time series variables provide valuable information about the time path of the impact of each variable on the rest of the variables under investigation. Information about the
month-by-month impact of each variable, with respect to the other variables in the model, are particularly useful in sorting out their relative contribution in explaining the declines
in output, prices, and money supply.
Based on data used in the Bernanke 1983 study, and historical decompositions of the time series variables in the VAR model, our results indicate that bank failures did not play
an important role in explaining the drop in output until the last few months of the Great Depression episode. In this regard, persistent bank failures over at least a two-year period
which escalated over time did contribute to output declines. Importantly, the VAR model results reveal that chronic and increasing bank failures had severe negative impacts on not
only output but prices, money supply, and business failures. The policy implication of these findings to banking regulation is that bank failures by themselves do not necessarily
have deleterious effects on the economy; however, chronic and severe bank failures seriously disrupt the financial intermediation process and potentially have pervasive
adverse effects on the economy. Corroborating evidence for this inference is the finding by Mason 1998 that failed bank assets are liquidated more slowly and with lower
recovery rates during periods of financial crisis. Consequently, at some point, government intervention is justified to stabilize the banking system. Although a direct link to current
banking issues is not possible, these findings tend to suggest that, as long as there is a lender of last resort i.e., the central bank to overcome the problem of chronic and
deepening failures, isolated failures of individual institutions in the context of today’s more competitive banking environment do not appear to be a major problem with respect
to economic productivity.
The next section overviews related empirical literature. Section III describes the Johansen 1988, 1991 cointegration procedure and the data. Section IV reports the
empirical results, and the last section contains conclusions and implications.
II. Related Literature
Friedman and Schwartz 1963 argued that banking panics in the Great Depression reduced the money supply, which they found to be highly correlated with the dramatic
decline in U.S. output. In contrast to this monetarist view of the causes of the Great Depression, Gurley and Shaw 1955 argued that bank failures were an important
explanatory factor for reasons of credit intermediation services, i.e., the so-called credit hypothesis
. Empirical work by Bernanke 1983 tended to support the notion that, apart from their role in the money supply process, bank failures raised the cost of credit
intermediation and thereby lowered business investment and output. The landmark study of Bernanke 1983 empirically tested the credit hypothesis by
using a Lucas-Barro type model to initially examine the effects of money shocks and price shocks on real output in two separate regressions. Price surprises were found to have a
stronger relationship to output than money surprises. More importantly, although both
2
More specifically, the dependent variable is the rate of growth of industrial production relative to the exponential trend. The money supply independent variable is the rate of growth of M1 nominally and
seasonally adjusted less the predicted rate of growth, and price variable is the rate of growth of the wholesale price index less its predicted growth rate.
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effects were statistically significant, they explained only about half of the decline in output during the period 1930 –1933.
Based on this evidence, Bernanke 1983 argued that there was an error of omission in the monetary model and, subsequently, sought proxies for nonmonetary factors affecting
output. Two key proxies were selected: the liabilities of failed businesses and the deposits of failed banks. In both the money shocks and price shocks regression models, these
nonmonetary variables and lagged first differences were significant, and the money and price coefficients were unchanged for the most part. Bernanke 1983, p. 270 concluded
that “ . . . nonmonetary effects of the financial crisis augmented monetary effects in the short-run determination of output.” In general, inclusion of the nonmonetary proxies for
the financial sector predicted a more severe and longer decline in output than would be predicted by models of monetary contraction alone. Bernanke 1983 further observed that
the Great Depression was a global crisis and that countries experiencing bank crises i.e., the United States, Germany, Austria, Hungary, and others suffered the most severe
economic downturns.
Studies by Calomiris et al. 1986 and Gilbert and Kochin 1989 tested the effects of U.S. bank failures on regional economic activity. Calomiris et al. examined farm output
data from the period 1977–1984 for different states, while Gilbert and Kochin focused on economic activity as measured by both the state sales tax and employment during the
period 1981–1986 in Kansas and Nebraska. Both studies found that bank failures signif- icantly affected economic activity, thereby contributing evidence in support of the credit
hypothesis.
More recent literature has been directed to international comparisons of banking crises and macroeconomic effects. For example, Bernanke and James 1991 examined data
from a panel of 24 countries and found that the length of banking panics significantly affected industrial production. Importantly, the authors argued that differences between
countries’ banking crises were related to institutional and policy differences, which implies that banking panics were not entirely explained by macroeconomic downturns
alone but, instead, had an independent macroeconomic effect. The significance of the length of banking panics was further supported by a related paper by Bernanke and Carey
1994, who collected data for 22 countries. Bernanke 1995 has overviewed these studies in more detail.
Another branch of literature examines the general role of bank credit, as opposed to bank failures and associated credit disruptions, on economic activity. For example, King
1985 used vector autoregression VAR techniques to test the credit hypothesis in non-Depression years and found mixed results based on aggregate U.S. data. Also,
Samolyk 1990 tested data on past insolvencies of corporate and noncorporate borrowers in Great Britain and found evidence in support of the credit view. This more general
approach to testing the credit hypothesis was supported by theoretical work by Bernanke and Gertler 1987. They argued that there is a link between economic growth and the
health of the financial system. In the macroeconomic model developed by the authors, investment and output were determined by the “willingness of banks to undertake risky
projects,” which in turn is determined by the net capital of the banking system. Of course, net bank capital would be impaired by unexpected loan losses and, subsequently, reduced
credit availability could further slow economic activity.
3
The nonmonetary variables were measured as the first difference of deposits of failed banks and the liabilities of failed businesses. Both variables were deflated by the wholesale price index.
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A. Anari and J. Kolari
Another theoretical proposition by Bernanke and Gertler 1987b is that information asymmetries between lenders and entrepreneurs can, at times, cause higher costs of capital
to firms and cause decreased investment and economic output. At times of financial distress, there is increased demand for loans from low-quality borrowers, which creates a
lemons problem for lenders attempting to sort out low- and high-quality firms. A lemons premium is subsequently added to the cost of capital, which diminishes efficient invest-
ment and, in severe circumstances, can lead to an investment collapse. For those inter- ested, Gertler 1988 provides an in-depth survey of the interaction between the financial
sector and real economic output, with particular emphasis on the production and transfer of information in the credit process. Another more recent survey of theory and empirical
research by Levine 1997, which draws a close linkage between the functioning of the financial system and long-run economic growth, cites international comparisons as
supporting evidence.
The importance of the credit hypothesis rests in its policy implications. As Moore 1997 has observed, the policy debate centers on the extent to which government should
respond to financial crises. On the one hand, government intervention can create a moral hazard problem, in which banks increase risk-taking due to their limited liability for
losses. The result of excessive government assistance is greater systemic risk in the banking industry than otherwise. By contrast, it can be argued that there are no close
substitutes for bank credit, as banks provide unique information production services to the financial market. Government assistance is recommended in this instance to sustain the
supply of credit to firms and prevent an economic collapse due to a credit crunch. Apparently, this latter viewpoint motivated U.S. policy after the Great Depression. The
Banking Acts of 1933 and 1935 introduced heavy regulation of banks to reduce compe- tition and preserve the safety and soundness of the banking industry.
More recently, as cited by Moore 1997, U.S. policy has shifted away from govern- ment assistance as a way to control bank risk. Today, under the Federal Deposit Insurance
Corporation Improvement Act of 1991 FDICIA, government regulation is linked to bank capital, and prompt corrective action guidelines reduce regulators’ ability to forbear bank
condition problems. Thus, while the credit hypothesis had its roots in the Great Depres- sion, it has contemporary significance from a policy perspective. In this respect, an
anonymous referee noted that, if bank failures have immediate effects, then rapid policy responses in the context of a fairly strict regulatory environment are needed. Alternatively,
if occasional bank failures do not have short-run effects, then policy makers need not intervene unless chronic or a large surge in failures threatens the credit intermediation
process. In the latter case, weak banks can be allowed to fail, sometimes in large numbers as in the 1980s and early 1990s without important macro consequences or the need for
undue regulatory burdens.
In the forthcoming section, we overview an empirical methodology that has the advantage of providing some insights into short-run versus long-run effects between bank
failures and economic output during the U.S. Great Depression.
4
As observed by an anonymous reviewer, an interesting question from this literature is whether deposits or loans are driving the credit hypothesis. In the cases of bank capital impairment or informational distortions, it
would appear that loans are the driving mechanism. However, in periods of severe financial system distress, such as the Great Depression, bank runs on deposits, destruction of bank assets due to illiquidity, and loss of public
confidence in the banking system are deposit motivated. Thus, the underlying source of credit problems can differ depending on whether there is a panic-induced bank run or a significant downturn in general economic
conditions that is associated with a deterioration in banking system health.
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III. Methodology
