Greatly Strengthened Banking System Aided Economy Since Early 1990s

William Poole

Between the end of the brief 1990-91 recession and the fourth quarter of 2007, a span of 67 quarters, the U.S. economy experienced only three quarters of decline in real gross domestic product (GDP). The down quarters were fewer than 5 percent of the total. During the prior 44 years, 19 percent of the quarters (33 out of 176) saw a decline in real GDP. No wonder we call the period since 1991 the Great Moderation.

The general agreement is that during the Great Moderation, improved inventory management among businesses and better Fed monetary policy probably played some role. Some observers believe we also have been lucky because we haven't faced economic shocks like those of the 1970s, including oil embargoes and grain harvest failures.

My view is that good luck flows from good policy. The U.S. economy has faced serious financial and economic shocks in recent years, but despite them has been more stable than in the past. Consider some of the shocks: emerging-market debt crises in 1994 (Mexico) and 1997-98 (Asia); financial market turbulence when short-term interest rates rose sharply (1994-95) and when the large hedge fund Long-Term Capital Management imploded (1998); and, of course, the terrorist attacks of Sept. 11. The bursting of the high-tech stock-market bubble (2000-02) caused ripple effects throughout the economy and financial markets. Since late 2001, the oil price has quintupled to nearly $100 per barrel. Other commodity prices also have risen strongly in recent years. The dollar has been volatile. And, today, we are facing a potentially historic correction in the housing market at the same time that credit markets are experiencing unusual strains from defaults on sub-prime mortgages.

A notable aspect of the U.S. economy's improved performance since the early 1990s, despite many shocks, is a greatly strengthened banking system. As the nation's central bank, we are keenly aware of the importance of strong depository institutions in which the public justifiably can place its confidence.

It was not always so. Failures of banks and thrifts averaged 255 per year between 1982 and 1992-an average of more than 21 every month![1] Many of the banks and thrifts that survived the 1980s and early 1990s were under stress; the economic recovery from the 1990-91 recession was hampered by a credit crunch-reduced credit availability for marginal and even some strong borrowers.

The bank failures themselves weeded out many of the unsound bankers and thrift managers who operated during the 1980s. Those who remained understood that higher ratios of bank capital to assets would be necessary to survive and prosper in the future.

New legislation and bank regulations reinforced this new-found financial discipline. Bank failures during 1997-2007 averaged only four per year. Bank profitability has been consistently strong since the early 1990s, encouraging hundreds of new banks to begin operations. Bank-lending growth has comfortably exceeded and, therefore, supported GDP growth for most of the past 15 years.

There is no reason to expect that we will be any more or less lucky than those who came before. We should expect to face our share of economic and financial challenges. A strong, well-capitalized banking system subject to well-designed prudential supervision increases the economy's resilience. Low inflation from sound monetary policy and sound banking practices will go a long way in creating the good luck the economy needs.

Endnotes

  1. Data on bank and thrift failures are available at www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=30. [back to text]

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