Nonmonetary Effects of the Financial Crisis
in the Propagation of the Great Depression
DURING 1930–33, THE U.S. FINANCIAL SYSTEM experienced conditions that were among the most difficult and chaotic in its history. Waves of bank failures culminated in the shutdown of the banking system (and of a number of other intermediaries and markets) in March 1933. On the other side of the ledger, exceptionally high rates of default and bankruptcy affected every class of borrower except the federal government.
An interesting aspect of the general financial crises—most clearly, of the bank failures—was their coincidence in timing with adverse developments in the macroeconomy.1 Notably, an apparent attempt at recovery from the 1929–30 recession2 was stalled at the time of the first banking crisis (November–December 1930); the incipient recovery degenerated into a new slump during the mid-1931 panics; and the economy and the financial system both reached their respective low points at the time of the bank “holiday” of March 1933. Only with the New Deal’s rehabilitation of the financial system in 1933–35 did the economy begin its slow emergence from the Great Depression.
A possible explanation of these synchronous movements is that the financial system simply responded, without feedback, to the declines in aggregate output. This is contradicted by the facts that problems of the financial system tended to lead output declines, and that sources of financial panics unconnected with the fall in U.S. output have been documented by many writers. (See Section IV below.)
Among explanations that emphasize the opposite direction of causality, the most prominent is the one due to Friedman and Schwartz. Concentrating on the difficulties of the banks, they pointed out two ways in which these worsened the general economic contraction: first, by reducing the
Reprinted with permission from American Economic Review, vol. 73 (June 1983).
I received useful comments from too many people to list here by name, but I am grateful to
each of them. The National Science Foundation provided partial research support.
1 This is documented more carefully in Sections I.C and IV below.
2 This paper does not address the causes of the initial 1929–30 downturn. Milton Friedman
and Anna Schwartz (1963) have stressed the importance of the Federal Reserve’s “anti-specula-
tive” monetary tightening. Others, such as Peter Temin (1976), have pointed out autonomous