US banking now and in the '30s: some parallel peril?
Could the banking collapse of the 1930s be repeated today? Probably not. But with the current troubles of the savings-and-loan industry , there is at least some reason for an edge of concern.
A few doomsayers have for years predicted a general banking breakdown. More responsible economists doubt that possibility.
Some solid economists have had a certain fascination for studying the economic disaster of the Great Depression. They ask, Why did the banking collapse occur? Was it the result of mass hysteria producing a run on deposits? Was it predictable? Are any lessons from the 1930s mess applicable to today's situation?
For instance, Robert P. Flood Jr., a Federal Reserve System economist in Washington, and Peter M. Garber, of the economics department of the University of Rochester, made a theoretical economic model of such a banking collapse. Then, in a paper for the National Bureau of Economic Research (and not for the Fed), they compare their theoretical predictions with the financial events of the 1930s. The model's forecasts and the actual events match rather closely.
After the paper was out, Mr. Garber wondered how the same theoretical exercise would work with today's economic and banking scenario. Lo and behold, his preliminary exercise shows that today's inflationary environment, like the deflation of the 1930s, could produce another bank collapse.
Of course, the circumstances are widely different today from the 1930s. But there is one important similarity. In the Great Depression, bank assets were badly hit by the widespread default of corporations on their bonds. Today, inflation has a similar detrimental effect on many fixed assets held by some financial institutions, especially savings-and-loan associations. Low-interest mortgages, for example, could only be sold on the free market at a sizable loss from their face value. In fact, some S&Ls are becoming insolvent.
Garber speculates on a sequence of events in which the federal regulatory authorities and insurance agencies must rescue a number of S&Ls by buying up depressed assets, such as low-interest mortgages, at book value. Soon the insurance agencies' reserves start running low on funds. The public becomes scared at some point and starts to remove deposits from the savings institutions. The Fed prints money in huge amounts to provide funds for the panicky depositors. That results in a sharp burst of additional inflation, further weakening many financial institutions and ending with a banking collapse.
Of course, this is just an incomplete theoetical exercise at this time, and Mr. Garber isn't ready to stick his neck out by predicting an actual collapse. But his exercise does hint at the dangers in extremes of either inflation or deflation.
In looking at the 1930s, economists Flood and Garber come to two possibly surprising conclusions:
* The banking collapse of the 1930s, contrary to public mythology, was not just the consequence of an unpredictable psychological phenomenon, with masses of depositors fearfully taking their money out of banks and forcing the banks to sell assets at depressed prices. The collapse was the result of the economy's dynamic workings when faced by a deflationary government policy.
* The deflationary policy of the Federal Reserve System during the Great Contraction was not the entire story. So-called "high-powered money" -- the reserves and cash supplied the banking system by the central bank -- remained essentially static from 1925 to 1931, rather than declining during the Great Depression. Another element hurting the economy, the two economists state, was the demand for greenbacks in foreign countries. there was a series of banking collapses or hyperinflations in Central Europe during the 1920s and early '30s. These apparently prompted foreign institutions and individuals to hold what they considered a safe store of value, the US dollar. That hoarding tendency created a shortage of money in the United States, forcing the deflation and banking collapse.
Garber suggests this causative element of the depression is not described in the massive 1963 volume of economists Milton Friedman and Anna Schwartz, "A Monetary History of the United States, 1867-1960." The book puts the blame for the depression on the Federal Reserve System. Garber sees the foreign demand for dollars as an unrecognized complication.
The Fed's rigid policy in the 1930s certainly hurt. When, on March 6, 1933, President Roosevelt declared a three-day bank holiday, there were 17,800 commercial banks in the nation. Congress passed the Emergency Banking Act on March 9, creating a new environment for banking. The regulators licensed about 12,000 banks to reopen from March 13 through March 15. Of the 5,000 unlicensed banks, some 2,000 never did reopen. The remaining 3,000 were licensed gradually for reopening over the next year. Depositors, on average, lost $2.15 on every $ 100 of deposits.
Today there is federal insurance on bank deposits. More important, bank regulatory authorities are presumably more alert to signs of financial weakness and willing to produce remedies if needed.