I have received very thoughtful comments on my five articles on public sector housing. I shall respond to these comments in two weeks on 26 October 2011.


This is the first of two articles on government failures during the two major global economic crises of the past century. The defining features of both crises were bank panics followed by a severe and protracted economic downturn. But the underlying causes go back much further. This crisis started first and foremost as a bank panic. Similarly the Great Depression was an economic crisis that started with a bank panic, in October 1930.


Bank panics historically have occurred at the onset of a recession or depression. Individuals, fearful for their savings and not knowing if their bank will survive the coming downturn, rush to their banks to withdraw their money. These runs occur at all banks because people do not know which banks are safe, and once they start, they spread.


Fear of Bank Failures


When everyone demands to withdraw cash from their banks at the same time, it is not possible for the banking system to meet their demands and the banking system becomes insolvent. The money has already been lent out and the banks cannot sell their loans because the assets of the banking system are simply too large for anyone to buy. This is what makes a banking panic a systemic event. Banks understand this and they know that trying to sell their loans would be a disaster, so banks as a group would suspend convertibility. In other words, they would refuse to give back the cash to their depositors. This would save the banking system from destruction. But when suspension happens, bank checks would no longer be accepted, and cash would be hoarded. There would be a “currency famine”, often triggering a flight to safe assets like gold.


Withdrawing money from banks is a rational response by people given concerns that the bank might fail during a recession. The problem is people outside the bank do not know whether the bank is weak and therefore risky. They lack some important information about the bank. Requiring such information to be disclosed is a hypothetical possibility, but for bank deposits to be considered as money and a widely accepted means of payment, it is necessary to make sure that there is no secret information of any importance about the riskiness of the bank that would affect the value of its deposits. In other words, bank deposits are money as long as their value is information insensitive. As soon as people suspect that the deposits of a bank are information sensitive, they no longer function well as money. 


One year after the stock market crash of 1929, the first bank panic appeared in October 1930. The bank runs became worse after financial conglomerates inNew YorkandLos Angelesfailed in prominently reported scandals. The Great Depression contained several banking crises consisting of runs on multiple banks up to 1933. The greatest economic damage during the Great Depression (1929-1939) was caused directly by bank failures.


Once the banks started to fail, other businesses began to follow. These failures resulted in major capital losses for owners and depositors. Workers also lost their jobs as the contagion spread throughout the economy. In the period 1930–33 the rate of deflation was approximately 10% a year and peak unemployment reached 25%. The failures of the banks and businesses also destroyed capital values that were embedded in these institutions. Many bankers and business owners committed suicide. Economic recovery did not begin until the Second World War ended the Great Depression.


Failures of Government Policy


Three major policy mistakes were committed that resulted in the worst global economic crisis in the past century. The first policy mistake, identified by Milton Friedman and Anna Schwartz in their monumental work A Monetary History of the United States, 1867-1960, was the failure of the directors of the Federal Reserve to comprehend that bank failures were systemic events. Instead they saw bank failures as only a problem of bank management which was not the Federal Reserve’s responsibility. As a consequence, when the public made a panicked attempt to convert deposits into currency, the Fed had a puzzling response: it allowed bank credit to contract and even refused to expand money supply through expansionary open market operations.


The second policy mistake was to refuse to inflate in the face of deflationary pressures. In 1933,U.S.President F. D. Roosevelt (FDR) nationalized gold owned by private citizens and abrogated contracts in which payment was specified in gold. This effectively resulted in a dollar depreciation policy during 1933-34. Rapid inflation occurred during this period, but was not sustained. This was an aggressive monetary policy at the time. Nevertheless, many serious people objected, claiming it was an inflationary time bomb which would explode in a couple of years. One of those critics was John Maynard Keynes who attacked the policy in late 1933 as being too inflationary (when gold prices rose above USD28). When FDR went back to the Gold Standard in January 1934 (at USD35), Keynes congratulated FDR for rejecting the views of the “extreme inflationists”.


The third policy mistake was FDR’s adoption of the New Deal policy. This started with what historians call the “first new deal” in 1933, shortly afterRooseveltassumed the presidency. At the time, the populist left was campaigning for a re-distribution of wealth, such as generous pensions for every elderly American and a guarantee that every family have an income no less than one-third the national average.Rooseveltwas concerned about this movement, which explains why he then enacted his ambitious New Deal. There were plenty of left-wing voices in the Senate and Congress promoting ideas such as the Townsend plan to guarantee generous pensions to every elderly American, which had organizers in every state in the union. Senator Huey Pierce Long, Jr. was promoting a “Share our Wealth” movement demanding that incomes be capped at $1 million and every family should be guaranteed an income no less than one-third the national average.


Roosevelt was concerned about the populist left, which explains why he then enacted the more ambitious “second new deal,” which included the Federal Deposit Insurance Act 1934, the Social Security Act 1935, a massive public jobs program called the Works Progress Administration, the National Labor Relations Act 1935 (also known as the Wagner Act to give unions the right to collective bargaining and put Washington on the side of labor unions), and the Fair Labor Standards Act 1938 mandating the payment of minimum wages at 25 cents an hour. The Great Depression was the origin of many Keynesian-type liberal policies and institutions that have continued to the present time.


Wage Shocks Caused Slowdowns


There was immediate damage from FDR’s high wage policies. The most revealing data is seen in the monthly industrial production figures around each wage shock. As part of the National Industrial Recovery Act (NIRA) 1933, FDR ordered industries to cartelize and instituted 5 wage shocks of which 4 can be easily dated.


FDR’s high wage policy was a disaster as seen from the Table. Industrial production either fell or growth slowed after each wage shock. Without the high wage policy the economy would probably have recovered by 1934-35, instead it dipped into a second recession. The missing wage shock is the Wagner Act 1937 (a response to the Supreme Court’s 1935 decision to declare the NIRA unconstitutional). It made it easier to form unions to increase membership and engage in successful collective bargaining for wage increases. The resulting wage shock slowed the economic recovery sharply in 1937 despite high prices. And when prices stopped rising the industrial production began to fall sharply under the burden of higher wages.


Table: Four Month (non-Annualized) Growth Rates for Industrial Production


  Wage Shocks Before After
July 1933 hourly wage raised by 20% +57.4% -18.8%
May 1934 work week reduced by 20% +11.9% -15.0%
Nov 1938 minimum wage instituted +15.8% +2.5%
Nov 1939 minimum wage raised +16.0% -6.5%


Looking to today, the crisis that started in August 2007 was also triggered by a bank panic. Unlike the American bank panics during 1864-1913, this time the bank panic did not produce long queues of depositors outside banks demanding their deposits back. It took place in the shadow banking system where clients including firms, other banks and institutional investors redeemed their holdings of deposits. Since these were not retail clients who had to physically queue up, this bank panic appeared invisible to the public. It nevertheless produced one of the most severe credit crunches in banking history.


Financial Innovation and Credit Creation


What makes things different this time is that financial innovations in capital markets in the last 25-30 years have radically changed the way in which bank credit is created. These innovations have transformed the capital market into a shadow banking system. At the center of this operation is the over-the-counter repo market. Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often a bond. On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds.


There are two ways of looking at the transactions in the repo market. There is a finance side and a banking side.


The repo market is widely used for investing surplus funds short term, or for borrowing short term against collateral. Imagine an investor with $500 million who wants to earn some interest, wants the money to be safe (no risk), and wants to have easy access to the money. A large depositor is not willing to deposit large sums in a bank because it cannot be insured. One thing to do is to buy a very liquid asset like US Treasury bonds. An alternative is to “deposit” the $500 million overnight with a non-bank financial institution. In exchange the investor receives $500 million worth of collateral – usually a securitization-related bond – as a repo purchase. The interest on this type of bond is paid by a special purpose vehicle (SPV which is a legal entity) that holds a portfolio of loans, for example, mortgage loans, credit card loans, consumer loans, student loans, etc. The portfolio may be rated as AAA quality.


From the finance side the investor has just financed the bonds (that were given as collateral). Finance theorists and market practitioners usually perceive it as no more than an ordinary purchase and sale of an asset.


But to an economist and banking practitioner this is banking activity. The essential function of banking is to create a special kind of debt that can be used as money. The leading example of this is demand deposits. This kind of debt contains no secret information of any importance about the riskiness of the issuing bank that would affect its value. It is also very liquid because its value rarely changes, and so it can be traded without fear that someone would possess secret information about the value of the debt that would cause it to cease being a generally accepted means of payment. This information-insensitive debt was originally limited to demand deposits. But it can now be created in the repo market.


Rise of the Shadow Banking System


In the repo market, the “deposit” is placed with a non-bank financial institution and collateralized with bonds, which the depositor receives and which can be reused in some other transaction that the investor may undertake. In other words, the collateral can be “spent” again. This process of reusing collateral repeatedly is called “re-hypothecation”. Reusing it is similar to being able to write checks. Like demand deposits, repo is short-term and can be withdrawn at any time.


Repo resembles checking in that it is short-term, overnight, backed by collateral, and the bond received by the investor can be used again as collateral in some other transaction that the investor may undertake. In other words, the collateral can be “spent” again. Repo, then, is banking. And that is why the Fed had counted these transactions as “money” when it computed a measure of money called M3 (now discontinued). The People’s Bank of China has recently announced that they will be constructing a new measure of money to include such transactions.


With repos, the total supply of credit becomes the sum of bank credit and the amount of debt created in the repo market. That market became very large because there was a huge demand for collateralized debt. The financing of bank loans began to move out of the highly regulated banking sector into the less regulated capital markets. The capital markets then extended bank credit and performed the functions of the banking system – they became a shadow banking system.


The presence of the shadow banking system improved the efficiency of the capital market. Growth was facilitated by the ability of the shadow system to leverage up its business with minimal capital requirement, which banks could not do because of regulatory constraints. The non-bank financial institutions therefore could take much larger risks than the banks. Earnings were determined by the value of the transactions and executives were similarly remunerated. When executives were paid in effect on commission they had incentives to take unusual risks through leveraging.


The absence of a regulatory regime over the shadow banking system meant there was no need to report to a regulatory body on the transactions that had taken place. Information on the aggregate scale and scope of the activities was largely unknown. Even major participants did not know the whole picture. Since most of the transactions were made over the counter rather than traded on exchanges, it was rather difficult to gauge the overall scale of what was going on.


Benefits of Lessons from The Past


In August 2007, theUSeconomy was beginning to move into a recession and many large depositors became worried about whether the collateral they held was worth its stated value. At first the worry was focused on collateral backed by sub-prime mortgage loans and these depositors began to redeem their “deposits”. A “bank panic” appeared in the repo market. There were no queues outside the banks, but a bank run was taking place in the shadow banking system.


From this perspective, what happened in August 2007 was essentially the same thing that happened in October 1930 and also what happened in previousUSbank panics during 1864-1913. The absence of bank panics from the end of the Second World War to 2007 was the result of tight regulation of banks and the establishment of deposit insurance, which removed the cause of fear among retail depositors. The emergence of the shadow banking system re-created the old fears but in a new system.


After the bank panic started, the US Treasury and the Fed responded, to their credit, with boldness and effectiveness to prevent bank failures and to contain the panic in the market. By 2009, a year after the collapse of Lehman and the rescue of AIG, confidence was restored. The stress test for banks in 2009 is best understood as an attempt to restore confidence among large depositors so that they would cease to redeem their deposits from the shadow banking system. In other words, it sought to demonstrate that their collateralized deposits were information-insensitive debt and was good money. This took place after funds had already been injected to recapitalize the banks.


Compared to the failures of the Fed in the Great Depression era this was a hugely successful government mounted rescue. The Friedman and Schwartz study had provided a valuable lesson for today’s policy makers. Moreover deflationary pressures were headed off, but the debate on whether to re-inflate the economy remains a highly contentious issue. A Keynesian-like fiscal stimulus was adopted in 2009, but has had little effect on the economy and the unemployment rate remains stubbornly high. And there is little support for another new deal in the spirit of FDR.



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