Analysis of new data from the early 1930s suggests that depositors’ fears led to runs on banks that were clustered in time and space. These panics significantly reduced lending and monetary aggregates.
Between 1929 and 1932, the money supply and bank lending in the United States declined by more than 30 percent. In Contagion of Fear (NBER Working Paper 26859), Kris James Mitchener and Gary Richardson attribute much of this decline to the changing behavior of bank depositors. In 1930, after the collapse of Caldwell and Company, the largest bank-holding company in the South, runs on banks became widespread. The calling card of a panic, according to contemporaries, was the suspension of numerous banks in close proximity in a short period, such as within ten miles and 30 days. These panics deprived banks of deposits, which forced them to adjust their balance sheets and reduce lending to businesses and households. These declines in deposits and increases in reserves account for almost all of the decline in the money supply during the Great Depression.
The researchers assemble a new set of data on bank balance sheets, loans, deposits, and reserves as well as currency in circulation at the Federal Reserve district level, most of which was originally published in the Federal Reserve Bulletin. The data allow them to calculate the money supply in each Fed district at call dates, roughly quarterly. They compare this new data to microdata on bank failures gathered from the archives of the Fed.
The data demonstrate that the average number of weekly bank suspensions doubled after Caldwell’s failure in the fall of 1930, rising from 15.1 to 39.1. Panic-induced bank closures peaked in the last quarter of 1930 and in the last two quarters of 1931. Among the bank suspensions that occurred during panics, about 55 percent were associated with large regional or national events, while the remainder were due to local conditions.
The researchers find that when banks failed during periods that were not classified as panics, there was usually a “flight to quality,” with deposits flowing to Federal Reserve member banks; these banks were likely seen as more stable than non-member banks. During panics, however, the reverse was true, and deposits flowed out of the banking system, even from Fed member banks. These outflows were associated with reduced lending, although the magnitude of the effect varied by place. For each dollar that flowed out of a Federal Reserve System member bank in New York or Chicago, the two central reserve cities, business loans declined by an estimated 35 cents. By comparison, a dollar flowing out of a member bank in another city on average reduced lending by 54 cents. At non-member banks, a one-dollar deposit outflow was associated with a 51-cent decline in loans.
Combining microeconomic data on individual bank suspensions with these econometric estimates allows the researchers to calculate the aggregate impact of panics on economy-wide lending. Their findings indicate that banking panics reduced lending in banks that remained in operation by $6.4 billion, nearly twice the $3.3 billion in loans and investments trapped in failed banks. Keeping the money supply constant at the pre-Depression level would have required a 60 percent expansion in the monetary base. This expansion would have been feasible, given resources available to the Fed at the time, and would not have seemed unreasonable in the decades after the Depression. It was, for example, only one-third as large as the 200 percent expansion in the monetary base that policymakers enacted following the failure of Lehman Brothers in 2008. The researchers note that their findings underscore the importance of bank balance sheets in both downturns and recoveries.
— Linda Gorman
FAQs
When banks sought to protect themselves, they stopped lending money. Businesses couldn't get access to capital, and closed their doors, throwing millions of Americans out of work. Those unemployed Americans couldn't keep spending, and the toxic downward spiral continued.
How did fear of bank failures cause bank failures? ›
Analysis of new data from the early 1930s suggests that depositors' fears led to runs on banks that were clustered in time and space. These panics significantly reduced lending and monetary aggregates.
What was a fear that banks would fail and led people to rush to them to withdraw their money? ›
Customers in bank runs typically withdraw money based on fears that the institution will become insolvent. With more people withdrawing money, banks will use up their cash reserves and can end up in default. Bank runs have occurred throughout history, including during the Great Depression and the 2008 financial crisis.
How did the stock market crash of 1929 lead to an increase in bank failures in the early 1930s? ›
The more people pulled out their money in bank runs, the closer the banks came to insolvency. As the financial markets collapsed, hurting the banks that had gambled with their holdings, people began to fear that the money they had in the bank would be lost.
What were three root causes of the Great Depression? ›
The causes of the Great Depression included the stock market crash of 1929, bank failures, and a drought that lasted throughout the 1930s. During this time, the nation faced high unemployment, people lost their homes and possessions, and nearly half of American banks closed.
How do bank failures affect the economy? ›
Reduction in the Availability of Credit: Bank failures can impact the availability of credit in multiple ways. It can lower confidence in the financial system, making it harder for institutions to lend or invest. Liquidity diminishes which leads to a contraction in lending and a decrease in economic growth.
What was the primary cause of the bank failures? ›
Poor risk management can lead to significant losses, erode the bank's capital, and eventually lead to failure. Banks are highly dependent on the overall health of the economy. During a recession, banks are more likely to experience loan defaults, lower profits, and higher operating costs.
Why did so many banks fail in the 1920s? ›
It has been suggested that the twenties was a period of "too many banks and not enough bankers." A Federal Reserve study of bank failures in the twenties indicates that failed banks had a higher proportion of questionable assets and loans to officers, directors, and their interests than did banks that did not fail ( ...
How did the collapse of the money supply cause the Great Depression? ›
The declining supply of funds reduced average prices by an equivalent amount. This deflation increased debt burdens; distorted economic decision-making; reduced consumption; increased unemployment; and forced banks, firms, and individuals into bankruptcy.
How did the bank cause the Panic of 1819? ›
The Second Bank also called in loans from state banks. Without local farmers and businesses able to pay back their loans, the state banks could not pay back their loans to the federal government. This economic shock led to the Banking Crisis of 1819, which contributed to the Panic of 1819.
During the National Banking era (1863-1913) episodes of banking panics were accompanied by money market stringency, a stock market collapse, loan and deposit contractions, runs on banks, bank failures, the issue of Clearing House certificates, and in the case of the three major banking panics the partial suspension of ...
Why did so many banks fail during the Panic of 1837? ›
With lower monetary reserves in their vaults, major banks and financial institutions on the East Coast had to scale back their loans, which was a major cause of the panic, besides the real estate crash. Americans attributed the cause of the panic principally to domestic political conflicts.
How did the Great Depression lead to bank failures? ›
Many of the small banks had lent large portions of their assets for stock market speculation and were virtually put out of business overnight when the market crashed. In all, 9,000 banks failed--taking with them $7 billion in depositors' assets.
Who made money during the Great Depression? ›
Business titans such as William Boeing and Walter Chrysler actually grew their fortunes during the Great Depression.
Who was blamed for the Great Depression? ›
By the summer of 1932, the Great Depression had begun to show signs of improvement, but many people in the United States still blamed President Hoover.
How did bank failures lead to the Great Depression quizlet? ›
How did bank failures contribute to causing the Great Depression? The failure of investors to pay bank loans, the bank runs, and because money in banks was not insured, man people lost their money even though they had not invested in the stock market.
Which was a direct result of bank failures in the 1920s and 1930s? ›
Explanation: A direct result of bank failures in the 1920s and 1930s was that depositors lost their savings.
What was the cause of the Great Depression? ›
What were the major causes of the Great Depression? Among the suggested causes of the Great Depression are: the stock market crash of 1929; the collapse of world trade due to the Smoot-Hawley Tariff; government policies; bank failures and panics; and the collapse of the money supply.
