10-26-2005

BEN BERNANKE TAUGHT US HOW TO AVOID NEXT GREAT DEPRESSION

Glen Yago is director of capital studies at the Milken Institute.

By Glen Yago

WASHINGTON — Connoisseurs of economic research celebrate Ben Bernanke’s well-deserved nomination as chairman of the Federal Reserve. Bernanke’s work has moved us beyond both tabloid economics and mindless monetarism to combine theoretical insights and rich empirical work to understand the inner workings of credit and capital flows and the institutional arrangements that surround their performance, or lack thereof. My favorite is his now-classic — though, for the uninitiated, ponderously titled — “Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression,” in the American Economic Review in 1983.

This breakthrough work has enormous lessons for most of the world’s underdeveloped economies that slog through a slow-motion depression of their own. Looking back at data from the 1930s, Bernanke demonstrated how problems in the financial system tended to lead to output declines as there was a sharp contraction in lending to less creditworthy borrowers. The effects of this credit crunch on aggregate demand helped convert the severe, but not unprecedented, economic downturn of 1929 into a severe and protracted depression. 

The shrinkage of commercial and industrial loans during 1930 reflected the business recession; however, during 1931 and the first half of 1932, loan restrictions represented pressure by banks on customers for repayment of loans and refusal by banks to grant new loans. The pressure exerted by banks on customers for repayment of loans and their reluctance to make new loans to all but large corporations contributed to the depression.

Small- and medium-sized businesses faced extended difficulty in securing operating funds, which impeded any recovery. Households, farms and small businesses had the highest reliance on bank credit, and no alternatives or financial innovations yet existed in the capital markets.

Precisely at the time when the costs of financial intermediation needed to be reduced to spur growth, investors were discouraged from supporting financial institutions and borrowers were discouraged by new regulations insensitive to market needs. Equity and bond markets collapsed precipitously as a result.

In later work with his dissertation student, Cara Lown, Bernanke examined how similar processes emerged in more contemporary credit crunches where monetary aggregates alone could not explain business-cycle downturns and their arc of descent. Particularly, they examined international bank regulations like new risk-based capital ratio changes that depressed bank lending. Regulatory and institutional changes in markets — like changes in bank examination practices; proliferation of restrictive lending regulations; changes in risk-adjusted capital ratios compelling banks to downgrade existing assets, accept credit risks more cautiously and reduce lending; and the temporary dismantling of capital market outlets for bank risk — all conspired to slip the U. S. into recession in 1990-91.

Bernanke coined the term “financial accelerator” whereby developments internal to credit markets propagate and amplify shocks to the general economy. Institutional frictions in capital markets, lack of transparency, absences of financial innovation and underdevelopment of financial technologies to manage risk can dampen or fuel economic growth. Information costs, regulation, contract-enforcement costs and tax-regime changes can drive a wedge between the cost of capital from inside (retained earnings alone) or outside (banks and capital markets) a firm.  

If firms and an economy are to grow, they must escape the trap of over-dependence upon internal funds alone and have access to external investors. Economies grow at the margins, on the cutting edges of the economy where innovation occurs for new products, processes and technologies. That is also where capital is often scarce without an adequate understanding of monetary and financial institutions as well as of markets that can democratize capital and promote growth. Bernanke’s profound understanding of all of this puts the Federal Reserve in the best of hands.

(c) 2005, Global ECONOMIC Viewpoint
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