • A one-time negative shock can set off long recession E’s productivity down  E’s collateral down  Less trust  Reduced saving and lending by S  Reduced investment  Reduced capital stock and output in future

7. Back to Bernanke, Non-Monetary EffectsReal Consequences of Credit Contraction • Aggregate supply impacts Reduced intermediation  reduced allocative efficiency Large, indivisible projects not funded • Production Possibilities Frontier shifts inward • Upward shift of AS Y down, i up … but i didn’t rise • Aggregate demand impacts High cost of credit when CCI rises  would-be borrowers buy less stuff (substitution effect) • AD down  Y down and i down … as observed in Great Depression

8. The Credit Channel: Empirical Verification • 1919 – 1941 Output as function of money shocks (testing Friedman and Schwartz contraction hypothesis) • 1919 – 1941 Output as function of price shocks (testing Lucas confusion hypothesis) • Proxies for bank failures – financial crises significantly add to explanation of Y fluctuations • Resolve underestimate of Y decline in 1930 – 1933 • Challenge: financial crises were in anticipation of Y declines • Response: financial crises were associated with specific events: • Bank of the United States failure • Kreditanstalt failure • Britain off gold • Pyramid scheme scandals

9. Why did it last so long? • New credit channels emerge only slowly. • Insolvent debtors recover only slowly. • Credit difficulties for small business lasted 2+ years after 1933 banking holiday • Very little mortgage lending occurred for years after 1933 {Bernanke uses narrative methodology to make these points. Cites comments of contemporary authorities, news items, etc.} • New Deal recovery: • Rehabilitating the financial system was only positive contribution. • New Deal fiscal stimulus was weak • National Recovery Act (cartelization) hurt recovery