A Brief History of Doom

by Richard Vague

  That alone explains the failure of thousands of banks and other financial institutions across the country. When bad debt grows to a size that it approaches the total net worth of the lending institutions, a financial crisis is likely.

  When losses exceed 2 percent of loans in a commercial bank, it is of significant concern. By 1934, losses had reached 3.5 percent of loans, and cumulatively from 1930 to 1937, losses exceeded 13 percent of loans. More than nine thousand banks failed between 1930 and 1933, equal to some 30 percent of all banks extant at the end of 1929. In just a hundred days after the banking panic of 1930, more than eight hundred banks closed their doors. At the landmark moment when New York’s Bank of the United States failed in early 1931, other bank failures began to snowball.31

  Home prices plummeted, and residential mortgage foreclosures reached a thousand per day in 1933. Building-and-loan associations had funded the largest portion of mortgage growth in the 1920s and had increased in number from some 8,000 in 1919 to 13,000 at the 1927 peak, but they declined by more than 5,000 by 1933 as associations were frozen or closed. Henry Hoaglund of the newly formed Federal Home Loan Bank Board summarized the mortgage lending problem nicely in 1935: “A tremendous surge of residential building in the [last] decade . . . was matched by an ever-increasing supply of homes sold on easy terms. The easy terms plan has a catch. . . . Only a small decline in prices was necessary to wipe out this equity.”32

  A popular misconception was that all banks were equally vulnerable to runs and failure. But the banks that failed were those with the highest concentrations of mortgages and other real estate loans. One problem with these mortgages was their lack of liquidity, but the more fundamental problem was credit risk. In practice it is difficult to separate the two. Nonetheless, the facts are stark. For banks, the higher the concentration of real estate loans, the faster the failure; those with the lowest concentrations of real estate loans were most likely to survive.33

  Banks and other lenders had funded the expansion. Bad loans were made, and for many banks the total of these bad loans was so large that it approached or exceeded their capital. Rumors started about certain banks, many well-founded stories of troubled borrowers and bad lending practices. Millions of dollars of deposits fled as customers made runs on these banks, lining up outside to withdraw their precious deposits one by one.

  It is important to understand those runs on banks, and why those runs led banks to call loans—in other words request early repayment—and how banks calling loans was one of the key causes of the collapse of GDP.

  As customers made runs on banks by withdrawing deposits, banks could have survived by getting additional funding from the Federal Reserve or other institutions to cover the shortfall, or by selling stock to raise new funds. But for the most part, the Federal Reserve, other banks, clearinghouses, and other institutions were not willing to lend those banks funds to solve their liquidity problem because they had so much bad debt. And there was not enough time or investor confidence to raise funds by selling new shares of stock.

  So those troubled banks resorted to trying to sell loans to other banks to raise cash. But for most banks, there were no buyers for these loans. The loans were illiquid, and there was no well-developed secondary market of potential loan buyers. But even if there had been, these loans would have been sold at such massive discounts that would have left those institutions inadequately capitalized and subject to regulatory closure for the simple reason that the loans were often deeply troubled. The desperate need to sell loans is symptomatic of bank management that did not put in place other forms of funding and liquidity that could have tided that institution over in times of duress. Lack of secondary markets in which to sell loans does not cause financial crisis, it exposes a bank’s lack of preparedness for adversity. Most banks and other lenders kept only the thinnest layer of extra liquidity that provided little help in these times. Banks and other lenders, in the 1920s and today, largely neglect this pivotal safeguard.

  So troubled banks usually found they had only one option left. They needed to call the loans of their remaining solvent customers, or loans where they could sell the collateral. This is what they did on a massive scale, as their only and last-ditch effort to stay afloat. The evidence of this is that loan pay-downs, the amount of loan payments in excess of new loan advances, totaled $33 billion in this period, $20 billion in banks alone, all in an economy that was only $92 billion in 1930. This paydown was accompanied by vast asset sales, forcing down prices. It was a catastrophe. While the calling of loans, the dreaded specter haunting the 1930s, was not the only reason loans declined, it was a forcefully central one.

  Quite simply, the contraction of loans and other debt—forced and unforced—was the single most impactful event of this period. It contributed more than anything else to the collapse in spending. It impaired thousands of good businesses, radically curtailing their spending and investment—and thus GDP. For example, otherwise healthy retailers whose inventory loans were reduced by half since their bank was forced to call loans, ended up with their sales reduced by as much as half as a direct consequence. With smaller inventory loans they were forced to carry less inventory, which meant lower sales. Otherwise healthy retailers whose inventory loans were called in full were usually forced to close. It also forced the sale of thousands of homes and other assets, bringing fear to those households and radically changing their spending behavior. And it brought fear even to those who did not have to pay down a loan, causing many to hoard what cash they did have. This view is in essence the invaluable debt deflation theory of Irving Fisher.34

  For households, many mortgage loans were only five years in maturity in this era, and banks would not renew those loans as they came due, where they had previously renewed them routinely. If the mortgages of otherwise creditworthy borrowers were not renewed, that borrower was damaged. As in most financial crises, thousands upon thousands of inculpable citizens and businesses got hurt along with the offenders.

  The calling of loans caused businesses and households to use funds for loan paydown rather than spending, which took a chunk out of GDP. Calling loans affected spending directly because if a person spent $10,000 of income on paying down debt instead of on goods and services, then spending (and thus GDP) was reduced by $10,000. And if businesses and households collectively paid down debt out of earnings by $100 million in a given year, then GDP would have been reduced by up to $100 million. (The other option was for those businesses and individuals to elect to sell assets—often distressed selling—or take money out of their savings to pay down the loans instead.)

  The widespread contraction of loans on this scale in a crisis—a decline from $161 billion to $128 billion (a portion of the decline was a result of “charged-off” loans)—is inconceivable today, yet this loan contraction, or curtailment, and the consequent damage had been routine in the nineteenth and early twentieth centuries. Bank loans in that era had shorter maturities, and it was an obvious and expedient way to get cash to meet withdrawals—though it invariably exacerbated the crisis. In the 2008 crisis, because the U.S. government and the Federal Reserve acted in a very different way by providing banks with liquidity, there would be only 5.5 percent net loan paydown at year’s end versus 24 percent in the Depression. The impact on GDP would therefore be far less, only a 2 percent decline in the Great Recession versus a 46 percent decline in the Depression.

  It goes without saying that these banks were in no position to make new loans, and this further starved the economy. The money supply fell dramatically, as has been widely reported. But the money supply is largely the sum of deposits and currency, which fell because of the runs and loan paydown. The Fed could have intervened to reverse this but did not. So the decline in the money supply was a result and not a cause. Given that called loans and forced paydowns were part of the massive GDP contraction from 1929 to 1933, the bank runs that caused them were a vital part of the story.

  Even though banks called loans, it wasn’t enough
for many of them. The bank runs still caused thousands of banks to fail. As a general matter, banks failed not because of a lack of capital or earnings, as popularly believed, but because of a lack of “liquidity”—deposits or any other funding source—that resulted from these runs. Banks normally can pay salaries and other expenses out of the cash provided by earnings, but absent earnings (or newly raised capital), a bank can still pay salaries and other expenses out of new customer deposits—if a regulator is not present to prevent this. It’s an important, dimly understood, and somewhat frightening truth about banks. As long as a bank can raise new deposits, it can continue to operate. However, if a bank is losing money because of bad loans and the rapid withdrawal of existing deposits, and can garner no new deposits, then it has no source of money for its expenses and can no longer operate.

  The Federal Reserve and other government entities could have acted decisively to supply liquidity to the banks in the crucial period from 1929 to 1933 but did not. Though the Fed was very small in comparison to the private lending market, with only $5 billion in assets as compared with a private debt market of $160 billion, the Fed, backed by the government, had ample capacity to help. If it had, the extensive loan calling might have been averted. It did not act partly because of the widespread belief that banks deserved their fate. Americans were outraged at businesses, banks, and the government for the disaster, and some felt that calling the loans of borrowers and letting banks fail was a natural and appropriate consequence for their profligacy, which would “purge the rottenness out of the system.” President Hoover later attributed that very quote and attitude, perhaps unfairly, to his Treasury secretary Andrew Mellon. At the very least, many banks had little forbearance for their customers, and the government had little forbearance for those banks.

  Fear itself may well have been a large cause of the collapse in spending. Depositors who withdrew their funds from a bank in a panic were motivated to spend less, which also contributed to GDP contraction. Depositors taking these funds out in the form of cash or currency would often simply put as much as they could “under the mattress” and thus out of economic circulation.

  A word on rates: After a brief and ill-judged 2 percent increase in interest rates in 1929 (well after overcapacity had been created), interest rates declined, easing pressure on borrowers. Even though they declined, the Fed’s gold reserves actually grew slightly, and specie at banks only declined slightly—both in amounts minuscule compared with massive changes in loan and deposits. This cumulative 2 percent interest rate increase may well have added to the woes, but it was not decisive by itself. Interest rates have often increased by 2 percent without causing a stock market crash. Increasing interest rates certainly adversely affected borrowers in the period after the overbuilding occurred, but lower interest rates, even dramatically lower interest rates, would have perhaps softened but not prevented the economic collapse. If a building is empty, the loan is going to go bad no matter the interest rate.

  Other factors have also been cited as causes of the GDP collapse. For example, much has been made of the Smoot-Hawley Tariff Act, signed June 17, 1930, with the goal of restricting imports and preserving American jobs. Today, compared with other countries, trade is a small part of the U.S. economy with gross exports at 12 percent of GDP, and it was a much smaller part in the 1920s and 1930s, with gross exports at around 3 percent to 6 percent of GDP. Exports and imports were both only about $4 billion to $5 billion annually during the late 1920s, and while both did decline to $2 billion for a short span, it was an amount inadequate to explain the overall GDP drop. Net exports, which is the way trade is entered into the computation of aggregate demand and thus the measure of the impact on GDP, declined less than $1 billion. Smoot-Hawley may not have helped, but it was a minor factor.

  Others point to an effective moratorium on international debtor repayments to the United States as a cause. Two billion dollars’ worth of German loans payable to U.S. banks were at risk, primarily because of Germany’s reduced ability to obtain enough dollars through trade and in an increasingly bellicose international scene. This hampered liquidity and threatened the capital of certain banks but again was small in the context of the $160 billion of overall U.S. private-sector loans.

  The agricultural sector has been blamed as well and did suffer mightily in the period, including a significant volume of called mortgages. But in the late 1920s, the agricultural sector was less than 10 percent of GDP, so even a large agricultural calamity could only have affected overall GDP by a proportionate amount.

  Bad loans were at the heart of the Great Depression story. By 1930, since so much real estate sat empty, construction across the country slowed dramatically. Construction had become such a huge part of the economy, estimated at over 20 percent of GDP, that the resulting layoffs in the construction industry infected other sectors, eventually driving the nation’s unemployment rate, which had been near 4 percent in the 1920s, to the tragic levels of 12 percent by the end of 1930 and 32 percent by 1932 (Figure 1.7).

  Figure 1.7. United States: Unemployment Rate and Loan Losses as Percentage of Total Loans, 1920–1940

  On paper, President Hoover was amply qualified to lead the recovery phase. He had been a star in business and government when he assumed the presidency in 1929, just months before the stock market crash. A globe-trotting titan in the mining industry, he had had two highly lauded government turns, first fighting Europe’s famine after World War I and then helping victims of the Great Mississippi Flood of 1927. He had seen economic depression firsthand in the post–World War I depression and had been secretary of commerce under Presidents Harding and Coolidge. Though faulted by some for his arrogance and publicity seeking, he was a man of action, experientially suited for crisis.

  Through Hoover’s leadership, the U.S. government stepped up its spending from $3 billion to $4.5 billion—almost half as much as the increase under President Franklin Roosevelt. More spending could have increased GDP, but the thought of raising spending from $3 billion to $30 billion to compensate for the entire GDP shortfall was beyond the scope of anyone’s imagination, ability, or political creed at that time. By 1936, under Roosevelt, government spending would increase to $8 billion. But the spending shortfall from pre-Depression levels dwarfed even this amount. The amounts were simply much smaller than the problem. Ultimately, it would take World War II for government spending to approach the levels required to fully restore GDP to pre-Depression levels and then some.

  Some of the programs Hoover initiated foreshadowed Roosevelt’s efforts. Hoover tried to prop up wages, bring more protections to unions, lend funds to banks and corporations, provide unemployment relief, aid farmers, and expand public works. Two initiatives under Hoover are now widely panned as harmful: the restriction of international trade under Smoot-Hawley, discussed earlier, and the increase in taxes in the Revenue Act of 1932. Both had an adverse impact on spending at a time when more spending was the very thing the economy desperately needed—although the amounts involved in both of these erroneous policies were very small, once again, compared with the lending issue.

  However, whatever else he did, Hoover did not do the single most important thing needed. His administration did not enact policies and programs to stop bank runs or slow the instances of bankers calling loans and not renewing maturing loans. In other words, he did not stop the precipitous decline in loans. And so GDP continued its precipitous decline as well. Under Hoover, the Fed, wed to the constraints of the gold standard, did not act as lender of last resort or help offset the decline in lending (and money supply).

  By 1933, when Roosevelt took office to great fanfare, unemployment was 30 percent, and office vacancy rates were in excess of 30 percent. His administration put in place a number of job-creation and spending programs similar to Hoover’s, only larger: the Works Progress Administration (WPA), the Tennessee Valley Authority (TVA), the Public Works Administration (PWA), the Civil Works Administration (CWA), and the Civilian Conservation Co
rp (CCC). It supported increased lending activity through the Federal Housing Administration (FHA) and the Home Owners’ Loan Corporation (HOLC), and it put in place a safety net in the form of Social Security, to name just some of his administration’s key programs. Roosevelt took spending from the $4.5 billion level of the Hoover administration to as much as $7 billion to $8 billion a year. It was an amount still far short of what would have been needed to restore GDP to its pre-crisis levels—but it was something. Roosevelt’s programs meaningfully provided opportunity, restored hope, and saved lives, even if they did set a precedent for government spending and fiscal stimulus that conservatives still decry today.

  Figure 1.8. Change in Key National Financial Indicators 1934–1938

  As FDR took office, a quarter of the nation’s mortgage loans were in default, resulting in foreclosures by which nearly 25 percent of America’s homeowners lost their homes.35 To counter this, the FHA was founded in 1934 to provide insurance for mortgages that conformed to certain standards, and Fannie Mae (the Federal National Mortgage Association) was established in 1938, with the purpose of providing local banks with federal money for home mortgages.

  But by far the most important thing Roosevelt did through his policies and actions was to stop loans from further contraction. As a result, in the third phase of the crisis, from 1934 to 1938, GDP grew by $21 billion. Figure 1.8 illustrates this and provides a sense of the relative size of certain key spending and balance amounts during this period.