The Great Depression as a saving glut

by Victor Degorce (EHESS & European Business School) & Eric Monnet (EHESS, Paris School of economics & CEPR).

This blog is part of our EHS 2020 Annual Conference Blog Series.

Ben Bernanke, former Chair of the Federal Reserve, the central bank of the United States, once said ‘Understanding the Great Depression is the Holy Grail of macroeconomics’. Although much has been written on this topic, giving rise to much of modern macroeconomics and monetary theory, there remain several areas of unresolved controversy. In particular, the mechanisms by which banking distress led to a fall in economic activity are still disputed.

Our work provides a new explanation based on a comparison of the financial systems of 20 countries in the 1930s: banking panics led to a transfer of bank deposits to non-bank institutions that collected savings but did not lend (or lent less) to the economy. As a result, intermediation between savings and investment was disrupted, and the economy suffered from an excess of unproductive savings, despite a negative wealth effect caused by creditor losses and falling real wages.

This conclusion speaks directly to the current debate on excess savings after the Great Recession (from 2008 to today), the rise in the price of certain assets (housing, public debt) and the lack of investment.

An essential – but often overlooked – feature of the banking systems before the Second World War was the competition between unregulated commercial banks and savings institutions. The latter took very different forms in different countries, but in most cases they were backed by governments and subject to regulation that limited the composition of their assets.

Although the United States is the country where banking panics were most studied, it was an exception. US banks had been regulated since the nineteenth century and alternative forms of savings (postal savings in this case) were limited in scope.

By contrast, in Japan and most European countries, a large proportion of total savings was deposited in regulated specialised institutions. Outside the United States, central banks also accepted private deposits and competed with commercial banks in this area. There were therefore many alternatives for depositors.

Banks were generally preferred because they could offer additional payment services and loans. But in times of crisis, regulated savings institutions were a safe haven. The downside of this security was that they were obliged – often by law – to take little risk, investing in cash or government securities. As a result, they could replace banks as deposit-taking institutions, but not as lending institutions.

We prove our claim thanks to a new dataset on deposits in commercial banks, different types of savings institutions and central banks in 20 countries. We also study how the macroeconomic effect of excess savings depended on the safety of the government (since savings institutions mainly bought government securities) and on the exchange rate regime (since gold standard countries were much less likely to mobilise excess savings to finance countercyclical policies).

Our argument is not inconsistent with earlier mechanisms, such as the monetary and non-monetary effects of bank failures documented, respectively, by Milton Friedman and Anna Schwartz and by Ben Bernanke, or the paradox of thrift explained by John Maynard Keynes.

But our argument is based on a separate mechanism that can only be taken into account when the dual nature of the financial system (unregulated deposit-taking institutions versus regulated institutions) is recognised. It raises important concerns for today about the danger of competition between a highly regulated banking system and a growing shadow banking system.