Banking/financial crises

Long history: 1819, 1838, 1857, 1893, 1907 Bank runs

fractional reserve Suspension of payments

No federal level deposit insurance

A new Central Bank

We had First bank of the United States, 1791-1811 Second bank of the US, 1816-1836

Charter renewal vetoed by President Jackson in 1832

New one: the Federal Reserve Permanent charter 12 districts Board of Governors

What does the central bank do? Modern days

Lender of last resort Monetary policy Regulation of banks

Money stock/interest rate

How does the central bank control money supply? Open market operation Buy/sell bonds Demand/supply of bonds That changes interest rate

Other factors: How much currency do people hold?

Money creation

Money is not just cash in your pocket (currency) Includes demand deposits, traveler’s checks Saving deposits, small time deposits, money

market mutual funds, etc Currency to deposit: creates extra money in

the banking system Through money multiplier

Gold standard

1900, Gold Standard Act Globally, it means a fixed exchange rate

Everything is tied to gold Benefits? Costs?

Inflexibility in money supply Fluctuations outside of economic force

Transmission mechanism

US productivity increase Same amount of money, more goods Prices fall US goods cheaper Britain buys more US goods Gold inflow for US, outflow for Britain

Trade imbalances

US running a trade surplus, Britain deficit Gold inflow for US, outflow for Britain US price level goes up, Britain down US goods more expensive, Britain goods

cheaper US buys more British goods

Built-in mechanism to balance trade

Gold Standard: Summary

Money supply tied to gold In general, expect deflation Built-in mechanism to balance trade

Relies on inflation when gold flows in A country has no control over price level

fluctuations International forces will create business cycles

On top of domestic factors

Interest rate

With free flow of capital, money goes where the return is high

If interest rate is high, capital flows in If interest rate is low, capital flows out

Stock Market Crash of 1929

Similar to South Sea Bubble 10/24/1929, 10/29/1929, black Thu/Tue But has some “fundamentals”

Stock price and fundamental factors? Fundamentals? Profitability, dividend How are they related?

Future profitability

Booming economies of 1920’s

Was there “bubble”?

No Booming economy New Federal Reserve System, confidence

Yes Economic boom might have initiated the bubble

but not sustainable Dividend growth not as high Speculation

What caused the crash?

Increased supply of new stocks? Smoot-Hawley tariff?

Should’ve hurt export industries Small proportion

International stock markets? Recessions?

Industrial production went down

NY Fed responded

To avoid the overall financial crisis NY Fed open up discount window Outside creditors demanded payment

Could cause widespread bankruptcy Which in turn hurts the banking system

Repercussions

The Stock market crash does not equal to the Great Depression

Less than 5% held stock Continued to trade after the crash

Large volumes through 1933 Historical evidence: stock market crash did

not always lead to recession

10/1929 Stock market crash

10/1930 Bank failures in Midwest and South

12/11/1930 Bank of the US in NY failed

5/1931 Failure of Kreditanstalt (largest in Austria)

7/1931 Closing of German banks

9/1931 Britain left Gold Standard

4/1932 Large Scale Open Market Operations

3/1933 Banking panic of 1933

4/1933 US off Gold Standard

Economic Indicators: 1929-1940

0

20

40

60

80

100

120

140

1929

1930

1931

1932

1933

1934

1935

1936

1937

1938

1939

1940

GDP

Real GDP

Investment

Consumption

Features of the Great Depression Monetary contraction

Deflation Caused by

Distrust of banking system Contraction in monetary money stock Expectation

Breakdown of banking system Bank runs/failures Channels to create money disrupted

High unemployment 25% at one point Definition varies after new deal

International aspect Smoot Hawley Tariff

Other countries followed Gold Standard fell apart

Commitment to GS became burdensome

Monetary Contraction

Because the contraction of money supply At first, bursting the bubble

Tighten credit to curb speculation Mechanism?

Did not increase money supply when they should Inexperience? Forming expectations of deflation

Deflation

But the Fed did not extend more credit That means deflation persisted

Price 24% lower between 1929 and 1933 consequences: debt deflation

Failed businesses, bankruptcy Real interest rate= nominal interest rate-

inflation Deflation= negative inflation

Economic Indicators

Year Money Supply

NNP Commercial paper rate

Real interest

(billions, $) (%)

1929 46.6 90.3 5.78 5.88

1930 45.7 76.9 3.55 8.15

1931 42.7 61.4 2.63 15.46

1932 36.1 44.8 2.72 14.99

1933 32.2 42.7 1.67 3.03

Banking crises

Confidence in banking Withdrawal of deposits

Higher reserve ratio Reinforces the decrease in money supply

More credit to save the banks? Solvent banks faced crises too Not about insolvency, more about confidence Lender of last resort!

Summary: Monetary Contraction At first, expectation Federal Reserve inaction Reinforced by lack of confidence in banking

system Household behavior– hoarding cash Bank’s response– raise reserve ratio

So far…

The stock market crash was only the beginning

Recessions and the Fed’s missteps Expectation of falling price level

High real interest rate– investment falling Deflation– low consumption

Collapse of financial system But there was no “macroeconomics” yet

International Aspects

The Great Depression was a world wide phenomena

(hindsight) the earlier a country left GS, the sooner the recovery

Remember

The circular adjustment Trade surplus Money supply increase (gold flow in) Price increase Export decrease Or trade deficit, gold outflow, price decrease,

export decrease

France and Britain

This mechanism broke down French gold inflow, Britain outflow But French did not inflate Thus more gold outflow for Britain, then

finally go off gold standard

Why?

Commitment to GS requires Tight control of monetary policy

Remember lower interest rate=expansionary monetary policy

If US lowers interest rates Expand money supply Price level rise US $ worth less

(cont’d)

US $ worth less Under GS

Say, US $ converts to 0.1 ounce of gold But it’s only worth 0.05 ounce in the open market What would you do? “Speculative attacks” The Fed could maintain GS so long as it meets the

demand of speculators But if it runs out of gold…

That means, US will have to keep the money supply low (interest rate high)

Economy suffers Key: it was the commitment of GS that really

fettered the monetary policy of the Fed

Recovery

1933 FDR inaugurated Hoover

“enlightened” conservative Small government, high wages, etc

FDR … the only thing we have to fear is fear itself Debt financed new deal Influenced by Keynes Reshaped the role of government

Two new deals

First new deal Banking (FDIC), securities market (SEC),

Abandon GS, centralized power for Fed, NIRA, price support

Second new deal Some of the first new deal acts ruled

unconstitutional Social security, unemployment insurance, Wagner

act, work relief program

First New Deal 1933-35

Banking reform Glass-Steagall act

Firewall FDIC

SEC (security exchange commission) Information disclosure

AAA (Agriculture Adjustment Adm.) Price support (floor) reduction in output

First New Deal (cont’d)

National Industrial Recovery Act (NIRA) Industry codes of “good behavior”

Industries set standards and enforced by gov’t Price cooperation

Price floor, abstain from price cutting High wages Shorten the work week Sanctioned trade union PWA Public Works Adm

What was the diagnosis? Effectiveness?

Second New Deal

NIRA and AAA ruled unconstitutional NIRA too much power in the executive branch AAA regulated agricultural production at the

Federal level Social Security

At first an insurance Then Pay-as-you-go

Unemployment insurance

Wagner Act Labor union encouragement

Work relief program WPA Works Progress Adm. Hire, educate workers Public projects Limit 30 hrs/week

Soil conservation and domestic allotment act (continuation of AAA) Lower quantity to control price

Fair labor standards act Minimum wage

Effectiveness?

Has to evaluate each individual policies Examples:

Public Works: stimulated local economy AAA & soil conservation: not as effective

Issues with the New Deal

Effectiveness? Economic sense? Heavy handed regulation?

Role of the government in economic life High wage rate: ideology

Distributive effects Interest groups– northern businesses

Work relief programs Political side

“swing states”? Gaining political support

House Election Results1930 1932

1934 1936

Dust Bowl

Dust bowl of 1930’s through 40’s Drought

Sterile the arable land Carried ton of fertile soil away

Loss in productivity (crop) $400 million annually Destruction and Damaging crop, livestock,

building, human health

A Coordination Problem

As much man-made disaster as a natural one Erosion techniques available but not used

Small farms: externality Large farms: internalization

But Homestead Act created large number of small farms