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Fetters of Debt, Deposit, Or Gold During the Great Depression? the International Propagation of the Banking Crisis of 1931

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Fetters of Debt, Deposit, Or Gold During the Great Depression? the International Propagation of the Banking Crisis of 1931 NBER WORKING PAPER SERIES FETTERS OF DEBT, DEPOSIT, OR GOLD DURING THE GREAT DEPRESSION? THE INTERNATIONAL PROPAGATION OF THE BANKING CRISIS OF 1931 Gary Richardson Patrick Van Horn Working Paper 12983 http://www.nber.org/papers/w12983 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 March 2007 Comments from Naomi Lamoreaux inspired us to investigate this topic. We thank colleagues and friends for comments on drafts of this essay. NSF Grant D/SES-0551232 funded portions of this research. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2007 by Gary Richardson and Patrick Van Horn. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Fetters of Debt, Deposit, or Gold during the Great Depression? The International Propagation of the Banking Crisis of 1931 Gary Richardson and Patrick Van Horn NBER Working Paper No. 12983 March 2007 JEL No. F02,F33,F34,N1,N12,N14,N2 ABSTRACT A banking crisis began in Austria in May 1931 and intensified in July, when runs struck banks throughout Germany. In September, the crisis compelled Britain to quit the gold standard. Newly discovered data shows that failure rates rose for banks in New York City, at the center of the United States money market, in July and August 1931, before Britain abandoned the gold standard and before financial outflows compelled the Federal Reserve to raise interest rates. Banks in New York City had large exposures to foreign deposits and German debt. This paper tests to see whether the foreign exposure of money center banks linked the financial crises on the two sides of the Atlantic. Gary Richardson Department of Economics University of California, Irvine Irvine, CA 92697-5100 and NBER [email protected] Patrick Van Horn 3151 Social Science Plaza University of California Irvine, CA 92697-5100 [email protected] 1. Introduction In May 1931, the largest financial institution in Austria, the Creditanstalt, collapsed, marking what is generally held to be the beginning of an international banking crisis. During the next month, financial difficulties spread throughout central Europe, as troubles beset banks in Hungary, Czechoslovakia, Romania, Poland, and Germany. On July 13, the failure of a large German bank, the Darmstadter- und Nationalbank, triggered runs throughout that nation and compelled the German government to close all depository institutions. Banks reopened for limited operations after two days and resumed normal operations after one month. Later that summer, the crisis spread to Britain. In September, sales of sterling and withdrawals from British banks accelerated. In order to halt financial outflows, Britain abandoned the gold standard (Barry Eichengreen, 1992; Peter Temin, 1989 and 1993; Charles Kindleburger, 1986). According to the conventional academic wisdom, Britain’s departure from gold transmitted the financial crisis from Europe to the United States (Milton Friedman and Anna Schwartz, 1963; Eichengreen, 1981 and 1992; Temin, 1989 and 1993). Anticipating a similar action on the part of American monetary authorities, central banks and private holders in Europe converted dollar assets in the New York money market into gold. The unloading of bills swiftly assumed panic proportions. Gold outflows rose rapidly, draining funds from the U.S. financial system. To stop the international drain, the Federal Reserve System raised the discount rate from 1½ to 3½ percent between October 9 and October 16. This was the sharpest rise within so brief a period in the whole history of the system, before or since … the move intensified internal financial difficulties and was accompanied by a spectacular increase in bank failures and runs on banks … in the six months from August 1931 through January 1932, 1,860 banks with deposits of $1,449 million suspended operations, and the deposits of those banks that managed to keep afloat fell by a much larger sum. Total deposits fell over the six-month period by nearly five times the deposits in suspended banks or by no less than 17 1 percent of the initial level of deposits in operating banks (Friedman and Schwartz, 1963, p. 317). Golden fetters, in other words, compelled the Federal Reserve to raise the discount rate and restrict the supply of credit, contributing to (or in many accounts, causing) the largest surge in bank suspensions in United States history. Recent research, however, reveals additional links that may have existed between the banking systems in the United States and Europe. Documents from the archives of “the Bank of England show that an intricate system of cross-deposits was set up by the Austrian Central Bank covertly to direct funds to the Creditanstalt via American and British banks – to compensate it for taking over the bankrupt Bodencreditanstalt (Iago Gil Aguado 2001, p. 199).” All of the American institutions involved in this shell game operated in New York City, the central money market of the United States. The cross-deposit involved tens of millions of dollars, a substantial multiple of the capital of the banks involved. In addition, bank balance sheets and clearing-house association reports show that New York banks’ foreign branches held deposits totaling over $600 million dollars. Foreigners also held large sums in New York City. Thus, banks in the United States’ central money market had large, direct exposure to European deposits. Records resulting from the Senate Hearings on the Sale of Foreign Bonds or Securities in the United States, which took place from December 18, 1931 to February 10, 1932, illuminate another link between banks in New York and Europe.1 New York banks organized over $1.4 billion in loans to German corporations, utilities, and governments (including local, state, and national) from 1924 through 1930. Nearly $1 billion of those loans floated in the United States were outstanding in June 1931 (Robert Kuczynski, 1932). Econometric analysis of the links between the German and United State’s economies during the 1930s suggests that German debt 1 72nd Congress, 1st Session, Sale of Foreign Bonds or Securities in the United States, Hearings on Senate resolution 19 before the Committee on Finance, Parts 1-4. 2 played a role, perhaps substantial, in transmitting financial shocks across the Atlantic (Albrecht Ritschl and Samad Sarferaz, 2006). Analysis of equity returns also suggests a link through this channel (Hanan Morsy, 2002). An initial inspection of recently discovered data on bank failures in the United States reinforces the appearance of a direct link between the German and American banking crisis. Previously available evidence aggregated information on bank suspensions for Federal Reserve Districts at the quarterly level and for states at the annual level. This aggregation prevented scholars from determining whether bank failures in the central money market of the United States occurred in July and August, contemporaneous with the German crisis, or in September and October, when golden fetters bound. The disaggregated data show that almost all of the failures of banks in the central money market coincided with the crisis in Germany and preceded Britain’s departure from gold. Bank distress in New York City, in other words, rose when bank distress rose in Germany. Bank distress peaked in the weeks following the German panic. The banking crisis struck the central money market of the United States more than a month before financial pressures forced Britain off gold. This correlation raises questions about the channels that transmitted banking crises across the Atlantic. Temin (1993, pp. 93-4) describes three potential channels for the international transmission of banking crises. The first is a contagion of fear which jumps across nationally boundaries, when domestic depositors panic as foreigners withdraw funds. The second is the impact on portfolios when values of foreign assets fall and patterns of financial flows change. The third is the impact of capital flows on national economies and central bank policies, particularly in nations on the gold standard which raise interest rates to defend gold reserves. Temin indicates 3 that … it would be nice to choose between the alternative models, [but] this does not seem possible at the current state of our knowledge. … Economists do not yet know enough about international transmission of financial crises to have a single model, or even to choose which transmission channel was most important (Temin 1993 p. 93-4). Our data-collection endeavors enable us to answer question such as: which channel transmitted the banking crisis from Europe to the United States in the third quarter of 1931? Did direct links exist between the banking crises in Germany and the United States? Did deposits, debt, correspondent relationships, or some other financial factor link the fate of money-center banks in New York to the fate of banks in Germany? This remainder of this essay answers those questions. Section 2 describes the quantitative, qualitative, and narrative sources of evidence. Section 3 examines patterns in the aggregate evidence which suggest a direct link between the crisis in Europe and the United States. Section 4 describes our statistical tests and econometric results. Section 5 examines contemporary evidence of the causes of bank distress in the central money market during the summer of 1931. Section 6 examines contemporary accounts of the regulatory regime changes that raised rates of bank distress in the central money market of the United States during the summer of 1931. Section 7 discusses the implications of our analysis. While the aggregate evidence suggests that a direct link existed between the financial crisis in Europe and the surge in bank failures in the central money market of the United States during the summer of 1931, the microeconomic evidence proves otherwise.
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