Monday, September 22, 2008

Great Depression:Not A Single Canadian Bank Failed

The McFadden Act of 1927 specifically prohibited interstate branch banking in the U.S., and only allowed banks to open branches within the single state in which it was chartered. Therefore, U.S. banks were forced to be small and local, with an undiversified loan portfolio tied to the local economy of a single state, or a specific region of a single state. The strict regulatory framework of the McFadden Act created a delicate and fragile banking system that could not easily withstand the shock of the Great Depression. Exhibit A: 9,000 banks failed in the U.S. in the early 1930s (see chart above).

Could it have been different? Could a different regulatory framework have enabled the U.S. banking system to withstand the Great Depression, thereby lessening its impact on the overall economy? Yes. Consider the following:

San Francisco Federal Reserve -- During the Great Depression years—1930 through 1933—5.6% (1,352 banks), 10.5% (2,294 banks), 7.8% (1,500), and 12.9% (4,000) of U.S. banks failed in each year; by the end of that four-year stretch, almost half of U.S. banks had either closed or merged. In all, 9,000 banks failed during the 19300s (see chart above).

Bernanke (American Economic Review, 1983) argues that this banking crisis worsened the magnitude of the downturn because credit supply fell as banks failed. Thus, many firms were unable to finance potential investments. Most of the failed banks were small and operated out of just a single office. In Canada, where not a single bank failed, branching was the rule; in fact, Canada had only ten large banks during the 1930s (see chart above). The Canadian economy fared much better than did the United States economy, in large part because of its better diversified and integrated banking system.

Bottom Line: Strict banking regulations are not always the answer to creating a sound and stable banking system. Exhibit A: The McFadden Act and The Great Depression, and the fact that 0 banks failed in Canada (due to a more sensible regulatory system) vs. 9,000 bank failures in the U.S. largely due to the repressive regulatory framework of the McFadden Act.


At 9/22/2008 11:09 PM, Anonymous Anonymous said...

Ooo you're talking about the great depression now. Have you come around to the fact that thing aren't so rosy?

Btw the biggest "regulation" that needs to be repealed is the Federal Reserve act. The proximate cause for every bubble and inflation in American history, including the Great Depression and the inflation of the 70s. Why not talk about that, rather than the superficial stuff?

At 9/23/2008 1:25 AM, Anonymous Anonymous said...

Great depression? THIS IS NO TIME TO PANIC

This is a crisis, but not a disaster that should strain thinking toward the abandonment of common sense. America is still America.

... and yes, some note should be taken of the Canadian banking since it did not issue the kinds of loans that fueled the U.S. economy and transfered so many dollars to China. However, Canada banking monopolies have failed Canadian entrepreneurialism.

At 9/23/2008 7:55 AM, Blogger Dave Narby said...

The problem is fiat currency and a fractional banking system (that allows banks, via loans and deposits beyond the Fed, to inflate debt (money) ~1:100.

This inevitably leads to cycles of inflation, which leads in turn to booms, busts and bailouts.

Watch "Money as Debt"

for how this happens.

Don't worry though - The cycles are coming faster and faster.

I put the next one about 6-10 years out, so eventually this system should implode and force a different one.

At 9/23/2008 9:16 AM, Blogger K T Cat said...

Brokers were rewarded for profit, but not punished for loss. There was an inherent bias towards risk in the compensation system. I'm pretty much a free market guy, but hiding the fact that massive greed and dishonesty by folks in the financial markets caused a great portion of this isn't doing anyone any good at all.

Drawing conclusions about bank regulations from an era where regulations were wildly different than today is doomed to failure and smacks of an attempt to hide from the truth.

At 9/23/2008 11:54 AM, Anonymous Anonymous said...

The most recent installment of the blame game that Elliot Spitzer is to blame because his shakedown of the financial industry caused businesses to cut their # of analysts to 1/2 the level they were in 2000 (ie. no canaries in the coal mine to give early warning). Do we ever get closer to the truth or for that matter, good policy with this unending search for scapegoats?

Can we not agree that there have been mistakes on all sides and that the present downward spiral is a particularly complex and difficult problem to solve?

If this was a natural disaster or a patient suffering a heart attack, would grandstanding help or wouldn't it be more practical to address the aftermath/give CPR?

This discussion reminds one of the quip about the weather: "Everyone talks about it but nobody does anything about it".

At 9/23/2008 3:16 PM, Blogger the buggy professor said...

1) A very informative link, Mark --- and until you posted it, I knew nothing about Canada's banking system in the 1930s.

2) Please note though. The McFadden act was passed in the booming 1920s during an unchallengeable Republican hold on the presidency and the two houses of Congress.

It was aimed at doing two things:

a) Within the limits set by each state, to allow national banks to expand fully.

b) Within the limits on national banks, to preserve 9000 independent small banks who contributed mightily to Republican candidates for office.


3) By contrast, the Riegal-Neal act that was signed in 1994 in an era of a Democratic president and Congress repealed the McFadden act and allowed banks to expand across state lines by merging with one another.


4) Back to Canadian banks in the Great Depression. A few clarifying observations --- drawn from some googled links --- might add a different perspective.

Canada, it turns out, suffered much more from the Great Depression than the US: unemployment was higher (27-30% by 1933 compared to the US's 25%); GDP fell more (43% in Canada, about 30% in the USA at the troughs in both); and as in the US, but even worse, the financial assets of most Canadians disappeared; worse yet for Canada, it was heavily dependent on commodity exports, and those shrank 50% in just four years after 1929.


5) This analysis can be taken a step or two farther. In particular, contrary to the impression left by the linked article, more and more Canadians in the early 1930s blamed their banking system for the quick surge of unemployment, the crash of GDP, and other problems.

Some evidence: A history of the Canadian economy says this about the banks there in the period of the early 1930s:

" . . . While there were some advocates for a central bank in the early part of the twentieth century, most notably farmers, the status quo remained unaltered. This changed with the onset of Great Depression. Many in Canada blamed the policies of the Canadian banks for aggravating the Depression.

"The money supply was contracting and deflation was common. The farmers were joined by manufacturing interests and other groups in demanding a central bank. Another major proponent was the Royal Bank of Canada, which wanted to see the government business taken away from the rival Bank of Montreal. The government also claimed it was constrained by its inability to deal directly with its foreign debts.

"Prime Minister R.B. Bennett called a Royal Commission in 1933 and it reported in favour of a central bank . . . "



6) In case some posters in this thread are dubious about the last source, here is what the official Canadian government site for the Bank of Canada says about the era:

" . . . The time was ripe to set up a central bank. During the Great Depression, Canadians had criticized and mistrusted the commercial banking system. They had doubts about the efficiency of Canada’s financial structure. (See 1929 - 1939—The Great Depression.) Pressure also came from outside our borders to create a central bank to help settle international accounts. There was no independent agency issuing notes or managing government banking

"Not everyone embraced the idea. Commercial banks were generally opposed, since they would lose some of their responsibilities and control over the financial system. But the idea carried enough momentum, and so the Bank of Canada came into being..."



7) Something else now, jumping back to September 2008:

Unlike the US financial system today --- which has expanded in a variety of directions since de-regulation of it began in the Reagan era --- the Canadian banking system remains generally solvent and has avoided the extravagant market-driven financial flim-flam and hucksterism that has marked US financial activity in this decade. The Canadian economy has, instead, continued largely to perform well in the growth of GDP, the soundness of its currency, and --- until the last year --- lowering its otherwise traditionally higher-than-the-US’s unemployment rate. It’s now 6.1%.

But the main point remains.

The US financial system has, since the start of large de-regulation, careened every few years from one excess to another:

* Black Monday in 1987, the biggest one-day plunge in Stock Market activity (until then, brokerage houses touting that they would quickly move over their equity-holders to the bond-market: ha!)

* The Savings and Loan Crisis, which was the biggest financial crisis since the Great Depression, costing 2.6% of GDP for the US government to clean it up. (The current $700 billion bailout, if that is the right figure in the end, is about double that percentage.)

* The ballooning stock market and crash of the late 1990s.

* The collapse of Long Term Capital Management, necessitating a bailout organized by the Federal reserve of this symbolic hedge-company --- run by two Nobel prize economists (with 25 Ph.D. economists as its main analysts) --- to the tune of nearly $4 billion.

* The accounting scandals of the last decade, symbolized by Enron . . . a huckster company that neither produced anything or did anything but switch around energy contracts.

* The housing market balloon and crash of this decade, with all sorts of new-fangled risk-taking derivatives and sliced-diced-and-repackaged high-risk asset-based stuff passed on, with such rapidity, that nobody today knows what the actual assets and liabilities of this or that financial institution involved in them are. And something that will, once the government starts buying their assets, will require lots of guess-work (to put it mildly).

* And the subsequent credit-crunch, necessitating one bailout of this brokerage house or that or of AIG or this investment or commercial bank or that.


8) Here a question rears up: was there ever a golden age of financial stability, steady solid investment, and financial institutions doing what they’re supposed to in a market economy --- allocate capital efficiently and manage risks over the entire business cycle --- before the FDR-initiated regulations, which stood in place until the 1980s?

If you think that, you might look at the financial and economic crises in US history from 1790 until this decade. Click here for a good easy-to-follow list:


Note that not all these crises were grave. In this century, two have been: 1929 on and maybe ---- let us hope not! --- right now, before extensive government regulation and oversight and the end of it in the 1980s and 1990s.


9) What emerges by way of conclusion?

Well, on an economic level, just this: Add in some other startling facts about the US economy’s performance in this decade --- good GDP growth, 90% of whose income increases went to the top 10%, and the remainder to 90% of Americans; unprecedented surges in national debt: owed not least to corrupt gangster-regimes in oil-rich countries and a neo-mercantilist corrupt Chinese Communist Party and government; and staggering oil price increases --- and is it surprising, however much some of us might regret it, that 80% of Americans even before this financial meltdown said that we have been in a “very bad or fairly bad” economy?

And maybe the most startling fact of all here: the income of the heads of the top 24 hedge-funds last year exceeded the collective income of the Fortune 500 Company CEOs!


That’s the economic fall-out. The political fall-out is fully on display now.

If anything, the worries and discontent of our countrymen about our economy run so deep and wide that we now have the spectacle of John McCain --- who at the start of last week assured the public that all was sound with our economy (and indeed, underlying productivity growth in labor and multifactor technology-driven growth) --- transfigured himself overnight into Populist-Pete, the slayer of Wall Street, the defender of Main Street, and the 24-year long Senate-tenure turned sour against his colleagues, all badly in need of a “thorough cleansing.” Who knows? Once they’ve been sniped and are lying on the ground, Veep Palin might show us how to do some nifty on-the-ground dressing of Corpus Politicus before the rot reaches to the White House.


Michael Gordon, AKA, the buggy professor

At 9/23/2008 11:22 PM, Blogger Matt S said...

Sensible Regulation? Why Yes! I'm glad you agree with me.

At 10/01/2008 6:03 PM, Anonymous Anonymous said...

Very interesting fact that hasn't been picked up on in main stream media. Not so sure about the Canada fairing better bit, by 1933 Canada still had 27% unemployment and a GDP decrease in excess of 40%, but if you work for a bank in the U.S, Canada must look awful good right now.

At 10/15/2008 2:54 PM, Anonymous Anonymous said...

I still cannot believe many people think that deregulation caused our economic woes in America. In a truly free market, the govt would not push banks to lend out risky loans and subsidize banks to give them much too large a market share of loans. While I think the bailout is a long-term waste of taxpayers' money, I can concede that the bailout may help prevent another great depression. I think it wise for the government to encourage private banks to come out and create new loans. The government needs to get out of the banking industry and let the free markets operate to clean up this mess. It needs to be made clear that the government will slowly back out of the banking business and allow failed banks to fail in the future, or we will likely be in the same scenario in a few years.

At 12/02/2008 11:17 AM, Anonymous Anonymous said...

Did Canadia's federal government pump a lot of fast and easy cash and credit into the economy for a decade (the roaring 20's) then rapidly withdraw it causing a collapse like the Americans - or was their problems living too close to the US both physically and economically.

At 12/05/2008 8:17 PM, Anonymous Anonymous said...

Canada's banking system is stable, but many of us have regretted the absence of local banks, as in the US, which seem more sympathetic and responsive to local business. Many people have thought that having only a few large banks was one of the factors making our industrial economy so much weaker than in the US.


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