¡Descarga The Great Depression: Understanding Banking Crises and their Impact on the Economy y más Apuntes en PDF de Derecho Civil solo en Docsity! CHAPTER 7: THE GREAT DEPRESSION. BANKING AND FINANCIAL CRISIS INDEX I. GETTING THE FACTS RIGHT II. FINANCIAL SYSTEM AND BANKING CRISES III. FINANCIAL CRISIS OF 1931 AND RECOVERY I. GETTING THE FACTS RIGHT During the 1930s the bank failures were much higher than in the 2008 crisis. As we saw in the previous lecture, the fall in the money supply wasn’t driven by currency (base money), it was driven by bank deposits. Additionally, the period 1929-1939 was characterized by a high intensity of crisis frequency. II. FINANCIAL SYSTEM AND BANKING CRISES The financial system The financial system is composed of the institutions in the economy that facilitate the flow of funds from savers (typically households) to borrowers (typically firms and government). A good financial system will foster investment and consumption, as well as higher efficiency in the market. Components of the financial system 1. Financial markets: where firms and households directly provide funds to each other (stock markets, bond markets, etc). 2. Financial intermediaries: where firms and households indirectly provide funds to each other (banks, insurance companies, etc). * Financial markets are more developed in the US while financial intermediaries (banks) are more developed in Europe. Why does the economy need intermediaries? 1. Asymmetric information: asymmetric information occurs when one party in a transaction has more information about it than the other. Banks help mitigating the effects of asymmetric information in two ways: (1) they pay analysts to analyze possible risks of the transaction. (2) They examine and restrict how borrowers spend the loans. 2. Maturity transformation : financial intermediaries convert liabilities that have different maturities into an asset, in the sense that they take deposits (liabilities for banks) and make loans. The underlying problem is that deposits are short- term, and loans are long-term. The banks can assume this risk because they have millions of clients, so the risk diversifies, but an individual could never assume this risk. Why are bank failures important? They reduce the level of wealth and hence of savings. As bank deposits get destroyed, money supply decreases. According to Bernanke, bank failures increase the credit cost intermediation. This is damaging because neither borrowers or banks can be changed overnight. For this reason, contraction of the money supply is not just a monetary phenomenon, it also destroys valuable information about the economy in the sense that these relationships tend to be focused on the long-term, and it takes time to create this information again. The risks faced by banks 1. The liquidity risk: This occurs when banks can’t honor their short-term debts (although they may be solvent in the long-term). This happens when a lot of people massively want to withdraw cash. It happens because there is a mismatch between assets (loans, etc) and liabilities (deposits, etc). The problem is that banks have long-term assets and short-term liabilities. During the Great Depression, it could have been solved if the FED should have provided emergency liquidity. 2. The contagion risk : Either because of illiquidity of insolvency, the bankruptcy of a bank negatively affects other banks (which maybe have made them a loan). Not only can this situation create losses to other banks, but also reduces The recovery from the Great Depresion Exit of the Gold Standard: Eichengreen and Romer argued that the exit from the Gold Standard led to this recovery, because it allowed central banks to boost money supply, decrease interest rates and stimulate the economy. Ultimately central banks could lend freely to banks to save them, they were no more constraint by the policies imposed by the Gold Standard. (As explained in chapter 6) Fiscal expansion: The “New Deal” in the US introduced an important increase in government expenditure and an increase in taxes. However, this policy is controversial, as it wasn’t a classical fiscal expansion (more G; less T), it was a neutral fiscal policy which didn’t really increase budget deficit. In Japan, there was a debt-financed fiscal expansion. This was not a neutral fiscal expansion financed by taxes, it was a proper expansion which increased deficit and public debt. (More similar to fiscal expansion policies nowadays). Glass-Steagall Act of 1933: boosted confidence in the banking system by (1) separating commercial and investment banking and (2) creating a federal deposit insurance. (Nowadays its $100.000 in almost every bank) CONCLUSIONS • The recession of 1929/1930 turned into a Great Depression lasting until 1933 because of bank failures and financial crises • Bank failures are catastrophic for the economy • “Too big to fail” mentality during 2007-2009 financial crisis, and thus massive bailing out of banks • The 1931 financial crisis was a global crisis where banking and currency problems were closely intertwined, magnifying each other • The recovery was mostly led by monetary expansion, fiscal expansion was mostly not tried
