The Role of Bank Failures & Panics: The Great Depression

David Wheelock: Let me start with bank failures. Obviously we've had a lot of bank failures in the last two or three years, I mentioned a minute ago we had 7,000 banks fail during the Great Depression as opposed to a few hundred recently. Many of them were during these banking panics.

Now banking panics are hard for us to really think — to get our hands around because we've never really lived through one because we've all lived through the era in which there's been Federal Deposit Insurance. So, as Scott mentioned a moment ago I used to teach the University of Texas back in the 1980s following the collapse of oil prices and Texas had a big wipeout of their banking system and all these Savings and Loans were going under. I had my money in a shaky Savings and Loan in Austin, Texas, and I could — they published their balance sheet in the paper every now and then and I could see that it was going down the tubes. I knew some money and banking.

I happened to be talking to my mother once on the phone who — my mother had lived through the Great Depression, and I had mentioned fact that I had my checking account with this shaky Savings and Loan. She said, "Why would you do that? You know that your grandfather lost all of his money with the bank failure in the 1930s. It would be crazy to keep your money in it." I said "No mom, there's deposit insurance. If I don't get my money back from the FDIC, we got much worse troubles than..."

You know, I just had complete faith that the federal government was going to stand behind the Federal Deposit Insurance Corporation or the Federal Savings and Loan Insurance Corporation at that time. So I had no reason to run on my bank. But in the 1930s, that's exactly what people did. They saw their neighbor's bank fail. What's the rational thing to do? You run to your bank, get all your money out, put it in a coffee can, and bury it in the backyard. Or, stuff it under your mattress. You want to hold that money--you want to hold your wealth in the form of cash because it's the only asset that you can really count on. You can't count on your bank deposit because you don't know if tomorrow your bank will still be open and you'll be able to get your cash out. So people, when they got fearful about this, the safety of the banking system, they would run on their banks, get in line as quickly as they could, and get their cash out before the bank closed its doors.

And in banking system, banks never have in reserve or cash in the vault or other forms of liquid assets, they never have as much as what they owe their depositors in the form of their checking accounts or their savings accounts. In other words, the bank's liabilities, which are your deposits, will greatly exceed their cash assets because most of what they have is invested in loans and securities. That's the business of banking, otherwise they wouldn't be doing it. Ordinarily it works, but when people, depositors, lose faith in the safety of the banks, it doesn't work.

So what happens when banks fail? That can be contractionary. One is simply a decline in expenditures. My other grandfather, the one who lost his job altogether, he had money in two banks. He was diversified in Texas. One of them failed, he lost half his wealth overnight. Okay. You lose half your wealth, you're going to spend less. Research has been done. A professor at Indiana University years ago did a study in which he showed that locations around the country that have more bank failures had larger declines in spending. Local consumption, local sales taxes went down, local retail sales went down, so there's a direct effect. If people lose money, they spend less.

There's another channel. Ben Bernanke, when he was an academic, did a lot of research, including some research on the Great Depression. He did a study of the effects of bank failures during the 1930s in which he argued that one of the problems was that when banks fail, that severed relationships that borrowers had with those banks. And lending is all about knowing your customer, or least it was in those days before we had credit bureaus and credit reports and FICO scores and all all the quantitative information we have today. It was all about building trust and building a relationship.

You're a small business owner, you go to a bank, you want to borrow money, the banker says I don't know you, I've never lent any money to you, but you look like an honest character so I'll lend you a little bit, and if it turns out to be good, you know, maybe next time we'll make it a little more. Well, if you're a successful businessperson, you're smart, you get income, you repay your loan, next time around, you're going to get a bigger loan, and so forth. Well, suppose that banker fails. He goes out of business because he isn't solvent, he's lost all that cash out of his vault, and so now you're the small businessperson. You have to go to find a new bank. You go into the new bank and say "I'd like to borrow money." The banker looks at you, say, "I don't know you. I've never seen you. I'm not going to lend you any money." Well, that relationship is severed, so it raises what Bernanke terms the cost of credit intermediation. Makes it tougher to get loans.

Think of the financial system as the grease that keeps the wheels of the economy spinning. Well, bank failure is like throwing sand into the end of the wheel or even chopping off bits of the wheel.

Yes, ma'am.

Woman in audience: Did you mention the crisis in the farming sector at all? The Dust Bowl and all of that? Because I know when I teach American history, there's some historians that say it certainly didn't cause the Depression, but it certainly didn't help get out of it quicker.

Wheelock: Absolutely. The Dust Bowl. Tremendously important in the farming community, the Midwest. Particularly the kind of the southwest part of the Midwest. I don't talk about it here for two reasons: one, quantitatively it was not large for the macroeconomy as a whole. Even by 1929, the farming sector was maybe 10% of U.S. GDP. It's about 2% now. It had been, before the Civil War, it had been more than 50%. So by the Thirties, the agriculture sector was already small, so the fact that people are losing their farms and not being as productive as a result of the Dust Bowl, it really was tragic for them. That picture by Dorothea Lange was actually of a Dust Bowl family.

But quantitatively, from the macroeconomy, it was small. So that's you know, as you say, it's not a causal factor of the Great Depression, it was symptomatic and you know, it was obviously a coincidence that there was a drought that occurred in the 1930s along with the Great Depression. Made it harder, particularly for the agricultural sector, to get out of the Great Depression.

Man in audience: One way that, in my understanding, connects what you're talking about is that the majority of bank failures were in rural areas. So in terms of the banking collapse...

David Wheelock: Yep, that's a good point. Right, it's not just a Dust Bowl area, so it's in the rural areas in general. And I'll actually come back to that in just a moment in talking about how that contracts the money supply. And this is where it gets a little more complicated because this is thinking about the money and banking channels that, you know, are just more complicated than the direct relationships with spending. So again, I've got one of these comparative charts just to show you — you know we have the big bank failure shakeout in the 1980s. I don't have S&Ls plotted here. It's hard to get comparative data over time with the Savings and Loans, so they're just left out, but they would have added considerable amount here in the Eighties. They've been pretty much wiped out now.

Here's the more recent recession. We had a significant number of bank failures in comparison with our post-war experience, but again, nothing in comparison with the 1930s.

So what are these banking panics? Again, it's matter of confidence in the banking system. Bank runs, what's the chain here? Bank runs drain the banks of reserves. In those days, we were on the gold standard, people wanted to get their gold out or their dollar bills out — the Federal Reserve notes because those, you know, short of being robbed, you aren't going to lose those. OK. Pulling all those reserves out of the banking system forces the banks to contract their loans. They call in existing loans, they don't renew outstanding lines of credit, and they certainly aren't making new loans. They're contracting.

Now, how do banks make money? They make money by — for themselves — profits for their shareholders by making loans and investments. When a bank makes a loan, it doesn't just hand over cash over the window, but it creates a deposit. So it's adding to the stock of deposits.

As those deposits are withdrawn, cash is pulled out and that forces a multiplier multiple contraction of the amount that banks can lend and a contraction of the overall money stock. Deposits have to be extinguished by a greater amount than people are actually pulling out in the form of cash. That forces the money stock to collapse, that reduces spending in the economy, that's the basic chain Milton Friedman in his famous Monetary History of the United States and the chapter called “The Great Contraction,” this is the channel he talked about as being the major impetus for the Great Depression. And that reduced spending in the economy, causes firms to layoff people, cut wages, cut back in production, close factories and so forth. It also produces falling prices. Since people are not spending as much, firms cut prices. As farmers are continuing to grow crops and sell them on the market, but people aren't buying to the extent, prices fall. Commodity prices fell like a stone. Bread was a nickel a loaf, but yet people — many people — didn't have money to buy it.

I had a great aunt and uncle who were farmers and they burned corn cobs or they burned the corn for fuel because it wasn't worth anything selling it. The only way they survived was my great aunt had chickens and she sold eggs. And that was the cash crop. Acres of corn wasn't worth anything.

So as the money stock fell, the price level fell. When the money stock stabilized and began to rise from 1933 on, price level stabilized and the economy started to grow again, as reflected here. M2 is the broad measure of the money supply that includes all forms of deposits. That comes down, GDP comes down. Money supply goes up, GDP goes up. There was a recession in 1937-38 some argue because the money supply fell. When the money supply recovered, the economy started expanding again.

That is the monetary explanation for the Great Depression. Bank failures, bank runs caused a contraction of the money supply, causes a decline in spending, investing, and GDP.