View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Nonmonetary Effects of the Financial Crisis in the
Propagation of the Great Depression

clines, and that sources of financial panics
unconnected with the fall in U.S. output
have been documented by many writers. (See
Section IV below.)
Among explanations that emphasize the
opposite direction of causality, the most
prominent is the one due to Friedman and
Schwartz. Concentrating on the difficulties
of the banks, they pointed out two ways in
which these worsened the general economic
contraction: first, by reducing the wealth of
bank shareholders; second, and much more
important, by leading to a rapid fall in the
supply of money. There is much support for
the monetary view. However, it is not a
complete explanation of the link between the
financial sector and aggregate output in the
1930's. One problem is that there is no theory of monetary effects on the real economy
that can explain protracted nonneutrality.
Another is that the reductions of the money
supply in this period seems quantitatively
insufficient to explain the subsequent falls in
output. (Again, see Section IV.)
The present paper builds on the Friedman-Schwartz work by considering a third
way in which the financial crises (in which
we include debtor bankruptcies as well as the
failures of banks and other lenders) may
have affected output. The basic premise is
that, because markets for financial claims are
incomplete, intermediation between some
classes of borrowers and lenders requires
nontrivial market-making and informationgathering services. The disruptions of 193033 (as I shall try to show) reduced the effectiveness of the financial sector as a whole
in performing these services. As the real costs
of intermediation increased, some borrowers
(especially households, farmers, and small
firms) found credit to be expensive and difficult to obtain. The effects of this credit
squeeze on aggregate demand helped convert
the severe but not unprecedented downturn
of 1929-30 into a protracted depression.

During 1930-33, the U.S. financial system
experienced conditions that were among the
most difficult and chaotic in its history.
Waves of bank failures culminated in the
shutdown of the banking system (and of a
number of other intermediaries and markets)
in March 1933. On the other side of the
ledger, exceptionally high rates of default
and bankruptcy affected every class of borrower except the federal government.
An interesting aspect of the general financial crises—most clearly, of the bank failures
—was their coincidence in timing with adverse developments in the macroeconomy.1
Notably, an apparent attempt at recovery
from the 1929-30 recession2 was stalled at
the time of the first banking crisis (November-December 1930); the incipient recovery
degenerated into a new slump during the
mid-1931 panics; and the economy and the
financial system both reached their respective low points at the time of the bank "holiday" of March 1933. Only with the New
Deal's rehabilitation of the financial system
in 1933—35 did the economy begin its slow
emergence from the Great Depression.
A possible explanation of these synchronous movements is that the financial system
simply responded, without feedback, to the
declines in aggregate output. This is contradicted by the facts that problems of the
financial system tended to lead output de* Stanford Graduate School of Business and Hoover
Institution. I received useful comments from too many
people to list here by name, but I am grateful to each of
them. The National Science Foundation provided partial research support.
This is documented more carefully in Sections I.C
and IV below.
This paper does not address the causes of the initial
1929-30 downturn. Milton Friedman and Anna
Schwartz (1963) have stressed the importance of the
Federal Reserve's "anti-speculative" monetary tightening. Others, such as Peter Temin (1976), have pointed
out autonomous expenditure effects.




It should be stated at the outset that my
theory does not offer a complete explanation
of the Great Depression (for example, nothing is said about 1929-30). Nor is it necessarily inconsistent with some existing explanations.3 However, it does have the virtues
that, first, it seems capable (in a way in
which existing theories are not) of explaining
the unusual length and depth of the depression; and, second, it can do this without
assuming markedly irrational behavior by
private economic agents. Since the reconciliation of the obvious inefficiency of the depression with the postulate of rational private
behavior remains a leading unsolved puzzle
of macroeconomics, these two virtues alone
provide motivation for serious consideration
of this theory.
There do not seem to be any exact antecedents of the present paper in the formal
economics literature.4 The work of Lester
Chandler (1970, 1971) provides the best historical discussions of the general financial
crisis extant; however, he does not develop
very far the link to macroeconomic performance. Beginning with Irving Fisher (1933)
and A. G. Hart (1938), there is a literature
on the macroeconomic role of inside debt;
an interesting recent example is the paper by
Frederic Mishkin (1978), which stresses
household balance sheets and liquidity. Benjamin Friedman (1981) has written on the
relationship of credit and aggregate activity.
Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued
for the inherent instability of the financial
system, but in doing so have had to depart
from the assumption of rational economic
behavior.5 None of the above authors has
emphasized the effects of financial crisis on

See Karl Brunner (1981) for a useful overview of
contemporary theories of the depression. Also, see
Robert Lucas and Leonard Rapping's article in Lucas
This is especially true of the more recent work,
which tends to ignore the nonmonetary effects of the
financial crisis. Older writers often seemed to take the
disruptive impact of the financial breakdown for granted.
I do not deny the possible importance of irrationality in economic life; however, it seems that the best
research strategy is to push the rationality postulate as
far as it will go.

JUNE 1983

the real costs of credit intermediation, the
focus of the present work.
The paper is organized as follows: Section
I presents some background on the 1930-33
financial crisis, its sources, and its correspondence with aggregate output movements.
Section II begins the principal argument of
the paper. I explain how the runs on banks
and the extensive defaults could have reduced the efficiency of the financial sector in
performing its intermediary functions. Some
evidence of these effects is introduced.
Possible channels by which reduced financial efficiency might have affected output are
discussed in Section III. Reduced-form
estimation results, reported in Section IV,
suggest that augmenting a purely monetary
approach by my theory significantly improves the explanation of the financial sector-output connection in the short run. Section V looks at the persistence of these
Some international aspects of the financial
sector-aggregate output link are briefly discussed in Section VI and Section VII concludes.
I. The Financial Collapse: Some Background
The problems faced by the U.S. financial
system between October 1930 and March
1933 have been described in detail by earlier
authors,6 but it will be useful to recapitulate
some principal facts here. Given this background, attention will be turned to the more
central issues of the paper.
The two major components of the financial collapse were the loss of confidence in
financial institutions, primarily commercial
banks, and the widespread insolvency of
debtors. I give short discussions of each of
these components and of their joint relation
to aggregate fluctuations.
A. The Failure of Financial Institutions

Most financial institutions (even semipublic ones, like the Joint Stock Land Banks)
came under pressure in the 1930's. Some,
See especially Chandler (1970, 1971) and Friedman
and Schwartz.

VOL. 73 NO. 3


such as the insurance companies and the
mutual savings banks, managed to maintain
something close to normal operations. Others,
like the building-and-loans (which, despite
their ability to restrict withdrawals by depositors, failed in significant numbers) were
greatly hampered in their attempts to carry
on their business.7 Of most importance, however, were the problems of the commercial
banks. The significance of the banking difficulties derived both from their magnitude
and from the central role commercial banks
played in the financial system.8
The great severity of the banking crises in
the Great Depression is well known to students of the period. The percentages of operating banks which failed in each year from
1930 to 1933 inclusive were 5.6, 10.5, 7.8,
and 12.9; because of failures and mergers,
the number of banks operating at the end of
1933 was only just above half the number
that existed in 1929.9 Banks that survived
experienced heavy losses.
The sources of the banking collapse are
best understood in the historical context. The
first point to be made is that bank failures
were hardly a novelty at the time of the
depression. The U.S. system, made up as it
was primarily of small, independent banks,
had always been particularly vulnerable.
(Countries with only a few large banks, such
as Britain, France, and Canada, never had
banking difficulties on the American scale.)
The dominance of small banks in the United
States was due in large part to a regulatory
environment which reflected popular fears of
large banks and "trusts"; for example, there
were numerous laws restricting branch banking at both the state and national level. Com-


petition between the state and national banking systems for member banks also tended to
keep the legal barriers to entry in banking
very low.10 In this sort of environment, a
significant number of failures was to be expected and probably was even desirable.
Failures due to "natural causes" (such as the
agricultural depression of the 1920's upon
which many small, rural banks foundered)
were common.11
Besides the simple lack of economic viability of some marginal banks, however, the
U.S. system historically suffered also from a
more malign source of bank failures; namely,
financial panics. The fact that liabilities of
banks were principally in the form of fixedprice, callable debt (i.e., demand deposits),
while many assets were highly illiquid,
created the possibility of the perverse expectational equilibrium known as a "run" on
the banks. In a run, fear that a bank may fail
induces depositors to withdraw their money,
which in turn forces liquidation of the bank's
assets. The need to liquidate hastily, or to
dump assets on the market when other banks
are also liquidating, may generate losses that
actually do cause the bank to fail. Thus the
expectation of failure, by the mechanism of
the run, tends to become self-confirming.12
An interesting question is why banks at
this time relied on fixed-price demand deposits, when alternative instruments might
have reduced or prevented the problem of
runs.13 An answer is provided by Friedman
and Schwartz: They pointed out that, before
the establishment of the Federal Reserve in
1913, panics were usually contained by the
practice of suspending convertibility of bank
deposits into currency. This practice, typically initiated by loose organizations of urban


Hart describes the problems of the building-andloans. An interesting sidelight here is the additional
strain on housing lenders caused by the existence of the
Postal Savings System; see Maureen O'Hara and David
According to Raymond Goldsmith (1958), commercial banks held 39.6 percent of the assets of all financial
intermediaries, broadly defined, in 1929. See his Table
Cyril Upham and Edwin Lamke (1934, p. 247).
Since smaller banks were more likely to fail, the fraction
of deposits represented by suspended banks was somewhat less. Eventual recovery by depositors was about 75
percent; see Friedman and Schwartz, p. 438.

Benjamin Klebaner (1974) gives a good brief history of U.S. commercial banking.
Upham and Lamke, p. 247, report that approximately 2-3 percent of all banks in operation failed in
each year of the 1920's.
Douglas Diamond and Philip Dybvig (1981) formalize this argument. For an alternative analysis of the
phenomenon of runs, see Robert Flood and Peter Garber
For example, equity-like instruments, such as those
used by modern money-market mutual funds, could
have been used as the transactions medium. See Kenneth Cone (1982).



banks called clearinghouses, moderated the
dangers of runs by making hasty liquidation
unnecessary. In conjunction with the suspension of convertibility practice, the use of
demand deposits created relatively little instability.14
However, with the advent of the Federal
Reserve (according to Friedman-Schwartz),
this roughly stable institutional arrangement
was upset. Although the Federal Reserve introduced no specific injunctions against the
suspension of convertibility, the clearinghouses apparently felt that the existence of
the new institution relieved them of the responsibility of fighting runs. Unfortunately,
the Federal Reserve turned out to be unable
or unwilling to assume this responsibility.
No serious runs occurred between World
War I and 1930; but the many pieces of bad
financial news that came in from around the
world in 1930-32 were like sparks around
tinder. Runs were clearly an important part
of the banking problems of this period. Some
evidence emerges from contemporary accounts, including descriptions of specific
events precipitating runs. Also notable is the
fact that bank failures tended to occur in
short spasms, rather than in a steady stream
(see Table 1, col. 2, for monthly data on the
deposits of failing banks). The problem was
not arrested until government intervention
became important in late 1932 and early
We see, then, that the banking crises of the
early 1930's differed from earlier recorded
experience both in magnitude and in the
degree of danger posed by the phenomenon
of runs. The result of this was that the behavior of almost the entire system was adversely
affected, not just that of marginal banks. The
bankers' fear of runs, as I shall argue below,
had important macroeconomic effects.
B. Defaults and Bankruptcies
The second major aspect of the financial
crisis (one that is currently neglected by
historians) was the pervasiveness of debtor

Diamond and Dybvig derive this point formally,
with some caveats.

JUNE 1983

insolvency. Given that debt contracts were
written in nominal terms,15 the protracted
fall in prices and money incomes greatly
increased debt burdens. According to Evans
Clark (1933), the ratio of debt service to
national income went from 9 percent in 1929
to 19.8 percent in 1932-33. The resulting
high rates of default caused problems for
both borrowers and lenders.
The "debt crisis" touched all sectors. For
example, about half of all residential properties were mortgaged at the beginning of the
Great Depression; according to the Financial
Survey of Urban Housing (reported in Hart),
as of January 1, 1934,
The proportion of mortgaged
owner-occupied houses with some interest or principal in default was in
none of the twenty-two cities [surveyed]
less than 21 percent (the figure for
Richmond, Virginia); in half it was
above 38 percent; in two (Indianapolis
and Birmingham, Alabama) between 50
percent and 60 percent; and in one
(Cleveland), 62 percent. For rented
properties, percentages in default ran
slightly higher. [p. 164]
Because of the long spell of low food
prices, farmers were in more difficulty than
homeowners. At the beginning of 1933,
owners of 45 percent of all U.S. farms, holding 52 percent of the value of farm mortgage
debt, were delinquent in payments (Hart, p.
138). State and local governments—many of
whom tried to provide relief for the unemployed—also had problems paying their
debts: As of March 1934, the governments of
37 of the 310 cities with populations over
30,000 and of three states had defaulted on
obligations (Hart, p. 225).
In the business sector, the incidence of
financial distress was very uneven. Aggregate
corporate profits before tax were negative in
1931 and 1932, and after-tax retained earnings were negative in each year from 1930 to
1933 (Chandler, 1971, p. 102). But the subset
Finding an explanation for the lack of indexed debt
during the deflationary 1930's—as in the inflationary
1970's—is a point on which I stumble.

VOL. 73 NO. 3


of corporations holding more than $50 million in assets maintained positive profits
throughout this period, leaving the brunt to
be borne by smaller companies. Solomon
Fabricant (1935) reported that, in 1932 alone,
the losses of corporations with assets of
$50,000 or less equalled 33 percent of total
capitalization; for corporations with assets in
the $50,000-$100,000 range, the comparable
figure was 14 percent. This led to high rates
of failure among small firms.
Although the deflation of the 1930's was
unusually protracted, there had been a similar episode as recently as 1921-22 which had
not led to mass insolvency. The seriousness
of the problem in the Great Depression was
due not only to the extent of the deflation,
but also to the large and broad-based expansion of inside debt in the 1920's. Charles
Persons surveyed the credit expansion of the
predepression decade in a 1930 article: He
reported that outstanding corporate bonds
and notes increased from $26.1 billion in
1920 to $47.1 billion in 1928, and that nonfederal public securities grew from $11.8 billion to $33.6 billion over the same period.
(This may be compared with a 1929 national
income of $86.8 billion.) Perhaps more significantly, during the 1920's, small borrowers, such as households and unincorporated businesses, greatly increased their
debts. For example, the value of urban real
estate mortgages outstanding increased from
$11 billion in 1920 to $27 billion in 1929,
while the growth of consumer installment
debt reflected the introduction of major consumer durables to the mass market.
Like the banking crises, then, the debt
crisis of the 1930's was not qualitatively a
new phenomenon; but it represented a break
with the past in terms of its severity and
C. Correlation of the Financial Crisis
with Macroeconomic Activity

The close connection of the stages of the
financial crisis (especially the bank failures)
with changes in real output has been noted
by Friedman and Schwartz and by others.
An informal review of this connection is


facilitated by the monthly data in Table 1.
Column 1 is an index of real industrial production. Columns 2 and 3 are the (nominal)
liabilities of failing banks and nonbank commercial businesses, respectively.
The industrial production series reveals
that a recession began in the United States
during 1929. By late 1930, the downturn,
although serious, was still comparable in
magnitude to the recession of 1920-22; as
the decline slowed, it would have been reasonable to expect a brisk recovery, just as in
With the first banking crisis, however, there
came what Friedman and Schwartz called a
"change in the character of the contraction"
(p. 311). The economy first flattened out,
then went into a new tailspin just as the
banks began to fail again in June 1931.
A lengthy slide of both the general economy and the financial system followed. The
banking situation calmed in early 1932, and
nonbank failures peaked shortly thereafter.
A new recovery attempt began in August,
but failed within a few months.16 In March
1933, the bottom was reached for both the
financial system and the economy as a whole.
Measures taken after the banking holiday
ended the bank runs and greatly reduced the
burden of debt. Simultaneously aggregate
output began a recovery that was sustained
until 1937.
The leading explanation of the correlation
between the conditions of the financial sector and of the general economy is that of
Friedman and Schwartz, who stressed the
effects of the banking crises on the supply of
money. I agree that money was an important
factor in 1930-33, but, because of reservations cited in the introduction, I doubt that it
completely explains the financial sectoraggregate output connection. This motivates
Judging by Table 1. the failure of this recovery
seems to be unrelated to financial sector difficulties.
However, accounts from the time suggest that the banking crisis of late 1932 and early 1933 (which ended in
the banking holiday) was in fact quite severe; see Susan
Kennedy (1973). The relatively low reported rate of
bank failures at this time may be an artifact of state
moratoria, restrictions on withdrawals, and other interventions.


















JUNE 1983



.607 a


Notes: IP = seasonally adjusted index of industrial production, 1935-39 = 100; Federal Reserve Bulletin.
Banks = deposits of failing banks, $millions; Federal Reserve Bulletin.
Fails = liabilities of failing commercial businesses, $millions; Survey of Current Business.
L/PI= ratio of net extensions of commercial bank loans to (monthly) personal income; from Banking and
Monetary Statistics and National Income.
L/D= ratio of loans outstanding to the sum of demand and time deposits, weekly reporting banks; Banking and
Monetary Statistics.
DIF= difference (in percentage points) between yields on Baa corporate bonds and long-term U.S. government
bonds; Banking and Monetary Statistics.
A national bank holiday was declared in March 1933.

VOL. 73 NO. 3


my study of a nonmonetary channel through
which an additional impact of the financial
crisis may have been felt.
II. The Effect of the Crisis on the Cost
of Credit Intermediation
This paper posits that, in addition to its
effects via the money supply, the financial
crisis of 1930-33 affected the macroeconomy
by reducing the quality of certain financial
services, primarily credit intermediation. The
basic argument is to be made in two steps.
First, it must be shown that the disruption of
the financial sector by the banking and debt
crises raised the real cost of intermediation
between lenders and certain classes of borrowers. Second, the link between higher intermediation costs and the decline in aggregate output must be established. I present
here the first step of the argument, leaving
the second to be developed in Sections III-V.
In order to discuss the quality of performance of the financial sector, I must first
describe the real services that the sector is
supposed to provide. The specification of
these services depends on the model of the
economy one has in mind. We shall clearly
not be interested in economies of the sort
described by Eugene Fama (1980), in which
financial markets are complete and information/transactions costs can be neglected. In
such a world, banks and other intermediaries
are merely passive holders of portfolios.
Banks' choice of portfolios or the scale of the
banking system can never make any difference in this case, since depositors can
offset any action taken by banks through
private portfolio decisions.17
As an alternative to the Fama completemarkets world, consider the following stylized
description of the economy. Let us suppose
that savers have many ways of transferring
resources from present to future, such as
holding real assets or buying the liabilities of

It should be noted that the phenomena emphasized
by Friedman and Schwartz—the effects of the contraction of the banking system on the quantity of the
transactions medium and on real output—are also impossible in a complete-markets world.


governments or corporations on well-organized exchanges. One of the options savers
have is to lend resources to a banking system. The banks also have a menu of different
assets to choose from. Assume, however, that
banks specialize in making loans to small,
idiosyncratic borrowers whose liabilities are
too few in number to be publicly traded.
(Here is where the complete-markets assumption is dropped.)
The small borrowers to whom the banks
lend will be taken, for simplicity, to be of
two extreme types, "good" and "bad." Good
borrowers desire loans in order to undertake
individual-specific investment projects. These
projects generate a random return from a
distribution whose mean will be assumed
always to exceed the social opportunity cost
of investment. If this risk is nonsystematic,
lending to good borrowers is socially desirable. Bad borrowers try to look like good
borrowers, but in fact they have no "project."
Bad borrowers are assumed to squander any
loan received in profligate consumption, then
to default. Loans to bad borrowers are socially undesirable.
In this model, the real service performed
by the banking system is the differentiation
between good and bad borrowers.18 For a
competitive banking system, I define the cost
of credit intermediation (CCI) as being the
cost of channeling funds from the ultimate
savers/lenders into the hands of good borrowers. The CCI includes screening, monitoring, and accounting costs, as well as the
expected losses inflicted by bad borrowers.
Banks presumably choose operating procedures that minimize the CCI. This is done by
developing expertise at evaluating potential
borrowers; establishing long-term relationships with customers; and offering loan conditions that encourage potential borrowers to
self-select in a favorable way.19
Given this simple paradigm, I can describe
the effects of the two main components of
To concentrate on credit intermediation, I neglect
the transactions and other services performed by banks.
See Dwight Jaffee and Thomas Russell (1976) and
Joseph Stiglitz and Andrew Weiss (1981) on the way
banks induce favorable borrower self-selection.



the financial crisis on the efficiency of the
credit allocation process (i.e., on the CCI).
A. Effect of the Banking Crises on the CCI
The banking problems of 1930-33 disrupted the credit allocation process by creating large, unplanned changes in the channels
of credit flow. Fear of runs led to large
withdrawals of deposits, precautionary increases in reserve-deposit ratios, and an increased desire by banks for very liquid or
rediscountable assets. These factors, plus the
actual failures, forced a contraction of the
banking system's role in the intermediation
of credit.20 Some of the slack was taken up
by the growing importance of alternative
channels of credit (see below). However, the
rapid switch away from the banks (given the
banks' accumulated expertise, information,
and customer relationships) no doubt impaired financial efficiency and raised the
It would be useful to have a direct measure of the CCI; unfortunately, no really
satisfactory empirical representation of this
concept is available. Reported commercial
loan rates reflect loans that are actually made,
not the shadow cost of bank funds to a
representative potential borrower; since
banks in a period of retrenchment make only
the safest and highest-quality loans, measured loan rates may well move inversely to
the CCI. I obtained a number of interesting
results using the yield differential between
Baa corporate bonds and U.S. government
bonds as a proxy for the CCI; however, the
use of the Baa rate is not consistent with my
story that bank borrowers are those whose
liabilities are too few to be publicly traded.
While we cannot observe directly the effects of the banking troubles on the CCI, we
can see their impact on the extension of bank
credit: Table 1 gives some illustrative data.
Column 4 gives, as a measure of the flow of
For an interesting contemporary account of this
process, see the article by Eugene H. Burris in the
American Banker, October 15, 1931.
Since intermediation resources could have been
shifted out of the beleaguered banking sector (given
enough time), mine is basically a costs-of-adjustment

JUNE 1983

bank credit, the monthly change in bank
loans outstanding, normalized by monthly
personal income.22 One might have expected
the loan-change-to-income ratio to be driven
primarily by loan demand and thus by the
rate of production. Comparison with the first
two columns of Table 2 shows, however, that
the banking crises were as important a determinant of this variable as output. For
example, except for a brief period of liquidation of speculation loans after the stock
market crash, credit outstanding declined
very little before October 1930—this despite
a 25 percent fall in industrial production that
had occurred by that time. With the first
banking crisis of November 1930, however, a
long period of credit contraction was initiated. The shrinkage of credit shared the
rhythm of the banking crises; for example, in
October 1931, the worst month for bank
failure before the bank holiday, net credit
reduction was a record 31 percent of personal income.23
The fall in bank loans after November
1930 was not simply a balance sheet reflection of the decline in deposits. Column 5 in
Table 1 gives the monthly ratio of outstanding bank loans to the sum of demand and
time deposits. This ratio declined sharply as
banks switched out of loans and into more
liquid investments.
The perception that the banking crises and
the associated scrambles for liquidity exerted
a deflationary force on bank credit was
shared by writers of the time. A 1932 National Industrial Conference Board survey of
In the construction of the bank loans series, data
from weekly reporting member banks (which held about
40 percent of all bank loans) were used to interpolate
between less frequent aggregate observations. N o t e that,
for our purposes, looking at the change in loans is
preferable to considering the stock of real loans outstanding: In a regime of nominally contracted debt and
sharp unanticipated deflation, stability of the stock of
real debt does not signal a comfortable situation for
The effect of bank failures o n credit outstanding is
somewhat exaggerated by the fact that the credit contraction measure includes the loans of suspending banks
that were not transferred to other banks; however, I
estimate that this accounting convention is responsible
for less than one-eighth of the total (measured) credit
contraction between October 1930 and February 1933.

VOL. 73 NO. 3


credit conditions reported that "During 1930,
the shrinkage of commercial loans no more
than reflected business recession. During
1931 and the first half of 1932 (the period
studied), it unquestionably represented pressure by banks on customers for repayment of
loans and refusal by banks to grant new
loans" (p. 28). Other contemporary sources
tended to agree (see, for example, Chandler,
1971, pp. 233-39, for references).
Two other observations about the contraction of bank credit can be made. First, the
class of borrowers most affected by credit
reductions were households, farmers, unincorporated businesses, and small corporations; this group had the highest direct or
indirect reliance on bank credit. Second, the
contraction of bank credit was twice as large
as that of other major countries, even those
which experienced comparable output declines (Klebaner, p. 145).
The fall in bank loans outstanding was
partly offset by the relative expansion of
alternative forms of credit. In the area of
consumer finance, retail merchants, service
creditors, and nonbank lending agencies improved their position relative to banks and
primarily bank-supported installment finance companies (Rolf Nugent, 1939, pp.
114-16). Small firms during this period significantly reduced their traditional reliance
on banks in favor of trade credit (Charles
Merwin, 1942, pp. 5 and 75). But, as argued
above, in a world with transactions costs and
the need to discriminate among borrowers,
these shifts in the loci of credit intermediation must have at least temporarily reduced
the efficiency of the credit allocation process,
thereby raising the effective cost of credit to
potential borrowers.
B. The Effect of Bankruptcies on the CCI
I turn now to a brief discussion of the
impact of the increase in defaults and bankruptcies during this period on the cost of
credit intermediation.
The very existence of bankruptcy proceedings, rather than being an obvious or natural
phenomenon, raises deep questions of economic theory. Why, for example, do the


creditor and defaulted debtor make the payments to third parties (lawyers, administrators) that these proceedings entail, instead of
somehow agreeing to divide those payments
between themselves? In a complete-markets
world, bankruptcy would never be observed;
this is because complete state-contingent loan
agreements would uniquely define each
party's obligations in all possible circumstances, rendering third-party arbitration unnecessary. That we do observe bankruptcies,
in our incomplete-markets world, suggests
that creditors and debtors have found the
combination of simple loan arrangements
and ex post adjudication by bankruptcy
(when necessary) to be cheaper than attempting to write and enforce complete state-contingent contracts.
To be more concrete, let us use the "good
borrower-bad borrower" example. In writing
a loan contract with a potential borrower,
the bank has two polar options. First, it
might try to approximate the complete
state-contingent contract by making the borrower's actions part of the agreement and by
allowing repayment to depend on the outcome of the borrower's project. This contract, if properly written and enforced, would
completely eliminate the possibility of either
side not being able to meet its obligations;
its obvious drawback is the cost of monitoring which it involves. The bank's other option is to write a very simple agreement
("payment of such-amount to be made on
such-date"), then to make the loan only if it
believes that the borrower is likely to repay.
The second approach usually dominates the
first, of course, especially for small borrowers.
A device which makes the cost advantage
of the simpler approach even greater is the
use of collateral. If the borrower has wealth
that can be attached by the bank in the event
of nonpayment, the bank's risk is low. Moreover, the threat of loss of collateral provides
the right incentives for borrowers to use loans
only for profitable projects. Thus, the combination of collateral and simple loan contracts
helps to create a low effective CCI.
A useful way to think of the 1930-33 debt
crisis is as the progressive erosion of borrowers' collateral relative to debt burdens.



As the representative borrower became more
and more insolvent, banks (and other lenders
as well) faced a dilemma. Simple, noncontingent loans faced increasingly higher risks of
default; yet a return to the more complex
type of contract involved many other costs.
Either way, debtor insolvency necessarily
raised the CCI for banks.
One way for banks to adjust to a higher
CCI is to increase the rate that they charge
borrowers. This may be counterproductive,
however, if higher interest charges increase
the risk of default. The more usual response
is for banks just not to make loans to some
people that they might have lent to in better
times. This was certainly the pattern in the
1930's. For example, it was reported that the
extraordinary rate of default on residential
mortgages forced banks and life insurance
companies to "practically stop making mortgage loans, except for renewals" (Hart, p.
163). This situation precluded many borrowers, even with good projects, from getting
funds, while lenders rushed to compete for
existing high-grade assets. As one writer of
the time, D. M. Frederiksen, put it:
We see money accumulating at the
centers, with difficulty of finding safe
investment for it; interest rates dropping down lower than ever before;
money available in great plenty for
things that are obviously safe, but not
available at all for things that are in
fact safe, and which under normal conditions would be entirely safe (and there
are a great many such), but which are
now viewed with suspicion by lenders.
[1931, p. 139]
As this quote suggests, the idea that the low
yields on Treasury or blue-chip corporation
liabilities during this time signalled a general
state of "easy money" is mistaken; money
was easy for a few safe borrowers, but difficult for everyone else.
An indicator of the strength of lender
preferences for safe, liquid assets (and hence
of the difficulty of risky borrowers in obtaining funds) is the yield differential between Baa corporate bonds and Treasury

JUNE 1983

bonds (Table 1, column 6). Because this variable contains no adjustment for the reclassification of firms into higher risk categories, it
tends to understate the true difference in
yields between representative risky and safe
assets. Nevertheless, this indicator showed
some impressive shifts, going from 2.5 percent during 1929-30 to nearly 8 percent in
mid-1932. (The differential never exceeded
3.5 percent in the sharp 1920-22 recession.)
The yield differential reflected changing perceptions of default risk, of course; but note
also the close relationship of the differential
and the banking crises (a fact first pointed
out by Friedman and Schwartz). Bank crises
depressed the prices of lower-quality investments as the fear of runs drove banks into
assets that could be used as reserves or for
rediscounting. This effect of bank portfolio
choices on an asset price could not happen in
a Fama-type, complete-markets world.
Finally, it is instructive to consider the
experience of a country that had a debt crisis
without a banking crisis. Canada entered the
Great Depression with a large external debt,
much of it payable in foreign currencies. The
combination of deflation and the devaluation of the Canadian dollar led to many
defaults. Internally, debt problems in agriculture and in mortgage markets were as
severe as in the United States, while major
industries (notably pulp and paper) experienced many bankruptcies (A. E. Safarian,
1959, ch. 7). Although Canadian bankers did
not face serious danger of runs, they shifted
away from loans to safer assets. This shift
toward safety and liquidity, though less pronounced than in the U.S. case, drew criticism
from all facets of Canadian society. The
American Banker of December 6, 1932, reported the following complaint from a nonpopulist Canadian politician:
The chief criticism of our present
system appears to be that in good times
credit is expanded to great extremes...
but, when the pinch of hard times is
first being felt, credit is suddenly and
drastically restricted by the banks... At
the present time, loans are only being
made when the banks have a very wide

VOL. 73 NO. 3


margin of security and every effort is
being made to collect outstanding loans.
All our banks are reaching out in an
endeavor to liquefy their assets....
Canadian lenders other than banks also tried
to retrench: According to the Financial Post,
May 14, 1932, "Insurance, trust, and loan
companies were increasingly unwilling to
lend funds with real estate and rental values
falling, a growing number of defaults of
interest and principal, the increasing burden
of property taxes, and legislation which
adversely affected creditors" (quoted in
Safarian, p. 130).
More careful study of the Canadian experience in the Great Depression would be
useful. However, on first appraisal, that experience does not seem to be inconsistent
with the point that even good borrowers may
find it more difficult or costly to obtain
credit when there is extensive insolvency.
The debt crisis should be added to the banking crises as a potential source of disruption
of the credit system.
III. Credit Markets and Macroeconomic
If it is taken as given that the financial
crises during the depression did interfere with
the normal flows of credit, it still must be
shown how this might have had an effect on
the course of the aggregate economy.
There are many ways in which problems in
credit markets might potentially affect the
macroeconomy. Several of these could be
grouped under the heading of "effects on
aggregate supply." For example, if credit
flows are dammed up, potential borrowers in
the economy may not be able to secure funds
to undertake worthwhile activities or investments; at the same time, savers may have to
devote their funds to inferior uses. Other
possible problems resulting from poorly
functioning credit markets include a reduced
feasibility of effective risk sharing and greater
difficulties in funding large, indivisible projects. Each of these might limit the economy's
productive capacity.


These arguments are reminiscent of some
ideas advanced by John Gurley and E. S.
Shaw (1955), Ronald McKinnon (1973), and
others in an economic development context.
The claim of this literature is that immature
or repressed financial sectors cause the
"fragmentation" of less developed economies, reducing the effective set of production
possibilities available to the society.
Did the financial crisis of the 1930's turn
the United States into a " temporarily underdeveloped economy" (to use Bob Hall's felicitous phrase)? Although this possibility is
intriguing, the answer to the question is
probably no. While many businesses did
suffer drains of working capital and investment funds, most larger corporations entered
the decade with sufficient cash and liquid
reserves to finance operations and any desired expansion (see, for example, Friedrich
Lutz, 1945). Unless it is believed that the
outputs of large and of small businesses are
not potentially substitutes, the aggregate
supply effect must be regarded as not of
great quantitative importance.
The reluctance of even cash-rich corporations to expand production during the depression suggests that consideration of the
aggregate demand channel for credit market
effects on output may be more fruitful. The
aggregate demand argument is in fact easy to
make: A higher cost of credit intermediation
for some borrowers (for example, households
and smaller firms) implies that, for a given
safe interest rate, these borrowers must face
a higher effective cost of credit. (Indeed, they
may not be able to borrow at all.) If this
higher rate applies to household and small
firm borrowing but not to their saving (they
may only earn the safe rate on their savings),
then the effect of higher borrowing costs is
unambiguously to reduce their demands for
current-period goods and services. This pure
substitution effect (of future for present consumption) is easily derived from the classical
two-period model of savings.24

The classical model may be augmented, if the
reader desires, by considerations of liquidity constraints,
bankruptcy costs, or risk aversion; see my 1981 paper.



Assume that the behavior of borrowers
unaffected by credit market problems is unchanged. Then the paragraph above implies
that, for a given safe rate, an increase in the
cost of credit intermediation reduces the total
quantity of goods and services currently demanded. That is, the aggregate demand curve,
drawn as a function of the safe rate, is
shifted downward by a financial crisis. In
any macroeconomic model one cares to use,
this implies lower output and lower safe interest rates. Both of these outcomes characterized 1930-33, of course.
Some evidence on the magnitude of the
effect of the financial market problems on
aggregate output is now presented.
IV. Short-Run Macroeconomic Impacts
of the Financial Crisis
This section studies the short-run or "impact" effects of the financial crisis. For this
purpose, I use only monthly data on the
relevant variables. In addition, rather than
consider the 1929-33 episode outside of its
context, I have widened the sample to include the entire interwar period (January
1919-December 1941).
Section I.C above has already given some
evidence of the relationship between the
troubles of the financial sector and those of
the economy as a whole. However, support
for the thesis of this paper requires that
nonmonetary effects of the financial crisis on
output be distinguished from the monetary
effects studied by Friedman and Schwartz.
My approach will be to fit output equations
using monetary variables, then to show that
adding proxies for the financial crisis substantially improves the performance of these
equations. Comparison of financial to totally
nonfinancial sources of the Great Depression, such as those suggested by Temin, is
left to future research.
To isolate the purely monetary influences
on the economy, one needs a structural explanation of the money-income relationship.
Lucas (1972) has presented a formal model
in which monetary shocks affect production
decisions by causing confusion about the
price level. Influenced by this work, most
recent empirical studies of the role of money

JUNE 1983

have related national income to measures
of "unanticipated" changes in money or
The most familiar way of constructing a
proxy for unanticipated components of a
variable is the two-step method of Robert
Barro (1978), in which the residuals from a
first-stage prediction equation for (say) money are employed as the independent variables
in a second-stage regression. I experimented
with both the Barro approach and some
alternatives.26 Since my conclusions were
unaffected by choice of technique, I report
here only the Barro-type results.
In the spirit of the Lucas-Barro analysis, I
considered the effects of both "money
shocks" and "price shocks" on output. Money shocks (M—Me) were defined as the
residuals from a regression of the rate of
growth of Ml on four lags of the growth
rates of industrial production, wholesale
prices, and Ml itself; price shocks (P - Pe)
were defined symmetrically.27I used ordinary
least squares to estimate the effects of money
and price shocks on the rate of growth of
industrial production, relative to trend.
The basic regression results for the interwar sample period are given as equations (1)
and (2) in Table 2. These two equations are
of interest, independently of the other results
of this paper. The estimated "Lucas supply
curve," equation (2), shows an effect of price
shocks on output that is statistically and
economically significant. As such, it complements the results of Thomas Sargent (1976),
who found a similar relationship for the
postwar. The relationship of output to money surprises, equation (1), is a bit weaker.
The fact that we discover a smaller role for
money in the monthly data than does Paul
Evans (1981) is primarily the result of our
inclusion of lagged values of production on
the right-hand side. This inclusion seems
justified both on statistical grounds and for

A notable exception is Mishkin (1982).
Principal alternatives tried were 1) the use of anticipated as well as unanticipated quantities as explanatory
variables; and 2) reestimation of some equations by the
more efficient but computationally more complex
method of Andrew Abel and Mishkin (1981).
The first-stage regressions were unsurprising and,
for the sake of space, are not reported.

VOL. 73 NO. 3




Notes: Yt= rate of growth of industrial production (Federal Reserve Bulletin), relative to exponential trend.
( M - Me)t = rate of growth of M1, nominal and seasonally adjusted (Friedman and Schwartz, Table 4-1), less
predicted rate of growth.
(P - Pe)t= rate of growth of wholesale price index (Federal Reserve Bulletin), less predicted rate of growth.
DBANKSt= first difference of deposits of failing banks (deflated by wholesale price index).
DFAILSt= first difference of liabilities of failing businesses (deflated by wholesale price index).
Data are monthly; t-statistics are shown in parentheses.

the economic reason that costs of adjusting
production can be presumed to create a serial
dependence in output. Like Evans, I was not
able to find effects of money (or prices)
lagged more than three months.
While these regression results exhibit statistical significance and the expected signs
for coefficients, they are disappointing in the
following sense: When equations (1) and (2)

are used to perform dynamic simulations of
the path of output between mid-1930 and the
bank holiday of March 1933, they capture no
more than half of the total decline of output
during the period. This is the basis of the
comment in the introduction that the declines in money seem "quantitatively insufficient" to explain what happened to output in



Given the basic regressions (1) and (2), the
next step was to examine the effects of including proxies for the nonmonetary financial impact as explanators of output. Based
on the earlier analysis of this paper, the most
obvious such proxies are the deposits of failing banks and the liabilities of failing businesses.
A preliminary problem with the bank deposits series that needs to be discussed is the
value for March 1933, the month of the bank
holiday. As can be seen in Table 1, the
deposits of banks suspended in March 1933
is seven times that of the next worse month.
The question arises if any adjustment should
be made to that figure before running the
We believe that it would be a mistake to
eliminate totally the bank holiday episode
from the sample. According to contemporary
accounts, rather than being an orderly and
planned-in-advance policy, the imposition of
the holiday was a forced response to the
most panicky and chaotic financial conditions of the period. The deposits of suspended banks figure for March, as large as it
is, reflects not all closed banks but only
those not licensed to reopen by June 30,
1933. Of these banks, most were liquidated
or placed in receivership; less than 25 percent had been licensed to reopen as of December 31, 1936.28 Qualitatively, then, the
March 1933 episode resembled the earlier
crises; it would be throwing away information not to include in some way the effects of
this crisis and of its resolution on the economy.
On the other hand, the mass closing of
banks by government action probably created
less confusion and fear of future crises than
would have a similar number of suspensions
occurring without government intervention.
As a conservative compromise, I assumed
that the "supervised" bank closings of March
1933 had the same effect as an "unsupervised" bank crisis involving 15 percent as
much in frozen deposits. This scales down
the March 1933 episode to about the size of
the events of October 1931. The sensitivity of
the results to this assumption is as follows:

Federal Reserve Bulletin, 1937, pp. 866-67.

JUNE 1983

increasing the amount of importance attributed to the March 1933 crisis raises the
magnitude and statistical significance of the
measured effects of the financial crises on
output. (It is in this sense that the 15 percent
figure is conservative.) However, the bank
failure coefficients in the regressions retained
high significance even when less weight was
given to March 1933.
I turn now to the results of adding (real)
deposits of failing banks and liabilities of
failing businesses to the output equations
(see equations (3) and (4) in Table 2). The
sample period begins in 1921 because of the
unavailability of data on monthly bank
failures before then. In both regressions, current and lagged first differences of the added
variables enter the explanation of the growth
rate of industrial production (relative to
trend) with the expected sign and, taken
jointly, with a high level of statistical significance. The magnitudes and significance of
the coefficients of money and price shocks
are not much changed. This provides at least
a tentative confirmation that nonmonetary
effects of the financial crisis augmented
monetary effects in the short-run determination of output.
Some alternative proxies for the nonmonetary component of the financial crisis were
also tried. For the sake of space, only a
summary of these results is given. 1) To
examine the direct effects of the contraction
of bank credit on the economy, I began by
regressing the rate of growth of bank loans
on current and lagged values of suspended
bank deposits and of failing business liabilities. (This regression indicated a powerful
negative effect of financial crisis on bank
loans.) The fitted series from this regression
was used as a proxy for the portion of the
credit contraction induced by the financial
crisis. In the presence of money or price
shocks, the effect of a decline in this variable
on output was found to be negative for two
months, positive for the next two months,
then strongly negative for the fifth and sixth
months after the decline. For the period from
1921 until the bank holiday, and with monetary variables included, the total effect of
credit contraction on output (as measured by
the sum of lag coefficients in a polynomial

VOL. 73 NO. 3


distributed lag) was large (comparable to the
monetary effect), negative, and significant at
the 95 percent level. For the entire interwar
sample, however, the statistical significance
of this variable was much reduced. This last
result is due to the fact that the recovery of
1933-41 was financed by nonbank sources,
with bank loans remaining at a low level.
2) Another proxy for the financial crisis
that was tried was the differential between
Baa corporate bond yields and the yields on
U.S. bonds. As described in Section I.C, this
variable responded strongly to both bank
crises and the problems of debtors, and as
such was a sensitive indicator of financial
market conditions. The yield differential
variable turned out to enter very strongly as
an explanator of current and future output
growth, overall and in every subsample. As
much of this predictive power was no doubt
due to pure financial market anticipations of
future output declines, I also put the differential variable through a first-stage regression on the liabilities of bank and business
failures. Assuming that these latter variables
themselves were not determined by anticipations of future output declines (see below),
the use of the fitted series from this regression "purged" the differential variable of its
pure anticipatory component. The fitted
series entered the output equations less
strongly than the raw series, but it retained
the right sign and statistical significance at
the 95 percent confidence level.
In almost every case, then, the addition of
proxies for the general financial crisis improved the purely monetary explanation of
short-run (monthly) output movements. This
finding was robust to the obvious experiments. For example, with the above-noted
exception of the credit variable in 1933-41,
coefficients remained roughly stable over
subsamples. Another experiment was to include free dummy variables for each quarter
from 1931:1 to 1932:IV in the above regressions. The purpose of this was to test the
suggestion that our results are only a reflection of the fact that both the output and
financial crisis variables "moved a lot" during 1930-33. The rather surprising discovery
was that the inclusion of the dummies
increased the magnitude and statistical sig-


nificance of the coefficients on bank and
business failures. Finally, the economic significance of the results was tested by using
the various estimated equations to run dynamic simulations of monthly levels of industrial production (relative to trend) for
mid-1930 to March 1933. Relative to the
pure money-shock and price-shock simulations described above, the equations including financial crisis proxies did well. Equations (3) and (4) reduced the mean squared
simulation error over (1) and (2) by about 50
percent. The other (nonreported) equations
did better; for example, those using the yield
differential variable reduced the MSE of
simulation from 90 to 95 percent.
These results are promising. However, a
caveat must be added: To conclude that the
observed correlations support the theory outlined in this paper requires an additional
assumption, that failures of banks and commercial firms are not caused by anticipations
of (future) changes in output. To the extent
that, say, bank runs are caused by the receipt
of bad news about next month's industrial
production, the fact that bank failures tend
to lead production declines does not prove
that the bank problems are helping to cause
the declines.29
While it may not be possible to convince
the determined skeptic that bank and business failures are not purely anticipatory phenomena, a good case can be made against
that position. For example, while in some
cases a bad sales forecast may induce a firm
to declare bankruptcy, more often that option is forced by insolvency (a result of past
business conditions). For banks, it might well
be argued that not only are failures relatively
independent of anticipations about output,
but that they are not simply the product of
current and past output performance either:
First, banking crises had never previous to
this time been a necessary result of declines
in output.30 Second, Friedman and Schwartz,
as well as other writers, have identified

Actually, a similar criticism might be made of
Barro's work and my own money and price regressions.
Philip Cagan (1965) makes this point; see pp. 216,
227-28. The 1920-22 recession, for example, did not
generate any banking problems.



specific events that were important sources
of bank runs during 1930-33. These include
the revelation of scandal at the Bank of the
United States (a private bank, which in December 1930 became the largest bank to fail
up to that time); the collapse of the Kreditanstalt in Austria and the ensuing financial
panics in central Europe; Britain's going off
gold; the exposure of huge pyramiding
schemes in the United States and Europe;
and others, all connected very indirectly (if
at all) with the path of industrial production
in the United States.
If it is accepted that bank suspensions and
business bankruptcies were the product of
factors beyond pure anticipations of output
decline, then the evidence of this section
supports the view that nonmonetary aspects
of the financial crisis were at least part of the
propagatory mechanism of the Great Depression. If it is further accepted that the
financial crisis contained large exogenous
components (there is evidence for this in the
case of the banking panics), then there are
elements of causality in the story as well.
V. Persistence of the Financial Crisis
The claim was made in the introduction
that my theory seems capable, unlike the
major alternatives, of explaining the unusual
length and depth of the Great Depression. In
the previous section, I attempted to deal with
the issue of depth; simulations of the estimated regressions suggested that the combined monetary and nonmonetary effects of
the financial crisis can explain much of the
severity of the decline in output. In this
section, the question of the length of the
Great Depression is addressed.
As a matter of theory, the duration of the
credit effects described in Section II above
depends on the amount of time it takes to 1)
establish new or revive old channels of credit
flow after a major disruption, and 2) rehabilitate insolvent debtors. Since these
processes may be difficult and slow, the persistence of nonmonetary effects of financial
crisis has a plausible basis. (In contrast, persistence of purely monetary effects relies on
the slow diffusion of information or unexplained stickiness of wages and prices.) Of

JUNE 1983

course, plausibility is not enough; some evidence on the speed of financial recovery
should be adduced.
After struggling through 1931 and 1932,
the financial system hit its low point in March
1933, when the newly elected President
Roosevelt's "bank holiday" closed down
most financial intermediaries and markets.
March 1933 was a watershed month in several
ways: It marked not only the beginning of
economic and financial recovery but also the
introduction of truly extensive government
involvement in all aspects of the financial
system.31 It might be argued that the federally
directed financial rehabilitation—which took
strong measures against the problems of both
creditors and debtors—was the only major
New Deal program that successfully promoted economic recovery.32 In any case, the
large government intervention is prima facie
evidence that by this time the public had lost
confidence in the self-correcting powers of
the financial structure.
Although the government's actions set the
financial system on its way back to health,
recovery was neither rapid nor complete.
Many banks did not reopen after the holiday, and many that did open did so on a
restricted basis or with marginally solvent
balance sheets. Deposits did not flow back
into the banks in great quantities until 1934,
and the government (through the Reconstruction Finance Corporation and other
agencies) had to continue to pump large
sums into banks and other intermediaries.
Most important, however, was a noticeable
change in attitude among lenders; they
emerged from the 1930-33 episode chastened and conservative. Friedman and
Schwartz (pp. 449-62) have documented the
shift of banks during this time away from
making loans toward holding safe and liquid
investments. The growing level of bank
liquidity created an illusion (as Friedman
and Schwartz pointed out) of easy money;
See Chandler (1970), ch. 15, and Friedman and
Schwartz, ch. 8.
E. Carey Brown (1956) has argued that New Deal
fiscal policy was not very constructive. A paper by
Michael Weinstein in Brunner (1981) points out counterproductive aspects of the N.R.A.

VOL. 73 NO. 3


however, the combination of lender reluctance and continued debtor insolvency interfered with credit flows for several years
after 1933.
Evidence of postholiday credit problems is
not hard to find. For example, small businesses, which (as I have noted) suffered disproportionately during the Contraction, had
continuing difficulties with credit during recovery. Lewis Kimmel (1939) carried out a
survey of credit availability during 1933-38
as a companion to the National Industrial
Conference Board's 1932 survey. His conclusions are generally sanguine (this may reflect
the fact that the work was commissioned by
the American Bankers Association). However, his survey results (p. 65) show that, of
responding manufacturing firms normally
dependent on banks, refusal or restriction of
bank credit was reported by 30.2 percent of
very small firms (capitalization less than
$50,000); 14.3 percent of small firms
($50,001-$500,000); 10.3 percent of medium
firms ($500,001-$1,000,000); and 3.2 percent
of the largest companies (capital over $1
million). (The corresponding results from the
1932 NICB survey were 41.3, 22.2, 12.5, and
9.7 percent.)
Two well-known economists, Hardy and
Viner, conducted a credit survey in the Seventh Federal Reserve District in 1934-35.
Based on "intensive coverage of 2600 individual cases," they found "a genuine
unsatisfied demand for credit by solvent borrowers, many of whom could make economically sound use of working capital.... The
total amount of this unsatisfied demand for
credit is a significant factor, among many
others, in retarding business recovery." They
added, "So far as small business is concerned, the difficulty in getting bank credit
has increased more, as compared with a few
years ago, than has the difficulty of getting
trade credit." (These passages are quoted in
W. L. Stoddard, 1940.)
Finally, another credit survey for the
1933-38 period was done by the Small Business Review Committee for the U.S. Department of Commerce. This study surveyed
6,000 firms with between 21 and 150 employees. From these they chose a special
sample of 600 companies "selected because


of their high ratings by a standard commercial rating agency." Even within the elite
sample, 45 percent of the firms reported
difficulty in securing funds for working
capital purposes during this period; and 75
percent could not obtain capital or long-term
loan requirements through regular markets.
(See Stoddard.)
The reader may wish to view the American
Bankers Association and Small Business Review Committee surveys as lower and upper
bounds, with the Hardy-Viner study in the
middle. In any case, the consensus from
surveys, as well as the opinion of careful
students such as Chandler, is that credit difficulties for small business persisted for at
least two years after the bank holiday.33
Home mortgage lending was another important area of credit activity. In this sphere,
private lenders were even more cautious after
1933 than in business lending. They had a
reason for conservatism; while business
failures fell quite a bit during the recovery,
real estate defaults and foreclosures continued high through 1935.34 As has been
noted, some traditional mortgage lenders
nearly left the market: life insurance companies, which made $525 million in mortgage
loans in 1929, made $10 million in new loans
in 1933 and $16 million in 1934.35 During
this period, mortgage loans that were made
by private institutions went only to the very
best potential borrowers. Evidence for this is
the sharp drop in default rates of loans made
in the early 1930's as compared to loans
made in earlier years (see Carl Behrens, 1952,
p. 11); this decline was too large to be explained by the improvement in business conditions alone.
To the extent that the home mortgage
market did function in the years immediately
following 1933, it was largely due to the
direct involvement of the federal government. Besides establishing some important
new institutions (such as the FSLIC and the
system of federally chartered savings and
loans), the government "readjusted" existing
debts, made investments in the shares of

See Chandler (1970), pp. 150-51.
U.S. Department of Commerce (1975), series N301.
U.S. Department of Commerce (1975), N282.



thrift institutions, and substituted for recalcitrant private institutions in the provision
of direct credit. In 1934, the governmentsponsored Home Owners' Loan Corporation
made 71 percent of all mortgage loans extended.36
Similar conditions obtained for farm credit
and in other markets, but space does not
permit this to be pursued here. Summarizing
the reading of all of the evidence by
economists and by other students of the
period, it seems safe to say that the return of
the private financial system to normal conditions after March 1933 was not rapid; and
that the financial recovery would have been
more difficult without extensive government
intervention and assistance. A moderate
estimate is that the U.S. financial system
operated under handicap for about five years
(from the beginning of 1931 to the end of
1935), a period which covers most of the
time between the recessions of 1929-30 and
1937-38. This is consistent with the claim
that the effects of financial crisis can help
explain the persistence of the depression.
VI. International Aspects
The Great Depression was a worldwide
phenomenon; banking crises, though occurring in a number of important countries
besides the United States, were not so
ubiquitous. A number of large countries had
no serious domestic banking problems, yet
experienced severe drops in real income in
the early 1930's. Can this be made consistent
with the important role we have ascribed to
the financial crisis in the United States? A
complete answer would require another
paper; but I offer some observations:
1) The experience of different countries
and the mix of depressive forces each faced
varied significantly. For example, Britain,
suffering from an overvalued pound, had
high unemployment throughout the 1920's;
after leaving gold in 1931, it was one of the
first countries to recover. The biggest problems of food and raw materials exporters
were falling prices and the drying up of
U.S. Department of Commerce (1975), N278 and

JUNE 1983

overseas markets. Thus we need not look to
the domestic financial system as an important cause in every case.
2) The countries in which banking crises
occurred (the United States, Germany,
Austria, Hungary, and others) were among
the worst hit by the depression. Moreover,
these countries held a large share of world
trade and output. The United States alone
accounted for almost half of world industrial
output in 1925-29, and its imports of basic
raw materials and foodstuffs in 1927-28
made up almost 40 percent of the trade in
these commodities.37 The reduction of imports as these economies weakened exerted
downward pressure on trading partners.
3) There were interesting parallels between the troubles of the domestic financial
system and those of the international system.
One of the Federal Reserve's proudest
accomplishments had been the establishment, during the 1920's, of an international
gold-exchange standard. Unfortunately, like
domestic banking, the gold-exchange standard had the instability of a fractionalreserve system. International reserves
included not only gold but also foreign currencies, notably the dollar and the pound;
for countries other than the United States
and the United Kingdom, foreign exchange
was 35 percent of total reserves.
In 1931, the expectations that the international financial system would collapse became self-fulfilling. A general attempt to
convert currencies into gold drove one currency after another off the gold-exchange
standard. Restrictions on the movement of
capital or gold were widely imposed. By 1932,
only the United States and a small number
of other countries remained on gold.
As the fall of the gold standard parallelled
domestic bank failures, the domestic insolvency problem had an international analogue as well. Largely due to fixed exchange
rates, the deflation of prices was worldwide.
Countries with large nominal debts, notably
agricultural exporters (the case of Canada
has been mentioned), became unable to pay.
Foreign bond values in the United States
were extremely depressed.

U.S. Department of Commerce (1947), pp. 29-31.

VOL. 73 NO. 3


As in the domestic economy, these problems disrupted the worldwide mechanism of
credit. International capital flows were reduced to a trickle. This represented a serious
problem for many countries.
To summarize these observations: the fact
that the Great Depression hit countries which
did not have banking crises does not preclude the possibility that banking and debt
problems were important in the United States
(or, for that matter, that countries with strong
banks had problems with debtor insolvency).
Moreover, my analysis of the domestic financial system may be able to shed light on
some of the international financial difficulties of the period.
VII. Conclusion
Did the financial collapse of the early
1930's have real effects on the macroeconomy, other than through monetary channels?
The evidence is at least not inconsistent with
this proposition. However, a stronger reason
for giving this view consideration is the one
stated in the introduction: this theory has
hope of achieving a reconciliation of the
obvious suboptimality of this period with the
postulate of reasonably rational, market-constrained agents. The solution to this paradox
lies in recognizing that economic institutions,
rather than being a "veil," can affect costs of
transactions and thus market opportunities
and allocations. Institutions which evolve and
perform well in normal times may become
counterproductive during periods when exogenous shocks or policy mistakes drive the
economy off course. The malfunctioning of
financial institutions during the early 1930's
exemplifies this point.
Abel, Andrew and Mishkin, Frederic, "An Integrated View of Tests of Rationality,
Market Efficiency, and the Short-Run
Neutrality of Monetary Policy," Working
Paper 726, National Bureau of Economic
Research, 1981.
Barro, Robert, "Unanticipated Money, Output, and the Price Level in the United
States," Journal of Political Economy,


August 1978, 86, 549-80.
Behrens, Carl, Commercial Bank Activities in
Urban Mortgage Financing, New York:
National Bureau of Economic Research,
Bernanke, Ben, "Bankruptcy, Liquidity, and
Recession," American Economic Review
Proceedings, May 1981, 71, 155-59.
Brown, E. Carey, "Fiscal Policy in the Thirties: A Reappraisal," American Economic
Review, December 1956, 46, 857-79.
Brunner, Karl, The Great Depression Revisited,
Boston: Martinus Nijhoff, 1981.
Cagan, Philip, Determinants and Effects of
Changes in the Stock of Money, 1875-1960,
New York: National Bureau of Economic
Research, 1965.
Chandler, Lester, America's Greatest Depression, New York: Harper & Row, 1970.
, American Monetary Policy, 19281941, New York: Harper & Row, 1971.
Clark, Evans, The Internal Debts of the United
States, New York: Macmillan Co., 1933.
Cone, Kenneth, "Regulation of Depository
Financial Intermediaries," unpublished
doctoral dissertation, Stanford University,
Diamond, Douglas and Dybvig, Philip, "Bank
Runs, Deposit Insurance, and Liquidity,"
mimeo., University of Chicago, 1981.
Evans, Paul, "An Econometric Analysis of the
Causes of the Great Depression in the
U.S.," mimeo., Stanford University, 1981.
Fabricant, Solomon, Profits, Losses, and Business Assets, 1929-1934, Bulletin 55, National Bureau of Economic Research, 1935.
Fama, Eugene, "Banking in the Theory of
Finance," Journal of Monetary Economics,
January 1980, 6, 39-57.
Fisher, Irving, "The Debt-Deflation Theory of
Great Depressions," Econometrica, October 1933, 7, 337-57.
Flood, Robert and Garber, Peter, "A Systematic
Banking Collapse in a Perfect Foresight
World," Working Paper No. 691, National
Bureau of Economic Research, 1981.
Frederiksen, D. M., "Two Financial Roads
Leading Out of Depression," Harvard
Business Review, October 1931, 10,
Friedman, Benjamin, "Debt and Economic Activity in the United States," Working Paper



No. 704, National Bureau of Economic
Research, 1981.
Friedman, Milton, and Schwartz, Anna J., A
Monetary History of the United States,
1867-1960, Princeton: Princeton University Press, 1963.
Goldsmith, Raymond, Financial Institutions in
the American Economy Since 1900, Princeton: Princeton University Press, 1958.
Gurley, John G. and Shaw, E. S., "Financial
Aspects of Economic Development,"
American Economic Review, September
1955, 45, 515-38.
Hart, A. G., Debts and Recovery, 1929-1937,
New York: Twentieth Century Fund, 1938.
Jaffee, Dwight, and Russell, Thomas, "Imperfect Information and Credit Rationing,"
Quarterly Journal of Economics, November
1976, 90, 651-66.
Kennedy, Susan E., The Banking Crisis of 1933,
Lexington: University Press of Kentucky,
Kimmel, Lewis H., The Availability of Bank
Credit, 1933-1938, New York: National
Industrial Conference Board, 1939.
Kindleberger, Charles P., Manias, Panics, and
Crashes, New York: Basic Books, 1978.
Klebaner, Benjamin, Commercial Banking in
the United States: A History, Hinsdale:
Dryden Press, 1974.
Lucas, Robert E., Jr., "Expectations and the
Neutrality of Money," Journal of Economic Theory, April 1972, 4, 103-24.
, Studies in Business Cycle Theory,
Cambridge: Massachusetts Institute of
Technology Press, 1981.
Lutz, Friedrich, Corporate Cash Balances,
1914-43, New York: National Bureau of
Economic Research, 1945.
McKinnon, Ronald J., Money and Capital in
Economic Development, Washington: The
Brookings Institution, 1973.
Merwin, Charles L., Financing Small Corporations, New York: National Bureau of Economic Research, 1942.
Minsky, Hyman P., "A Theory of Systematic
Fragility," in E. I. Altman and A. W.
Sametz, eds., Financial Crises, New York:
Wiley-Interscience, 1977.
Mishkin, Frederic, "The Household Balance
Sheet and the Great Depression," Journal

JUNE 1983

of Economic History, December 1978, 38,
., "Does Anticipated Money Matter?
An Econometric Investigation," Journal of
Political Economy, February 1982, 90,
Nugent, Rolf, Consumer Credit and Economic
Stability, New York: Russell Sage Foundation, 1939.
O'Hara, Maureen and Easley, David, "The Postal
Savings System in Depression," Journal of
Economic History, September 1979, 39,
Persons, Charles E., "Credit Expansion, 1920
to 1929 and Its Lessons," Quarterly Journal of Economics, November 1930, 45,
Safarian, A. E., The Canadian Economy in the
Great Depression, Toronto: University of
Toronto Press, 1959.
Sargent, Thomas J., "A Classical Macroeconometric Model for the United States," Journal of Political Economy, April 1976, 84,
Stiglitz, Joseph E. and Weiss, Andrew, "Credit
Rationing in Markets with Imperfect Information," American Economic Review,
June 1981, 71, 393-410.
Stoddard, W. L., "Small Business Wants
Capital," Harvard Business Review, Spring
1940, 18, 265-74.
Temin, Peter, Did Monetary Forces Cause the
Great Depression!, New York: W. W. Norton, 1976.
Upham, Cyril B. and Lamke, Edwin, Closed and
Distressed Banks: A Study in Public Administration, Washington: The Brookings
Institution, 1934.
Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1943.
Federal Reserve Bulletin, various issues.
National Industrial Conference Board, The Availability of Bank Credit, New York, 1932.
Survey of Current Business, various issues.
U.S. Department of Commerce, Historical Statistics of the United States, Washington:
USGPO, 1975.
, National Income, Washington:
USGPO, 1954.
_, The United States in the World Economy, Washington: USGPO, 1947.