Monetary policy and banking crisis – lessons from the Great Depression

As the Euro zone crisis continues to escalate and European policy makers are trying to avoid that the Greek sovereign debt crisis develops into a European wide banking crisis it might be an idea to study history. The Great Depression gives us many insides to what to do and what not to do to avoid crisis.

Maybe European policy makers should start having a look at Richard Grossman’s excellent paper The Shoe That Didn’t Drop: Explaining Banking Stability During the Great Depression published in Journal of Economic History in 1994.

The key hypothesis in Grossman’s paper is that there is strong connection between banking crisis and the monetary policy regime in a country.

Here is the abstract for the paper:

“This article attempts to account for the exceptional stability exhibited by the banking systems of Britain, Canada, and ten other countries during the Great Depression. It considers three possible explanations of stability–the structure of the commercial banking system, macroeconomic policy and performance, and lender of last resort behavior–employing data from 25 countries across Europe and North America. The results suggest that macroeconomic policy–especially exchange-rate policy–and banking structure, but not lenders of last resort, were systematically responsible for banking stability.”

Peter Termin in “The Great Recession in Historical Context” summaries Grossman’s results nicely and puts it into a greater perspective:

“Many countries continued to maintain deflationary policies in the early 1930s as they tried to hold on to the gold standard or, in the case of Germany, follow their prescriptions even after abandoning the gold standard. Some countries followed England off gold and created room for expansive policies, which were neither large nor expansive enough to stimulate recovery in countries that remained in thrall to gold. It has become common to attribute the continued economic decline to banking crises, but banks failed only in countries that adhered to the gold standard (Grossman, 1994). As long as countries set policies to maintain the value of their currency, their banks were at risk; bank failures were a damaging outcome of the depression, not its cause. Governments and central bankers–not commercial banks–led the way into depression in country after country.

Policies were perverse because they were formulated to preserve the gold standard, not to stabilize output and employment. Central bankers thought that maintenance of the gold standard would in time restore employment, while attempts to increase employment directly would fail. The collapse of output and prices and the loss of savings as banks closed in the early 1930s were precisely what the gold standard promised to prevent. Reconciling outcomes with expectations consequently required interpreting these exceptional events in unexceptional terms. Where the crisis was most severe, blame was laid on the authorities’ failure to embrace the gold-standard mentality.”

Hence, if monetary policy fails so do banks. Its very simple. Let that be a lesson for central bankers around the world.

Luckily at the top of the ECB management we have somebody with great inside into the history and causes of Banking crisis. That is Aurel Schubert who wrote the excellent book “The Credit-Anstalt Crisis of 1931“. Aurel Schubert today is Director General Statistics at the ECB. Hopefully somebody will ask Mr. Schubert about the lessons from 1931.

Peter Coy the Economics editor of Bloomberg Businessweek provides an excellent overview of the Creditanstalt crisis of 1931 and draws parallels to the situation to in this article.

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4 Comments

  1. So financial crisis tend to be not the “cause” but one “consequence” of bad economic policy.

    Reply
  1. No Nouriel, I am no longer optimistic – it feels like 1932 « The Market Monetarist
  2. 1931-33 – we should learn something from history « The Market Monetarist
  3. The painful knowledge of monetary history « The Market Monetarist

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