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October 31, 2005

Banking Panics in the 1930s: Liquidity Crises or Solvency Crises?

Were the banking crises during the Great Depression liquidity crises or solvency crises? Gary Richardson is coming to talk about this tomorrow. I'm looking forward to it:

Gary Richardson and William Troost (2005), "Monetary Intervention Mitigated Banking Panics During the Great Depression: Quasi-Experimental Evidence from the Federal Reserve District Border in Mississippi, 1929 to 1933" http://orion.oac.uci.edu/~garyr/papers/MS_23may2005_final.pdf:

Abstract: The Federal Reserve Act of 1913 divided Mississippi between the 6th (Atlanta) and 8th (St. Louis) Federal Reserve Districts. Before and during the Great Depression, these districts’ policies differed. The Atlanta Fed championed monetary activism and the extension of credit to troubled banks. The St. Louis Fed adhered to the doctrine of real bills and eschewed expansionary initiatives. Outcomes differed across districts. In the 6th District, banks failed at lower rates than in the 8th District, particularly during the banking crisis in the fall of 1930. The pattern suggests that discount lending reduced failure rates during periods of panic. Historical evidence and statistical analysis corroborates this conclusion.

Even if the Federal Reserve had tried to alleviate the banking crisis, no clear evidence exists that it could have helped depository institutions. Two schools of thought exist on this issue. One school believes the principal causes of banking crises were withdrawals of deposits, illiquidity of assets, and the Federal Reserve’s reluctance to act. The Fed could have alleviated banking problems by acting as a lender of last resort (Friedman and Schwartz, 1963; Elmus Wicker, 1996). The second school concludes that banks failed because the economy contracted. Asset prices fell. Loan default rates rose. Banks became insolvent, continuing a process of liquidation and consolidation in the banking industry that began during the 1920s. In such circumstances, the Fed could not aid banks by injecting liquidity into the banking system (Temin, 1976; Charles Calomiris and Joseph Mason, 2003)...


St. Louis was a staunch advocate of non-intervention. Atlanta was a leading advocate of assisting banks in need. The St. Louis and Atlanta Feds applied their different policies to the portions of Mississippi lying within their jurisdictions. The adoption of these policies preceded the onset of the depression, and had little to do with circumstances in Mississippi, which was a small and peripheral portion of each Federal Reserve district, and much to do with the philosophies and experiences of the leadership of the two banks. Thus, the application of Federal Reserve policies to Mississippi possessed the characteristics of an exogenous policy experiment...


Compounding over the 73 days of the fall ’30 crisis reveals that the panic increased the cumulative hazard for each bank by 11.0%. The fall ’30 crisis, in other words, accounts for approximately one third of the total cumulative hazard experienced by banks in Mississippi between July 1929 and March 1933. Similar calculations reveal the effect of the Atlanta Fed’s expansionary policy during the fall ’30 crisis. Cumulative hazard in the 6th District was 10.2% lower than cumulative hazard in the 8th District. In other words, in the 8th District, where the St. Louis Fed followed the real bills doctrine, the crisis in the fall of 1930 raised cumulative hazard by 11.0%, while in the 6th District, where the Atlanta Fed followed Bagehot’s Law, the crisis increased cumulative hazard by only 0.8%...

Posted by DeLong at October 31, 2005 09:39 AM