Recent research has identified additional channels through which the financial crisis accelerated the decline in economic activity. The seminal research was done by Benjamin Bernanke (1983)—who later became chair of the Federal Reserve Board—who argued on the basis of a wide range of evidence that bank failures made it difficult for firms, particularly smaller firms, to get the credit they needed to remain in operation.
Bernanke’s interpretation stressed the problem of “asymmetric information.” When a borrower and lender negotiate, their access to key information differs. The lender cannot see into the mind of the borrower to learn the borrower’s determination to repay. Normally, this problem can be overcome by forging long-term relationships between borrowers and lenders or through the use of collateral. When a bank failed, however, the long-term relationships between the bank and its borrowers was severed. A borrower could approach another lender, but how would another lender know that in the past the borrower had struggled to faithfully repay loans or that the borrower was regarded by other members of the community as a good risk? In addition, Bernanke pointed out that the ongoing deflation increased the burden of debt carried by businesses and consumers and thus reduced their ability to qualify for credit. The decline in the value of stocks and land, both urban and rural, had a similar effect. Businesses and individuals did not have assets that they could offer as collateral. Although the role of nonmonetary effects of the crisis has received considerable attention in recent years, it has been thought about for a long time. Irving Fisher (1933), one of America’s leading economists
These figures illustrate Peter Temin’s famous critique of the monetarist interpretation of the Great Depression. They depict the supply of and demand for money, with the interest rate as the price of holding money. Temin’s rendering of the monetarist interpretation is in Figure A and the Keynesian interpretation is in Figure B. If the monetarists were correct (according to Temin), the dominant shift would have been the supply curve to the left (Figure A). If the Keynesians were right, the dominant shift would have been the demand
Curve to the left (Figure B). Because interest rates fell during the depression—as shown in column (4) of Table 23.2—Temin concluded that the Keynesians were right.
Monetarists countered that Temin neglected intermediate and longer-term effects of the decline in the quantity of money on the demand for money. Falling real income (caused by past decreases in the supply of money) reduced the demand for money. So part of the shift in the demand curve in Figure B could be attributed to the fall in the stock of money. Moreover, lower market rates were consistent with higher real rates.
Rate
Of the depression decade, blamed the depression on the rising real value of debt and its effect on spending.
In short, controversy continues over the exact role of the financial crisis in the Great Depression, but most economic historians now agree that the financial crisis was important, and the Federal Reserve deserves considerable blame for the disastrous path along which events unfolded (Temin 1989).
World History
