How important was the banking crisis in the United States in prolonging the Great
Depression? What was the role of policy?
The Great Depression was a prolonged period of economic contraction that originated in the
United States and dissipated across the rest of the world. Between 1929 and 1933, U.S. Real
GNP and aggregate price level shrank by more than one-third, industrial output fell by more
than 50% and unemployment surged to 25%, illustrating the sheer magnitude of the
depression (Bordo et al., 1998:6). In addition, it took until 1939 for the U.S. economy to
undergo a full recovery as measured by Real GNP, emphasising the enduring nature the
crisis. In the United States, the depression is notorious for its cascading waves of bank failure
with nearly a half of all operating banks being made insolvent between 1929 and 1933
(Bernanke, 1983). There exist two prominent schools of thought on the role of the banking
crisis during the depression (Richardson and Troost, 2009). One group believes that this was
a liquidity crisis exacerbated by the Federal Reserve’s unwillingness to act as the lender of
last resort. In contrast, the opposing school of thought believes that the bank failures stemmed
from a solvency crisis as the economy contracted and asset prices fell, leaving little room for
the Federal Reserve to intervene effectively. This essay will explore this dichotomy further.
One of the classical explanations for the Great Depression arises from Friedman and
Schwartz (1969), which propose the money hypothesis. This posits that the Great Depression
was a result of monetary contraction and inept monetary policy from the Federal Reserve,
which failed to undertake compensatory open market operations by pursuing tight monetary
policy. From 1929 to 1933, the money supply as measured by M2, decreased by a staggering
35.2% (Schwartz and Friedman, 1987:27). It can be argued that this was catalysed by
widespread bank failure. These impacted the money multiplier via two channels: individuals
1
, held currency rather than bank deposits and commercial banks, worried about their own
solvency, increased their reserves in anticipation of further bank runs and thus, decreased
lending to the real economy. This put downward pressure on the money multiplier which fell
by a half and thus, contracting the money supply. Mitchener and Richardson (2020) calculate
that nine-tenths of the decline in the money multiplier can be attributed to the decline in bank
lending. They argue that this triggered debt deflation as the resulting deflationary forces
increased the real interest rate and the real value of debt, resulting in a wave of bankruptcies
which further exacerbated deflation and in turn, stifling consumption and business
investment. But why did banks fail?
Evidently, there is scope for debate in the literature as to what explains the widespread bank
failure. Identifying whether this was a solvency or liquidity crisis remains at the heart of
answering this question. Mason and Calomiris (2003) examine this empirically and find the
presence of ex-ante balance sheet weakness as well as the liquidity crisis and contagion
playing a much smaller role in the banking crisis than envisioned by Friedman and Schwartz
(1963). Mason and Calomiris (2003) argue that the Federal Reserve should have instead
adopted expansionary monetary policy and bank bailouts via subsidised recapitalisation.
Traditional liquidity provision may have been insufficient in remedying widespread bank
failure, due to the crisis predominantly arising from solvency and fundamental issues. On the
other hand, Richardson and Troost (2009) utilise a natural experiment to exploit exogenous
variation in local Federal Reserve bank policy to examine the impact of heterogeneous
monetary policy on rates of bank failure within the same state. The state of Mississippi,
which was homogenous economically and demographically, was divided into two zones
under the jurisdiction of the Atlanta Fed and St. Louis Fed respectively. The Atlanta Fed
2
Depression? What was the role of policy?
The Great Depression was a prolonged period of economic contraction that originated in the
United States and dissipated across the rest of the world. Between 1929 and 1933, U.S. Real
GNP and aggregate price level shrank by more than one-third, industrial output fell by more
than 50% and unemployment surged to 25%, illustrating the sheer magnitude of the
depression (Bordo et al., 1998:6). In addition, it took until 1939 for the U.S. economy to
undergo a full recovery as measured by Real GNP, emphasising the enduring nature the
crisis. In the United States, the depression is notorious for its cascading waves of bank failure
with nearly a half of all operating banks being made insolvent between 1929 and 1933
(Bernanke, 1983). There exist two prominent schools of thought on the role of the banking
crisis during the depression (Richardson and Troost, 2009). One group believes that this was
a liquidity crisis exacerbated by the Federal Reserve’s unwillingness to act as the lender of
last resort. In contrast, the opposing school of thought believes that the bank failures stemmed
from a solvency crisis as the economy contracted and asset prices fell, leaving little room for
the Federal Reserve to intervene effectively. This essay will explore this dichotomy further.
One of the classical explanations for the Great Depression arises from Friedman and
Schwartz (1969), which propose the money hypothesis. This posits that the Great Depression
was a result of monetary contraction and inept monetary policy from the Federal Reserve,
which failed to undertake compensatory open market operations by pursuing tight monetary
policy. From 1929 to 1933, the money supply as measured by M2, decreased by a staggering
35.2% (Schwartz and Friedman, 1987:27). It can be argued that this was catalysed by
widespread bank failure. These impacted the money multiplier via two channels: individuals
1
, held currency rather than bank deposits and commercial banks, worried about their own
solvency, increased their reserves in anticipation of further bank runs and thus, decreased
lending to the real economy. This put downward pressure on the money multiplier which fell
by a half and thus, contracting the money supply. Mitchener and Richardson (2020) calculate
that nine-tenths of the decline in the money multiplier can be attributed to the decline in bank
lending. They argue that this triggered debt deflation as the resulting deflationary forces
increased the real interest rate and the real value of debt, resulting in a wave of bankruptcies
which further exacerbated deflation and in turn, stifling consumption and business
investment. But why did banks fail?
Evidently, there is scope for debate in the literature as to what explains the widespread bank
failure. Identifying whether this was a solvency or liquidity crisis remains at the heart of
answering this question. Mason and Calomiris (2003) examine this empirically and find the
presence of ex-ante balance sheet weakness as well as the liquidity crisis and contagion
playing a much smaller role in the banking crisis than envisioned by Friedman and Schwartz
(1963). Mason and Calomiris (2003) argue that the Federal Reserve should have instead
adopted expansionary monetary policy and bank bailouts via subsidised recapitalisation.
Traditional liquidity provision may have been insufficient in remedying widespread bank
failure, due to the crisis predominantly arising from solvency and fundamental issues. On the
other hand, Richardson and Troost (2009) utilise a natural experiment to exploit exogenous
variation in local Federal Reserve bank policy to examine the impact of heterogeneous
monetary policy on rates of bank failure within the same state. The state of Mississippi,
which was homogenous economically and demographically, was divided into two zones
under the jurisdiction of the Atlanta Fed and St. Louis Fed respectively. The Atlanta Fed
2
