How a financial crisis can turn into a Great Depression

On 10 October, the Swedish Royal Academy announced the Nobel Prize in Economics and the prize was jointly awarded to Ben S Bernanke, Douglas W Diamond and Philip H Dybvig. Their work in explaining the role of banks in the economy, how a financial crisis is escalated by a misstep in the banking system, and how a potential crisis can be averted by devising appropriate policies earned them this prestigious award.

Let's look at the background of Ben S Bernanke, and how his experience as the chairman of the US Federal Reserve during the financial meltdown in 2009 helped him come up with the theory. 

Ben Bernanke was the 14th Chairman of the Federal Reserve System, serving from 2006 to 2014. His career as the Chairman of the Fed was a colourful and challenging one for many reasons. The worldwide financial meltdown in 2007-09 triggered by the US subprime mortgage crisis was undoubtedly the most remarkable challenge for Bernanke during his tenure as the chairman of the Fed. 

Bernanke was the chieftain of the US monetary and financial system when the country suffered from the worst financial crisis in 2009, second after the great depression in 1929. He not only observed the collapse of century-old financial institutions such as Lehman Brothers and Washington Mutual but also remained silent during their death. 

Bernanke approved the mergers of large but moribund financial intuitions for the sake of economic recovery. More importantly, he rescued AIG (American International Group, the world's largest insurance company) from bankruptcy at the expense of taxpayers. 

The web of financial transactions of AIG with other financial institutions was so deep-rooted that letting AIG go bankrupt was akin to the collapse of the entire financial structure of the US. No doubt, Bernanke was praised, and equally criticised, for his role during the subprime mortgage crisis. However, it was obvious that his bold steps helped evade the damaging effect of the crisis to a great extent.

Bernanke's academic and professional experience equipped him with the required skills and policy acumen to tame the negative impact of a crisis. In particular, the focus of Bernanke's work was to analyse the economic and political causes of a financial crisis. He dissected the 1929 great depression in the light of monetary policy and other critical external forces. 

Bernanke followed the footsteps of his predecessor, the famous Milton Friedman, who pointed out the policy mistake of the Fed during the Great Depression. He argued that the central bank's tight monetary policy and sudden and early increase in interest rate disrupted the flow of liquidity in the market, which subsequently fueled the crisis. For Friedman, Fed's conservative attitude during the crisis not only fuels the crisis but also prolongs it.

Perhaps inspired by this idea, Bernanke adopted an expansionary monetary policy during the subprime crisis. 

Monetary easing continued for quite a long time in the post-crisis period to provide enough time and space for economic stability. Bernanke lowered the interest rates to zero with the aim to prevent the adverse effects of the 2009 financial crisis. He blamed his predecessors for their misguided monetary policies that eventually resulted in the crisis. 

Bernanke draws the evidence that in a span of eight years from 2000 to 2008, the federal fund rate was revised 42 times.

While Friedman attributed the cause of the crisis to monetary policy alone, Bernanke, however, illustrates that it is not the monetary policy that mostly affects the real economy; rather, it is the relationship between the banking industry and the manufacturing sector that is more important. For Bernanke, the effect of the financial sector's activities on the manufacturing sector is more pronounced than the relationship between the monetary policy and real activity. 

Bernanke analysed the Great Depression in light of this theory. He showed that the fragility of the financial sector was a major cause for the unwanted lingering of the great depression. Before this, US banks were small and fragile. The prevailing laws discouraged large-scale financial institutions, including branch banking. The entry requirement for new banks loosened to ensure competition among banks. Bank lending was heavily concentrated in a few sectors including agriculture and housing. In such a financial structure, even the slightest negative external shock is enough to destabilise the entire banking system. 

Bernanke specifically blamed the 'bank run' for the Great Depression of 1929.

Banks collect funds from depositors in the form of current, fixed, and term deposits. Current deposit is special because banks are obliged to return them whenever the depositors wish to withdraw. Hence, the deposits are mostly short-term. When banks distribute these deposits to entrepreneurs as loans, they turn into a long-term investment. This results in a 'maturity mismatch' (short-term deposit vs. long-term investment) which is sensitive for the financial sector. 

Since all depositors do not withdraw funds altogether from the bank, maturity mismatch does not cause any threat to the banking system. However, it becomes a major problem if the depositors flock together at the bank counters to withdraw their funds. 

For example, if there is a lack of confidence in the financial sector, depositors simply go to the bank to withdraw their funds. Since banks cannot meet the demand of all the depositors at once, the depositors may have an idea that whoever reaches the counter first will receive the funds, and those who arrive late lose their deposit. This motivates depositors to withdraw their funds even if they do not need them immediately, leading banks to the state of bankruptcy. This situation is referred to as a bank run.  

Before the Great Depression of 1929, the US economy was stable. Credit flows to the agriculture and housing sectors were high. Manufacturing firms began to borrow more through fixed-rate securities during the recession. 

At the onset of the Great Depression, the downward trend in agricultural commodity prices and low yields reduced farmers' income. This led to sluggish demand for goods and services. A lack of demand resulted in low profits for the industrial sector. Agriculture, housing and manufacturing enterprises are unable to repay bank loans as promised. This caused many small banks to collapse.

'Bank run' on the one hand, and the contraction of the supply of money on the other led many small banks to insolvency. The banking sector seriously suffered from inefficiencies; debt became costly. Small businesses were unable to take advantage of bank loans. 

Moreover, the conservative attitude of banks during the economic downturn further restricted the flow of credit. This accelerated as well as prolonged the great depression of 1929. According to Bernanke, this vicious cycle can turn a small or medium financial crisis into a Great Depression.

In light of this theory, Bernanke showed that the Great Depression of 1929 was caused not only by monetary policy mistakes but also by the collapse of the financial sector. From this vantage point, Bernanke argued that there is no room to underestimate the role of banks in the economy. 

Indeed, barriers prevailing in the banking sector need to be eliminated so that financial services can be delivered to users at a low cost, Bernanke urged. No doubt, his postulation will improve our understanding of the causes and consequences of financial crises and help avert a potential crisis in the future. Such an idea, during a time of financial fragility, is definitely worth a big recognition.

M Kabir Hassan/ Professor, University of New Orleans. Sketch: TBS

Dulal Miah/ Professor, University of Nizwa. Sketch: TBS