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!

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.”

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.

Real 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

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

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