Bernanke “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression” Economics 639 / American University / Vaughan 1

Motivation Problems with Friedman-Schwartz story – Doesn’t explain protracted non-neutrality of money – Doesn’t account for size of decline in real output. Missing piece – Impairment of financial sector – Disruption of financial sector by banking / debt crisis → higher real cost of intermediation between lenders and certain borrowers. – Higher intermediation costs → material decline in aggregate output. Theory suggests banks plug hole in financial markets by minimizing transactions costs and solving asymmetric- information problems. But, is this quantitatively important from macroeconomic standpoint? 2 - 9

PART ONE OF ARGUMENT: Show disruption of financial sector raised “cost of credit intermediation” (CCI). Typo: ∆L/PI Onset of first bank panic “CCI” not observable, but impact on bank credit is: BANK LOANS (Column 4) July 1929 – Oct. 1930, flow positive 9 of 16 months, despite 25% production↓. Nov March 1933, flow consistently negative. ‒Note 31%↓ in Oct

PART ONE OF ARGUMENT: Show disruption of financial sector raised “cost of credit intermediation” (CCI). Typo: ∆L/PI Onset of first bank panic “CCI” not observable, but impact on bank credit is: BANK LOANS Decline not driven by ↓deposits, banks switched from loans to safe investments. ‒Loan-to-deposit ratio↓ (column 5) ‒Yield spread (Baa – Treasuries)↑ (column 6) 4 - 9

PART TWO OF ARGUMENT: Show higher CCI depressed real output, beyond impact of money-supply decline. Lagged industrial production controls for trend. Lags in explanatory variables imply full impact takes time. M – M e controls for impact of unexpected money growth on production (assumes non-neutrality traceable to imperfect information). DBANKS/DFAILS captures impact of financial-sector shock on production. KEY FINDING: “Financial-sector shock” coefficients economically and statistically significant, with correct sign. Regression Evidence: 5 - 9

How Important are Bank Loans? 6 - 9

Critical Evaluation Robustness In follow-up study, Haubrich (JME 1980) extended Bernanke’s analysis to Canada. Canadian economy followed U.S. from 1919 to But Canada had branch banking (10 large banks with 4,000+ branches in 1929 vs. 24,000+ unit banks in U.S.) Canada : Bank stock prices, number of branches, and loans/deposits declined, but no runs/panics. Applied Bernanke to Canada, proxying CCI with bank stock prices and number of branches. KEY FINDING: Impact of financial-shock variables on industrial production not statistically or economically significant. PROBLEM How compelling is evidence? 7 - 9

Miron / Rigol “Bank Failures and Output during the Great Depression” Recent paper re-examines Bernanke’s (1983) evidence and “confirms” key results: 1.Contemporaneous money surprises positively correlated with industrial production. 2.Changes in deposits in failed banks and liabilities of failed businesses negatively correlated with industrial production. But… Results driven by March 1933 (bank holiday) - coefficients on failed bank deposits and failed firm liabilities no longer significant when that observation omitted

Potential simultaneity issue: Failures driving output or output driving failures? ‒Assume contemporaneous output drives contemporaneous failures (i.e., takes month for failures to reduce output). ‒With contemporaneous failures omitted (to isolate impact of failures on output), coefficients on failed bank deposits and failed firm liabilities no longer significant. Economic significance of financial-shock variables on output (assuming away other issues) modest at best. ─Simulating industrial production using Bernanke’s equation with/without failed bank deposits and failed firm liabilities shows only modest difference. Miron / Rigol “Bank Failures and Output during the Great Depression” 9 - 9