Ben Bernanke on Financial Crisis I would like to say to Milton - PDF document

Ben Bernanke on Financial Crisis “…I would like to say to Milton (Friedman) and Anna (Swartz): Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” Governor Ben S. Bernanke “On Milton Friedman's Ninetieth Birthday” At the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois November 8, 2002 - Bernanke was appointed Chairman of the US Federal Reserve in 2005. - Academically, he is best known for his theory of the Great Depression. - His Ph.D. thesis on this topic was well received when published. Thesis Paper : “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, American Economic Review , June 1983, p257-276. Context / Motivation : - The Great Depression (GD) was far greater in depth and duration than other depressions. - Existing theories cannot account for the depth or duration. - The GD was preceded by an unprecedented increase in credit. - Banking crises preceded credit crises, which preceded further large declines in output. - A credit crisis (CC) theory of the GD seems plausible. Research Question(s) : - Can the depth and duration of the GD be causally linked to the CC? - Can a theory of CC, consistent with microeconomics (which displays rational behavior) be devised? - Is the evidence consistent with the new theory? Model Type, Features and Key Result(s) : - The analysis outlines a theory rather builds an analytic model. - Incomplete markets (from asymmetric information) generate market imperfections requiring a special role for banks.

- Shocks to the banking system that increase these asymmetries increase the Cost of Credit Intermediation (CCI) and result in less credit and output. - Proxy variables that might capture increases in the CCI are econometrically significant and explain the depth of the GD. Contribution(s) : - The CC theory of the GD is consistent with microeconomics and complements the monetary theory of the GD. - Together they can explain the depth and duration of the GD. Detailed Description Alternative theories are lacking. 1. Real Theories: The real economy collapse caused the financial side to collapse. - Yet, the timing is the other way. Real output fell with a lag after each banking/credit crisis. 2. Monetary Theory (Friedman & Swartz): The failure of the Fed to stabilize the money supply lead to a 25% deflation, which triggered a debt crisis. - Yet, Friedman’s other theories predict that changes in the money supply quickly work through the system and leave real relative prices unaffected – so called “money neutrality”. (3. Keynesian Theories – ignored) Institutional Background - Crises, real and financial, weren’t uncommon in US. - Banks by nature are fragile as they borrow short term and lend long term. Banks are susceptible to runs. - Yet before the Fed, in 1913, bank crises were not allowed to propagate: “Suspension of the convertibility” of deposits was enforced by clearinghouses. - In Diamond and Dybvig (1983, JPE) suspension eliminates “bank run” equilibria (Engineer (1989, JME) shows not always). - Clearinghouses did not suspend convertibility in the GD thinking it was the Fed responsibility to deal with the crisis. - Fed is responsible for the GD: o Failed by not intervening to suspend convertibility o Allowed price deflation which hurt bank balance sheets

Some History. From 1929 –1933 - 25% deflation caused increase from 9% to 19% of GDP to service debt. - Mortgage, business, and farm arrears and bankruptcy became extremely high. - Unprecedented doubling in corporate, government and private debt over the 1920s - Table 1 documents correlations between output and bankruptcies and credit culminating with Bank Holiday of March 1933. The Credit Theory Part 1. Shocks increased Cost of Credit Intermediation (CCI). Model Example (from Stiglitz and Weiss (1981)) - Banks distinguish good from bad borrowers… - Debt contracts and collateral are ways of reducing losses and improving incentives for distinguishing borrowers. Increased in CCI - Fear of runs (asymmetric information as to which are good banks). - Liquidity scramble by banks to T-Bills out of loans. - With banks bankrupt, complex loan relationships were destroyed. - Reduction in borrowers collateral (from increased debt burden) imply fewer loans. - Banks decreased the number of loans (“credit rationing”) rather than increase loan rates. CCI is not observable - Proxy variables in Table 1. - Loan/Deposit ratio declined markedly after Nov 1930. - Other proxies discussed. Part 2. Increasing CCI reduced aggregate output. Aggregate Demand (AD) - Increase in CCI likely to effect AD not AS. - Shifts AD downward reducing output, the price level, and the safe interest rates. - Consistent with the data.

Estimation in Table 2 - Reduced form equation combines AD and AS curves. - Dependent variable is output growth rate. - Independent variables to capture money causal channel: - Money surprises, equations (1) and (3), or - Price level surprises equations (2) and (4) - Independent variables to capture credit causal channel: - Deposit of failing banks (DBANKS) and - Liabilities of failing businesses (DFAILS) Results: - All coefficients are of the correct sign and statistically significant. - Money and price surprises only explain half the depth of the GR. - DBANKS and DFAILS explain much of the further depth of the GR. - Monetary (Friedman/Swartz) and Credit (Bernanke) theories are complements. - Other proxies are said to give similar results. - Argued anecdotally that it took years for CCI to come down and this explains the duration of the GD. Credit Crisis: Causation or Correlation? - Did credit crises arise simply because of the belief that future output would fall? If so, then the CCs were endogenous and the theory fails. - However, if CCs occurred because of exogenous factors like banking panics, then the theory as a causal explanation for the GD. Epilogue : Bernanke (1983) is a landmark paper. Though the methodology is outdated, his credit crisis theory is still considered to partly explain the GD. However, the modern view includes other theories as well. The GD appears to be a perfect storm with many causes.