Lesson 5 of 7
The credit channel
What the destruction of lending relationships cost, quite apart from the money supply. Bernanke's 1983 paper, including the limits he states himself.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Bernanke's argument is that a bank does more than supply deposits. It gathers information about borrowers, and when banks fail that information is destroyed.
- The disruptions of 1930 to 1933, on his account, raised the real cost of getting credit to households, farmers and small firms, and that squeeze depressed demand independently of the money stock.
- He states his own limits plainly: his theory is complementary to Friedman and Schwartz, is not a complete explanation, and says nothing about 1929 to 1930.
The fourth account in this course is the youngest and the most modest in what it claims. It is also the one that changed how the profession reads the other three.
What a failed bank takes with it
What a bank failure removes
- Deposits, which are part of the money stock.
- The bank's own capital.
- Its ability to make new loans.
- These are what the monetary account counts.
What else goes with it
- Accumulated knowledge of who repays and who does not.
- Working relationships with borrowers too small to issue securities.
- The market-making and screening a lender performs.
- Rebuilding these takes years, not weeks.
The monetary account measures the first column. This paper is about the second.
The argument
Because markets for financial claims are incomplete, getting credit from savers to certain classes of borrower requires real services: market-making and gathering information. Bernanke's premise is that these are not free and are not easily replaced.
His claim is that the disruptions of 1930 to 1933 reduced the effectiveness of the financial sector at performing them. As the real cost of intermediation rose, some borrowers found credit expensive and hard to get, and he names them: households, farmers and small firms, which is to say the borrowers with no access to public securities markets.
The effect of that credit squeeze on aggregate demand, on his account, helped convert a severe but not unprecedented downturn into a protracted depression.
The evidence he points to
Timing. He argues against the view that the financial system was simply responding to falls in output, on the ground that financial problems tended to lead output declines rather than follow them, and that sources of panic unconnected with the fall in US output have been documented.
He also assembles a monthly table for July 1929 to March 1933 with the deposits of failing banks, the liabilities of failing commercial businesses, the ratio of new bank lending to personal income, the loan to deposit ratio of reporting banks, and the spread between Baa corporate bond yields and long-term government bonds.
Why he says the monetary account needs it
Two reasons, both stated in his introduction. That the reductions in the money supply in this period seem quantitatively insufficient to explain the subsequent falls in output. And that there is no theory of monetary effects on the real economy that can explain non-neutrality lasting as long as this episode did.
He is careful about the relationship: his approach is complementary to Friedman and Schwartz, who emphasised the monetary impact of the bank failures, while he focuses on credit-related aspects and on the problems of debtors as well as banks.
The limits he states himself
That the theory does not offer a complete explanation of the Great Depression, and that nothing in it is said about 1929 to 1930. And that it is not necessarily inconsistent with some existing explanations.
A reader should notice how rare that paragraph is, and treat it as the standard the other accounts in this course should be held to.
Check yourself
What does Bernanke say is destroyed when a bank fails, beyond deposits?
- Nothing that matters for output
- The information and relationships that let credit reach borrowers with no access to securities markets
- Only the shareholders' capital
Show the answer
Answer: B.
He names households, farmers and small firms as the classes that found credit expensive and hard to obtain as the real cost of intermediation rose.What two reservations does he state about the monetary account?
- That the money stock did not fall, and that banks were solvent
- That the reductions seem quantitatively insufficient for the output falls, and that no theory of monetary effects explains non-neutrality lasting that long
- That the Federal Reserve had no power to act
Show the answer
Answer: B.
He says in the same passage that there is much support for the monetary view and that his approach is complementary to it.Which limits does he state on his own theory?
- That it applies only outside the United States
- That it is not a complete explanation, that it says nothing about 1929 to 1930, and that it is not necessarily inconsistent with existing explanations
- That it cannot be tested
Show the answer
Answer: B.
That paragraph is the standard the other accounts in this course should be held to, and most of them do not meet it.Sources
- Bernanke, 'Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression', National Bureau of Economic Research working paper 1054, January 1983, published in the American Economic Review in 1983: the abstract and introduction for the complementarity with Friedman and Schwartz, for the incompleteness of markets for financial claims and the real services intermediation requires, for the rise in the real cost of credit intermediation and the borrowers affected, for the argument from timing that financial problems led output declines, for the two reservations about the sufficiency of the monetary account, and for the stated limits of his own theory including that nothing is said about 1929 to 1930. Table 1 for the monthly series he assembles.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The farm and its bank are invented and describe nobody.
- This lesson reads the 1983 working paper, which carries the same argument as the journal article of that year. Bernanke's later collection of essays on the Depression was not read and nothing is attributed to it.
- The paper is an addition to an existing account rather than a replacement for it, and this lesson does not claim it settles the argument between the four accounts in this course.