Lambert here: A history lesson. But those who don’t learn from history…
By Kris James Mitchener, Robert and Susan Finocchio Professor of Economics at the Leavey School of Business, Santa Clara University; Research Fellow, CEPR, and Gary Richardson, Associate Professor in Economics, UC Irvine. Originally published at VoxEU.
The Global Crisis emphasised the fragility of international financial networks. Despite this, there has been little historical research into how networks propagate financial shocks. This column explores how interbank networks transmitted liquidity shocks through the US banking system during the Great Depression. During banking panics, the pyramided-structure of reserves forced troubled banks to reduce lending, thus amplifying the decline in investment spending.
How financial networks propagate shocks and magnify recessions is of interest to both scholars and policymakers. The financial crisis of 2007-8 convinced many observers that financial networks were fragile, and while reforms are underway, much remains to be learned about how and why connections between financial firms matter for the macroeconomy. Indeed, the complexity and sheer number of linkages has made it particularly challenging to formulate empirical estimates of their role in amplifying downturns.
Economic theory suggests many channels through which networks may transmit shocks (Allen and Gale 2000, Cabellero and Simesek 2013) and empirical research has provided some evidence of contagious failures flowing through interbank markets, particularly for the recent financial crisis in the US and Europe (Puhr et al. 2012, Fricke and Lux 2012). History should have a lot to say about the role of networks in contributing to the severity of financial crises, but it is a surprisingly lightly studied aspect of earlier periods of financial turmoil – even for well-researched episodes such as the Great Depression. This lacuna exists despite the fact that financial networks of the past may be simpler in structure, thus making it somewhat easier to identify empirically how aggregate variables, such as lending, were affected when linkages were disrupted.
In a recent paper, we document how the interbank network transmitted liquidity shocks through the US banking system and how the transmission of these shocks amplified the contraction in real economic activity during the Great Depression (Mitchener and Richardson 2016). The paper contributes to the growing literature on financial networks and the real economy, illuminating both a mechanism for transmission (interbank deposits) as well as a source of amplification (balance-sheet effects). It also introduces an additional channel through which banking distress deepened the Great Depression and complements existing research on how bank distress during the Great Depression influenced the real economy.
We describe how a pyramid-like structure of interbank deposits developed in the 19th century, how the founding of the Fed altered the holdings of these deposits, and how this structure then influenced real economic activity during periods of severe distress, such as banking panics (Mitchener and Richardson 2016). The interbank network that existed on the eve of the Great Depression linked large money centre banks in New York and Chicago to tens of thousands of smaller rural banks throughout the US. The money centre banks served as correspondents holding deposits from institutions in the countryside. Interbank balances exposed correspondent banks to shocks afflicting banks in the hinterland. Interbank deposits were a liquid source of funds that could be deployed to meet sudden demands by depositors to convert claims to cash, and the removal of these deposits from correspondent banks peaked during periods that contemporary commentators described as – and that our detailed statistical analysis of bank suspensions confirms were – banking panics. Although the pyramided system of interbank deposits could handle idiosyncratic bank runs, when runs clustered in time and space (i.e. when panics occurred) the system became overwhelmed in the sense that banks higher up the pyramid were forced to adjust to these changes in liabilities by changing their assets (i.e. lending).
We use the timing and location of these panics to statistically identify the causal relationship between panics, deposit withdrawals, and the decline in lending that occurred in banks in reserve and central reserve cities throughout the US. During periods identified as panics, withdrawals of interbank deposits forced correspondent banks to reduce lending to businesses. These interbank outflows led to a substantial decline in aggregate lending, equal to approximately 15% of the total decline in commercial bank lending in the US, from the peak in 1929 to the trough in 1933.
Ironically, the Federal Reserve System had been created with the purpose of preventing crises such as those that had regularly plagued the banking system in the 19th century. We help to explain why the Fed failed to fulfil this basic responsibility. Because the Fed failed to convince roughly half of all commercial banks to join the system, a pyramided-structure of reserves persisted into the third decade of the 20th century and created a channel through which the interbank deposit could influence real economic activity. In theory, pyramided reserves could have been deployed to help troubled banks, but during the banking panics of the 1930s, just as in the panics of the late 19th century, the total size of these withdrawals overwhelmed correspondent banks, leaving those banks with the choice of either saving themselves, contracting on the asset side of their balance sheets, or borrowing from the Fed. With the Fed unable or unwilling to provide sufficient liquidity to support distressed correspondent banks, they were forced to react to interbank outflows by reducing lending, thus amplifying the decline in investment spending. Although the mechanism is new, our results corroborate other studies on the Depression, which emphasise how banking distress reduced loan supply (Bernanke 1983, Calomiris and Mason 2003b).
What might have alleviated this problem? One solution would have been for the Federal Reserve to extend sufficient liquidity to the entire financial system. The Fed could have done this by lending funds to banks in reserve centres. In turn, those banks could have loaned funds to their interbank clients. To do this, banks in reserve centres would have had to accept as collateral loans originated by non-member banks. Banks in reserve centres would, in turn, need to use those assets as collateral at the Federal Reserve’s discount window. However, leaders of the Federal Reserve disagreed about the efficacy and legality of such action.
Another potential solution would have been to compel all commercial banks to join the Federal Reserve System and require all commercial banks to hold their reserves at a Federal Reserve Bank. Due to powerful political lobbies representing state and local bankers, however, Congress was unwilling to contemplate legislation that would have effected such changes. Had they done so, the pyramid structure of required reserves would have ceased to exist, and the interbank amplifier, as defined here, would have been dramatically diminished. That said, given the inaction of some Federal Reserve Banks during the 1930s, had such changes taken place, they may have magnified banking distress as more banks would have depended on obtaining funds through Federal Reserve Banks that adhered to the real bills doctrine. As we show, the costs of the pyramid in terms of a contraction in lending were substantial, but banks still met some of their short-term needs through this structure during the turbulent periods of banking distress.
References
Allen, F and D Gale (2000) “Financial contagion,” Journal of Political Economy 108:1-33.
Bernanke, B S (1983) “Nonmonetary effects of the financial crisis in the propagation of the Great Depression”, American Economic Review, 73(3): 257-276.
Caballero, R J and A Simsek (2013) “Fire sales in a model of complexity”, The Journal of Finance, 68(6): 2549-2587.
Calomiris, C W and J R Mason (2003b) “Consequences of bank distress during the Great Depression”, American Economic Review, 93: 937-47.
Fricke, D and T Lux (2012) “Core-periphery structure in the overnight money market: Evidence from the e-MID trading platform”, Kiel Institute for the World Economy, Working Paper No 1759.
Mitchener, K and G Richardson (2016) “Networked contagion and interbank amplification during the Great Depression”, CEPR Discussion Paper 11164.
Puhr, C, R Seliger and M Sigmund (2012) “Contagiousness and vulnerability in the Austrian interbank market”, OeNB Financial Stability Report, No 24, Oesterreichische Nationalbank.
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Save the banks and the economy will be saved? It seems economists are completely and utterly wedded to that idea.
But hey, why not continue to recommend further lending to fix the problem of over-extendend borrowers? Banks profit from it and that is what counts, right?
It would be useful to have an update of the issues discussed in this paper. Interbank loans since the 2007-09 financial collapse have dwindled to a pale shadow of prior volumes, and the funding mechanisms that have replaced them are unclear to me:
https://research.stlouisfed.org/fred2/series/IBLACBW027NBOG
Both the transmission mechanisms of a potential future “Minsky Moment” (liquidity crisis) stemming from the huge global debt cornice, and the tools that remain available to central banks to enable them to raise interest rates are unclear to me in this unregulated era of activist central bankers, shadow banks, shadow markets, derivatives speculations by depository institutions, and global carry trades.
‘One solution would have been for the Federal Reserve to extend sufficient liquidity to the entire financial system … However, leaders of the Federal Reserve disagreed about the efficacy and legality of such action.’
Friedman and Schwartz’s Economic History of the United States reaches essentially the same conclusion — that the Fed not only failed to counter the liquidity panic (in which deposits were being converted into cash), but even hiked rates in October 1931 in a macabre example of bad timing, setting off the next wave of bank failures into the “dry heaves” trough of Summer 1932.
Why did they do it? For one thing, Britain had hiked its discount rate to 6 percent in Sep. 1931, to defend pound sterling after it was unpegged from gold. Monkey see, monkey do; the Federal Reserve hiked its discount rate too, by a swingeing 200 basis points (two full percentage points), to 3.5%. Meanwhile, year-on-year CPI was running at minus 8.5% as of Sep. 1931 — consumer prices were in flat-out collapse.
Thus, the Fed’s real discount rate after its Oct. 1931 rate hike was a staggering twelve (12) percent. Instead of healing the economy, the Fed’s monetary witch doctors were bloodletting it into a life-threatening coma. This is a real-life horror story from economic history; a kind of Hindenburg moment in the annals of central planning.
E-commerce amplifies the financial crisis in immeasurable ways. With e-commerce, the banking system has partners in crime. It seems to me, the NSA is the Federal Reserve of data networks. Central data banks are a public-private partnership (the Utah Data Center, Google, Facebook…) in an ecosystem where aggregated data recycles through clouds and lakes. Protected silos break down because of a climate change where privacy is exchanged for e-commerce.
We are beginning to understand that we create data deposits when we indiscriminately entertain ourselves in social media, browse the internet and fill out online surveys–held hostage to terms of use that are non-negotiable. We deposit a trail of cookie crumbs that are dividends in the pyramid-like structure of data banks which data brokers, in turn, purchase.
Data brokers match this information to data gleaned from public records and use black box algorithms to create digital dossiers of our private lives. Data brokers are quants who build tranches of our data derivatives selling them to the highest bidders. This works well for targeted advertisers who mine our fears and desires to sell us what we want–or rather what we’ve been manipulated to want.
There’s no way to meet all our digital doppelgängers. They hover over our lives as Big Data evangelists use predictive analytics to alter our outcomes. (See ProPublica’s investigation on Machine Bias.)
Some data brokers do it with a cloak of respectability with confidential information. Never mind “privacy” laws like HIPAA that are supposed to safeguard “protected” health information. In 2014, IMS Health Holdings went public joining other major NYSE-listed corporations that derive significant revenue from selling sensitive personal health data: General Electric, IBM, United Health Group, CVS Caremark, Medco Health Solutions, Express Scripts, and Quest Diagnostics. (See more at Patient Privacy Rights.) According to Wikipedia, IMS Health provides information, services and technology for the healthcare industry and is the largest vendor of U.S. physician prescribing data.
In the meantime, the healthcare industry makes broad claims that price negotiations are trade secrets, arguing it would be anti-competitive to divulge them.
Congress overwhelmingly passed the Defend Trade Secrets Act (DTSA) of 2016 this spring. It provides a federal private right of action to protect trade secrets under the Economic Espionage Act of 1996. That Act defines a trade secret very broadly as “all forms and types of financial, business, scientific, technical, economic, or engineering information” if the owner has taken reasonable steps to keep such information secret, and the information derives independent economic value from not being generally known or readily ascertainable through proper means.
It’s our “personal responsibility” to make sure we don’t get sick or just pay what the market will bear.
With e-commerce, how is it that corporations get trade secret protections, but people can’t keep their own secrets? How long can we debit our private lives to pay for Internet access?
:)
Funny. The percentage sucked into the financial black hole keeps growing, in demographic deceleration. And soon it will be subjected to an automated military response mechanism.
AI cannot replace human beings, but it can replace all expert systems, anyone involved in the create a problem propose a self biased solution economy. The University was toast a long time ago. It’s like an IPO sunk cost sold off.
The answer to escaping Silicon Valleys compiler, which it obviously cannot escape, is to build your own, because as you can see, no one is going to do it for you, and the majority is always fighting the last war, arguing over the narrative of the data, to be projected ahead, in their favor.
The sociopaths cannot even begin to contemplate the necessary code, but there are always groups competing to do so, for a lower standard of living, chasing debt arbitrarily assigned to others as money, only to wake up when the debt is shifted to their back, which when it’s way too late to replace habits.
Just preach equality to the slaves, and they will hunt everyone else down for you, to be prosecuted for , noncompliance. Notice how the solution is always to force everyone to participate. Regardless, the ponzi can only implode.
The bankers can’t spot a bubble because they have no idea what the counterweight is being used to do. They just know counterweights. Nature isn’t nearly so wasteful.
All the dc programmers can be replaced now. The only reason.They remain in SV is to set the appropriate example, of compliance. Whether that works is a matter of perspective.
Another canary in the mine:
brief excerpt:
The post includes some interesting historical observations, from ancient Greece (storing olive oil as capital assets held in reserve) to the late 19th century.
And this is just out–a TEDx talk by David Martin a typical mix of philosophical overview and in-your-face and outside-the-box thinking, describing the alchemy of new concepts of fulcrums as it relates to the economy.
AI isn’t just replacing the middle; its replacing the programmers and their clients don’t understand how the programs work, effectively making the empire a trust, with History as the executor. It’s already running on automatic. The machine has no use for humans. Why learn about compilers.
The majority is trapped in the implosion along with the designers of the trap, who have lost control. RE is a bait and swap aspirational ponzi, acting as a brake on production, creating a positive feedback loop with consumption. Those false RE contracts are just the tip of the iceberg.
Regurgitating on a test to get a certificate to get paid to comply is not an economy, and no matter how many complaints vote for a theory, the result doesn’t change MAD. Of course that’s nonsense to the majority, which doesn’t know what a compiler does.
The first not is to make gravity work for you instead of against you. Programming is like parenting, one size does not fit all, and if you build it that way, all must fit the program. Nature doesn’t like that, and in case anyone failed to notice, the more debt issued to build infrastructure in the Bay Area, the worse it gets for more people. The Internet is just the implosion.
Would Trump be running if all his units had real tenants? Would Bernie be running if the university wasn’t collapsing? Would Hillary be running if the Foundation itself were not collapsing?
Of the three, Bernie is sitting on the biggest can of worms.
“RE is a bait and swap aspirational ponzi, acting as a brake on production, creating a positive feedback loop with consumption. Those false RE contracts are just the tip of the iceberg.”
That’s one of the points D. Martin makes in the TEDx talk. Though that’s not his focus; he’s looking at ways out of the binary system in which most of us are trapped.
“Would Trump be running if all his units had real tenants? Would Bernie be running if the university wasn’t collapsing? Would Hillary be running if the Foundation itself were not collapsing?
Of the three, Bernie is sitting on the biggest can of worms.”
Hmmmmm.
Ok, Trump’s RE “empire” consists of empty shells, I can believe that.
Bernie running because a university is collapsing? Is this the college where his wife was in charge then the bank refused loan and the college collapsed and then closed? I can imagine that universities relying on trusts could be in trouble financially, and I can understand (from your previous posts) that there is an intellectual and moral bankruptcy as well–but the connection to Sanders’ personal engagement is harder to see.
CGI–no idea how dependent they are on specific inputs (e.g. Saudi Arabia) that are on the way down, but I don’t have the problem the Clintons are at personal financial risk
Bigger can of worms meaning Bernie would be in more trouble than the others if he “wins”? Do you mean personally? Or that he has more responsibility than the others by some logic I cannot fathom?
(I pity whoever “wins” the election, whether legit or not, because they get to “be in charge” when the walls of the system come tumbling down. Talk about a booby prize.)
CGI – I meant, I don’t have the impression the Clintons are at personal financial risk.