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.

Even Ben Bernanke is Sometimes Right

I reserve the right to be picky-picky-picky with Ben Bernanke because, for one, he's Chairman of the Federal Reserve Board and--more importantly--as journalists never tire of reminding us, he made his reputation as an expert on the Great Depression. So, Bernanke's views on the Depression deserve especially close scrutiny. In a recent address at the Center for the Study of the Presidency and the Congress, Bernanke made numerous assertions about the Depression that require closer examination.

Comparing actions by the Executive branch and the Fed during the 1930s and today, Bernanke claimed that the recent "stress tests" of financial institutions paralleled the evaluation of banks nationwide during the bank holiday of March 1933. Good lord, I hope not! Those "examinations" consisted at their most rigorous as a quick perusal of the latest periodic reports by state and federal bank examiners over a long weekend. That is, most bank examiners--with the assistance of Treasury and Fed staff and in most states with the help of internal auditors supplied by the biggest banks and trust companies--reviewed reports already submitted by examiners in January 1933. In many cases, banks didn't even get that close an inspection: big bankers, like Joseph Wayne of the Philadelphia National Bank, sat down with Fed governors, like George Norris in Philadelphia, and drew up lists of banks they figured were probably sound. Fed Chief Counsel Walter Wyatt later mused in a letter to Under Secretary of the Treasury Arthur Ballantine, "What would it have done to public confidence if we had published the formula finally adopted for determining which were sound banks there were to be permitted to reopen?" We can only hope that the "stress tests" were more reliable. I doubt they were.

Bernanke went on to roundly criticize then Treasury Secretary Andrew Mellon for recommending that debts needed to be liquidated, presumably through the courts and bankruptcy. Bernanke is only repeated orthodoxy in chastising Mellon for his ruthless heartlessness. But was Mellon wrong? The record of the next ten years (Mellon resigned in Feb. 1932) provides no powerful evidence to refute his insistence that piling more debt, via the RFC and other government programs, on top of existing bad debts was only compounding problems and delaying recovery. Many agreed with Mellon that clearing up the tangle of debts, especially European War debts to the United States, would have been the most effective road out of the Depression. I don't know that Mellon was right, but it is far from obvious to me that he was wrong.

When Bernanke argued the importance of cooperation of central bankers from the major financial powers, he was certainly right. More cooperation among bankers and statesmen from 1930 through 1933, when FDR sabotaged international talks underway in London to coordinate actions among the major nations, would have certainly helped the U.S. emerge from the Depression long before it did.

He finally compared the gush of money out of Wall St. hedge funds in 2008 to the bank runs of the 1930s. Hmmmm...I guess so, but it's a stretch. It's certainly true that in the early 1930s some depositors lost faith in some banks and yanked out their money, but the parallel here would be when large depositors, like Standard Oil of Ohio, lost confidence in reckless banks, like the National Bank of Kentucky, and withdrew their deposits. That was repeated many times and often by big banks that lost confidence in other banks, and yanked out their funds. Is the Chairman suggesting that the Federal Reserve or the U.S. Treasury should have stepped in and saved the National Bank of Kentucky, which was run into the ground by a swindler? The Fed was indeed asked to intervene in 1930 and refused to do so--and rightfully so. Many banks, like the Bank of United States in N.Y.C., lost the faith of their depositors for good reasons and they usually went under for good reasons. The Fed also declined to help the Bank of United States. Yes, those collapses caused shocks to the system, but the system was resilient enough to survive them and was better off without the offending institutions. That might be a better lesson for the Fed Chairman to learn from the Great Depression and parallels with the latest excitement on Wall St.