How the 1930s banking crises prolonged the Great Depression

Last week, we began looking at why the 1929 stockmarket crash turned into the Great Depression. The crash itself, of course, signalled the start of one of the longest economic downturns in modern history.

But even at the end of 1929, no one really knew that the Great Depression was going to end up being well, the Great Depression.

After all, there had already been three recessions in the 1920s alone. There was the massive, but short-lived collapse of 1920/21, and there had also been recessions in 1923 and 1926 (shortly after the housing bubble burst).

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So while the Wall Street crash of 1929 was shocking, there was no particular reason to suspect that it would be a lot worse than those previous recessions. 1920 in particular, had been extraordinary.

So what made the difference?

How the banking panics of the 1930s spread

The Dow Jones Industrial Average peaked in September 1929 at just above 380. By mid-November that year, it had fallen to below 200.

One of the few people to have an inkling of what would come next was Irving Fisher the same man who made the infamous "stocks seem to have reached a permanently high plateau" comment just before the crash.

At the start of 1930, Fisher warned in Time magazine that the world needed to reconsider the gold standard, or start producing more gold (in other words, we needed much looser monetary policy). Otherwise, he warned, "we shall throttle business, wringing out all profits and experiencing all the evils of deflation."

However, by April 1930, the stockmarket had managed to rally all the way back to just under 300. So it's understandable that many people thought that maybe the worst had passed.

Despite this early optimism and despite the efforts of the Hoover administration to prop up confidence the economic data never really materialised to back up the rallying market, unemployment continued to rise (raising fears of social upheaval), and April 1930 marked another peak that wouldn't be seen again for a very long time.

Then there was the folly of the Smoot-Hawley Act, passed in June 1930, that boosted US tariffs and hammered global trade (this is something we'll look at another time).

But it wasn't until November 1930 that the next really big financial shock hit. That was when Caldwell & Co viewed by some as the JP Morgan of the South went bust. Caldwell was headquartered in Nashville, Tennessee. It was the biggest financial holding company in the South, offering everything from banking to broking to insurance services an investment bank, basically.

However, it was nursing heavy losses from investments made prior to the 1929 stockmarket crash. The managers had tried to cover up the problems of the group by sucking money out of their various subsidiaries. But in November 1930, it all came to a head.

The Bank of Tennessee a subsidiary of Caldwell failed, and had to close its doors. Then Caldwell itself failed, and that inspired runs and closures of various other banks owned or associated with the company.

As with many aspects of the financial system, a lot of this is about confidence, or a lack of it. When banks went bust in those days, you lost your money. And so if you were going to panic, it made sense to panic first and panic fast.

Also, the plumbing of the financial system was far less sophisticated than it is today the physical location of money mattered in a way that just isn't the case now, for example, and there was no clear policy for the various Federal Reserve banks in terms of helping out struggling banks.

However, the banking panic in the southern states was easily dismissed as a regional problem, particularly as agricultural areas had been struggling all the way through the 1920s.

But then in December, the Bank of the United States in New York went bust. And then in June 1931, Chicago saw banking runs spread throughout the city. All of these regional panics increased fear among individual depositors, and also made it harder to get hold of credit.

Individual bank failures themselves at this time were not uncommon. The problem in the 1930s was the scale. About a third of all banks in the US collapsed between 1930 and 1933 roughly 9,000 in total.

It wasn't until March 1933, when the new president Franklin D Roosevelt declared a nationwide bank holiday, that the government started to get ahead of the panic.

The basic problem is, if your banking system breaks down, then it's very difficult to do any business. Those in debt become vulnerable to their debts being called in. Those in need of credit can't get it. Those with savings start hoarding them because they don't know where they can safely keep them. That's all very deflationary, and it's also a self-reinforcing spiral things just keep getting worse.

What happens when the financial plumbing goes wrong

When you look back at financial crashes, it seems that the difference between a relatively contained, and sometimes useful bubble (like dotcom, for example) and a catastrophic one, is the financial plumbing.

If stockmarkets crash in price, that can just be an adjustment to reality like 1987, for example. When a recession arises, it can simply be a pause while the economy shifts course or catches up.

But if the financial system itself breaks down, that's a lot more damaging and it takes a lot more time to come back from. That's why the Great Depression was so prolonged, and it's why the 2008 crisis has been so drawn out as well.

What's perhaps worrying about today is that, while we've avoided another depression, we've done it by pushing our financial plumbing to its very limits. Indeed, our current political turmoil is all about trying to find our way to a system that works and that we can all trust again. So I really don't think we're out of the woods yet.