How a Financial Crisis Can Turn into a Great Depression

On October 10, the Royal Swedish Academy announced the Nobel Prize in Economics and the prize was awarded jointly to Ben S Bernanke, Douglas W Diamond and Philip H Dybvig. Their work in explaining the role of banks in the economy, how a financial crisis is aggravated by a misstep in the banking system, and how a potential crisis can be averted by developing appropriate policies earned them this prestigious award.

Let’s look at Ben S Bernanke’s background and how his experience as Chairman of the US Federal Reserve during the 2009 financial crisis helped him form the theory.

Ben Bernanke served as the 14th Chairman of the Federal Reserve System, from 2006 to 2014. His career as Fed Chairman was colorful and challenging for many reasons. The 2007-2009 global financial meltdown triggered by the subprime mortgage crisis in the United States was arguably Bernanke’s most notable challenge during his tenure as Fed Chairman.

Bernanke was the head of America’s monetary and financial system when the country suffered the worst financial crisis in 2009, second only to the Great Depression of 1929. He not only watched the collapse of century-old financial institutions such as Lehman Brothers and Washington Mutual but also remained silent during their deaths.

Bernanke endorsed mergers of important but moribund financial hunches in the name of economic recovery. More importantly, he saved AIG (American International Group, the largest insurance company in the world) from bankruptcy at the expense of taxpayers.

AIG’s network of financial transactions with other financial institutions was so deeply rooted that letting AIG go bankrupt was akin to collapsing the entire financial structure of the United States. Undoubtedly, Bernanke has been praised, and also criticized, for his role during the subprime mortgage crisis. However, it was evident that his bold measures had largely contributed to averting the adverse effects of the crisis.

Bernanke’s academic and professional experience has equipped him with the skills and political savvy necessary to tame the negative impact of a crisis. In particular, the focus of Bernanke’s work was to analyze the economic and political causes of a financial crisis. He dissected the Great Depression of 1929 in light of monetary policy and other critical external forces.

Bernanke followed in the footsteps of his predecessor, the famous Milton Friedman, who pointed out the policy error of the Fed during the Great Depression. He argued that the central bank’s tight monetary policy and the sudden and early rise in interest rates disrupted the flow of cash into the market, which then fueled the crisis. For Friedman, the conservative attitude of the Fed during the crisis not only fuels the crisis but also prolongs it.

Perhaps inspired by this idea, Bernanke adopted an expansionary monetary policy during the subprime mortgage crisis.

Monetary easing continued long enough after the crisis to allow sufficient time and space for economic stability. Bernanke lowered interest rates to zero in an effort to forestall the damaging effects of the 2009 financial crisis. He blamed his predecessors for their misguided monetary policies that ultimately led to the crisis.

Bernanke draws evidence that in eight years, from 2000 to 2008, the federal funds rate was revised 42 times.

While Friedman attributed the cause of the crisis to monetary policy alone, Bernanke, however, illustrates that it is not monetary policy that primarily affects the real economy; rather, it is the relationship between the banking sector and the manufacturing sector that is more important. For Bernanke, the effect of financial sector activities on the manufacturing sector is more pronounced than the relationship between monetary policy and real activity.

Bernanke analyzed the Great Depression in light of this theory. He showed that the fragility of the financial sector was a major cause of the unwanted persistence of the Great Depression. Before that, US banks were small and fragile. Existing laws discouraged large financial institutions, including bank branches. Entry requirements for new banks have been relaxed to ensure competition between banks. Bank lending was heavily concentrated in a few sectors, including agriculture and housing. In such a financial structure, the slightest negative external shock is enough to destabilize the entire banking system.

Bernanke specifically blamed “bank flight” for the Great Depression of 1929.

Banks collect funds from depositors in the form of current, fixed and term deposits. The current deposit is special because the banks are obliged to return them each time the depositors wish to withdraw. Therefore, deposits are mainly short-term. When banks distribute these deposits to entrepreneurs in the form of loans, they turn into a long-term investment. This results in a “maturity mismatch” (short-term deposit versus long-term investment) which is sensitive for the financial sector.

Since not all depositors withdraw all funds from the bank, maturity mismatch does not pose a threat to the banking system. However, this becomes a major problem if depositors throng to bank counters to withdraw their funds.

For example, if there is a lack of confidence in the financial sector, depositors simply go to the bank to withdraw their funds. Since banks cannot meet the demand of all depositors at once, depositors may have the idea that whoever arrives first at the counter will receive the funds and those who arrive late lose their deposit. This motivates depositors to withdraw their funds even if they do not need them immediately, driving banks into bankruptcy. This situation is called a bank run.

Before the Great Depression of 1929, the American economy was stable. Credit flows to the agriculture and housing sectors have been strong. Manufacturing companies began to borrow more through fixed rate securities during the recession.

At the start of the Great Depression, the downward trend in agricultural commodity prices and low yields reduced farmers’ incomes. This has resulted in low demand for goods and services. A lack of demand has resulted in low profits for the industrial sector. Agriculture, housing and manufacturing businesses are unable to repay bank loans as promised. This caused the collapse of many small banks.

The “bank run” on the one hand, and the contraction of the money supply on the other hand, drove many small banks into insolvency. The banking sector has suffered seriously from inefficiencies; the debt has become costly. Small businesses have not been able to take advantage of bank loans.

In addition, the conservative attitude of banks during the economic downturn has further restricted the flow of credit. This accelerated and prolonged the Great Depression of 1929. According to Bernanke, this vicious circle can turn a small or medium financial crisis into a Great Depression.

In light of this theory, Bernanke showed that the Great Depression of 1929 was caused not only by mistakes in monetary policy, but also by the collapse of the financial sector. From this perspective, Bernanke argued that there is no reason to underestimate the role of banks in the economy.

Indeed, the obstacles that prevail in the banking sector must be eliminated so that financial services can be provided to users at a lower cost, insisted Bernanke. Undoubtedly, his postulation will improve our understanding of the causes and consequences of financial crises and help to avoid a potential crisis in the future. Such an idea, in times of financial fragility, certainly deserves great recognition.

Mr Kabir Hassan/ Professor, University of New Orleans. Sketch: TBS


Mr Kabir Hassan/ Professor, University of New Orleans. Sketch: TBS

Dulal Miah/ Professor, University of Nizwa. Sketch: TBS

Dulal Miah/ Professor, University of Nizwa. Sketch: TBS

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