The Great Depression: How Bank Failures Wiped Out Millions of Americans’ Savings

In this video on the Great Depression, expert David Wheelock of the St. Louis Fed explains the relationship between bank failures and the collapse of the money supply. He also describes how a declining money supply influences employment, inflation/deflation and economic output. “That is the monetary explanation for the Great Depression. Bank runoffs and failures reduce the amount of money in circulation, which lowers GDP, investment, and spending. “.

David Wheelock: Let me start with bank failures. Since I mentioned a minute ago, there have been a lot of bank failures in the last two or three years. During the Great Depression, there were 7,000 bank failures, compared to a few hundred recently. Many of them were during these banking panics.

Since we have all lived through the period of Federal Deposit Insurance, we have never truly experienced a banking panic, making them difficult for us to comprehend. As Scott just indicated, I used to be a professor at the University of Texas in the 1980s, right after the oil price collapse, when Texas’s banking system was severely damaged and many Savings and Loans were failing. I had my money in an unstable savings and loan in Austin, Texas, and I could see that it was failing because they periodically published their balance sheet in the newspaper. I knew some money and banking.

Once, while on the phone with my mother, who had experienced the Great Depression, I mentioned that I had my checking account with this dubious Savings and Loan. “You know your grandfather lost all of his money with the bank failure in the 1930s,” she said. “So why would you do that?” It would be crazy to keep your money in it. ” I said “No mom, theres deposit insurance. If I dont get my money back from the FDIC, we got much worse troubles than. “.

You know, I just had total confidence that at that point the Federal Deposit Insurance Corporation or the Federal Savings and Loan Insurance Corporation would be supported by the federal government. So I had no reason to run on my bank. But in the 1930s, thats exactly what people did. They saw their neighbors bank fail. The sensible course of action would be to head to your bank, withdraw all of your money, stuff it into a coffee can, and bury it in the backyard. Or, stuff it under your mattress. Since cash is the only asset you can truly rely on, you want to hold onto that money and keep your wealth in that form. You cannot rely on your bank deposit since you never know when your bank will reopen and allow you to withdraw your money. People would therefore rush to their banks, form lines as long as they could, and withdraw their money before the bank closed when they became anxious about this, the security of the banking system.

Furthermore, in the banking system, banks never have enough cash on hand, in a vault, or in other liquid assets to cover the amount that they owe depositors on their checking and savings accounts. Stated differently, the bank’s liabilities, which consist of your deposits, will significantly surpass their cash assets since the majority of their holdings are tied to securities and loans. Thats the business of banking, otherwise they wouldnt be doing it. Ordinarily it works, but when people, depositors, lose faith in the safety of the banks, it doesnt work.

So what happens when banks fail? That can be contractionary. One is simply a decline in expenditures. My other grandfather, the one who lost his job altogether, he had money in two banks. He was diversified in Texas. One of them failed, he lost half his wealth overnight. Okay. You lose half your wealth, youre going to spend less. Research has been done. Years ago, a professor at Indiana University conducted a study in which he demonstrated that areas of the nation with a higher rate of bank failures also had larger declines in spending. Local consumption, local sales taxes went down, local retail sales went down, so theres a direct effect. If people lose money, they spend less.

Theres another channel. During his tenure as an academic, Ben Bernanke conducted extensive research, some of which focused on the Great Depression. In an analysis of the consequences of bank failures in the 1930s, he made the case that one of the issues was the severing of borrowers’ relationships with failing banks. And knowing your customer is the key to lending, or at least it was back then, before credit bureaus, credit reports, FICO scores, and all the other quantitative data we have today It was all about building trust and building a relationship.

As a small business owner, you visit a bank and ask for a loan. The banker tells you that although she doesn’t know you and hasn’t given you any money, she will lend you a small amount and, if everything goes well, she might give you a little more the next time. If you are a successful business owner, you are intelligent, you earn money, you pay back your loan, you will get a bigger loan the next time, and so on. Well, suppose that banker fails. He closes his doors because he cannot afford to operate, having lost all of the money in his vault. This leaves you as the small business owner. You have to go to find a new bank. You go into the new bank and say “Id like to borrow money. ” The banker looks at you, say, “I dont know you. Ive never seen you. Im not going to lend you any money. ” Well, that relationship is severed, so it raises what Bernanke terms the cost of credit intermediation. Makes it tougher to get loans.

Think of the financial system as the grease that keeps the wheels of the economy spinning. Bank failure is akin to shoving sand into the wheel’s end or even chopping off pieces of it.

Woman in audience: Did you bring up the farming crisis at all, the Dust Bowl and all that? I know that some historians, when I teach American history, argue that while it didn’t cause the Depression, it didn’t help get out of it any faster either.

Wheelock: Absolutely. The Dust Bowl. Tremendously important in the farming community, the Midwest. Particularly the kind of the southwest part of the Midwest. I don’t discuss it here for two reasons: first, the macroeconomy as a whole did not see a significant increase in its quantitative value. Even by 1929, the farming sector was maybe 10% of U. S. GDP. Its about 2% now. It had been, before the Civil War, it had been more than 50%. Since the agriculture industry was already tiny by the 1930s, it was truly tragic for the people whose farms were lost and whose productivity suffered as a result of the Dust Bowl. That picture by Dorothea Lange was actually of a Dust Bowl family.

But quantitatively, from the macroeconomy, it was small. Thus, as you point out, it was merely a symptom of the Great Depression and, as you also point out, the fact that there was a drought in the 1930s coincided with the Great Depression was clearly a coincidence. Made it harder, particularly for the agricultural sector, to get out of the Great Depression.

Man in the audience: I understand that one way that links what you’re talking about is that most bank failures occurred in rural areas. So in terms of the banking collapse.

David Wheelock: Yep, thats a good point. Right, its not just a Dust Bowl area, so its in the rural areas in general. And I will actually return to that in a moment when discussing how that reduces the amount of money in circulation. And this is where things get a little trickier because we’re thinking about banking channels and money, which are just a little bit more complicated than the direct connections with spending. Again, I’ve included a comparison chart for your reference. As you can see, it includes the significant bank failure shakeout that occurred in the 1980s. I dont have S&Ls plotted here. Savings and loans are simply excluded because it is difficult to obtain comparable data over time, but they would have contributed significantly in the 1980s. Theyve been pretty much wiped out now.

Heres the more recent recession. When compared to our post-war experience, we had a good number of bank failures, but again, nothing like what happened in the 1930s.

So what are these banking panics? Again, its matter of confidence in the banking system. Bank runs, whats the chain here? Bank runs drain the banks of reserves. When we were on the gold standard back then, people wanted to get their dollar bills or gold out of the Federal Reserve notes because they knew they wouldn’t lose them unless they were robbed. OK. Pulling all those reserves out of the banking system forces the banks to contract their loans. They don’t renew active credit lines, they don’t call in current loans, and they most definitely don’t make any new ones. Theyre contracting.

Now, as for how banks make money, they do so by investing and making loans to their shareholders, which allows them to keep the profits for themselves. A bank creates a deposit when it makes a loan rather than simply passing cash through the window. So its adding to the stock of deposits.

Cash is taken out as those deposits are made, which results in a contraction of the money supply overall and a multiplier contraction of the amount that banks can lend. More money needs to be withdrawn from deposits than people are really taking out in the form of cash. This is the basic chain that Milton Friedman discussed as being the main cause of the Great Depression in his well-known Monetary History of the United States and the chapter titled “The Great Contraction.” It forces the money stock to collapse and reduces spending in the economy. And as a result of the economy’s decreased spending, businesses have to close factories, reduce staff, pay employees less, and so on. It also produces falling prices. Since people are not spending as much, firms cut prices. Prices decline as long as farmers keep growing crops and selling them, but not enough people are purchasing them. Commodity prices fell like a stone. Even though bread cost one nickel per loaf, many people were unable to afford it.

My great-aunt and uncle were farmers, and they burned corn cobs or burned the corn itself because there was no market value for it. The only way they survived was my great aunt had chickens and she sold eggs. And that was the cash crop. Acres of corn wasnt worth anything.

So as the money stock fell, the price level fell. As shown here, the price level stabilized and the economy began to grow once more when the money stock started to rise and stabilize in 1933. M2 is the broad measure of the money supply that includes all forms of deposits. That comes down, GDP comes down. Money supply goes up, GDP goes up. There was a recession in 1937-38 some argue because the money supply fell. When the money supply recovered, the economy started expanding again.

That is the monetary explanation for the Great Depression. Bank runs and bank failures reduced the amount of money in circulation, which in turn decreased GDP, investment, and spending.

Related Great Depression Videos

Part 6: The Role of Bank Failures and Panics (11:33)

How were Banks Affected by the Great Depression?