Wednesday, April 14, 2010

Paul Krugman is almost right!

I don't often agree with Paul Krugman, but sometimes I do. In his April 2 offering he briefly lays out his ideas on financial regulation reform. I agree with him as far as he goes. But as this blog is dedicated to clearing up misunderstandings about events of the 1930s, I'll stick to his assertion about the disastrous impact of small-bank failures during the Great Depression.

The problem with Krugman's assertion is there is no real evidence to back it up. In 1983 then Professor Ben Bernanke published an influential and oft-cited article about the impact of bank failures on the availability of credit. In it he argues that numerous pressures on banks, including loan defaults, fears of bank runs, and disappearing small banks staffed by knowledgeable experts, all combined to raise "the real costs of credit intermediation" or make the credit markets less effective and efficient at provisioning credit in the 1930s. But Bernanke argues that a host of issues combined to cause these problems, not just the collapse of small banks.

Had the system been faced simply with the slow elimination of small banks, then the 1930s would have looked a lot like the 1920s, when small banks failed by the thousands. There is no particular reason to think that the continued disappearance of small, mostly rural banks had a greater impact in the 1930s and I've seen no research to suggest that it did. The elimination of nearly 5,879 banks had no noticeable impact on the economy of the country during the 1920s. The worst year in the 1920s was 1926 when 976 small banks failed, freezing $260 million. The worst year for banks during the Depression was 1931 when 2,293 banks failed freezing $1.69 billion. Many of those banks were sizable national banks and trust companies in major cities like Boston, Philadelphia, Chicago, and Pittsburgh. When those banks collapsed they sent shock waves reverberating through the economic system.

The failure of larger banks in mid-sized towns and cities had a decided impact by freezing the deposits of many 1,000s--sometimes hundreds of thousands--of citizens and businesses, big and small. Locked out of their accounts--often for years--many small businesses succumbed to the dreadful conditions they faced during the Depression. Often the businesses forceably separated from their deposits were other banks, all of which maintained accounts in correspondent institutions. The failures of the larger institutions sent shock waves rippling through the economy while hundreds of millions of dollars remained locked away and unavailable.

The collapse of small banks did not produce those kinds of strains and most often affected only small local markets. That was always bad news for those mostly rural areas, but had little to no adverse impact on the nation.

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