One Mississippi, Two Mississippi

Policymakers facing a bank run can open the flow of credit or turn off the tap. Friedman and Schwartz argued that the Federal Reserve (America’s central bank) foolishly restricted credit as the Great Depression unfolded. Easy money might have allowed banks to meet increasingly urgent withdrawal demands, staving off depositor panic. By lending to troubled banks freely, the central bank has the power to stem a liquidity crisis and obviate the need for a bailout in the first place.

But who’s to say when a crisis is merely a crisis of confidence? Some crises are real. Bank balance sheets may be so sickened by bad debts that no amount of temporary liquidity support will cure ’em. After all, banks don’t lose their liquidity by random assignment. Rather, bank managers make loans that either fail or are fruitful. Injecting central bank funds into bad banks may throw good money after bad. Better in such cases to declare bankruptcy and hope for an orderly distribution of any remaining assets.

Support for bad banks also raises the specter of what economists call moral hazard. If bankers know that the central bank will lend cheaply when liquidity runs dry, they needn’t take care to avoid crises in the first place. In 1873, The Economist’s editor-in-chief Walter Bagehot described the danger this way:

If the banks are bad, they will certainly continue bad and will probably become worse

if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.-2

Bagehot was a professed Social Darwinist, believing that evolutionary principles applied in social affairs just as in biology. Which policy stance is more likely to speed a happy ending to an economic downturn, liquidity backstopping or survival of banking’s fittest? As always, masters of ’metrics would like to settle this question with a randomized trial. We have a grant proposal to fund such a bank liquidity experiment under review; we’ll surely blog the results if it comes through. In the meantime, we must learn about the effects of monetary policy from the history of banking crises and policy responses to them.

Fortunately for this research agenda, the U. S. Federal Reserve System is organized into 12 districts, each run by a regional Federal Reserve Bank. Depression-era heads of the regional Feds had considerable policy independence. The Atlanta Fed, running the Sixth District, favored lending to troubled banks. By contrast, the St. Louis Fed ran the Eighth District according to a philosophy known as the Real Bills Doctrine, which holds that the central bank should restrict credit in a recession. Especially happily for research on monetary policy, the border between the Sixth and Eighth Districts runs east-west smack through the middle of the state of Mississippi (District borders were determined by population size in 1913, at the birth of the Federal Reserve System). This border defines a within-state natural experiment from which we can profit.

Masters Gary Richardson and William Troost analyzed Mississippi’s monetary two – step.- As we might expect from their differing approaches to monetary policy, the Atlanta and St. Louis Feds reacted very differently to the Caldwell crisis. Within 4 weeks of Caldwell’s collapse, the Atlanta Fed had increased bank lending by about 40% in the Sixth District. In the same period, bank lending by the St. Louis Fed in the Eighth District fell almost 10%.

The Richardson and Troost policy experiment imagines the Eighth District as a control group, where policy was to do little or even restrict lending, while the Sixth District is a treatment group, where policy was to increase lending. A first-line outcome is the number of banks still operating in each District on July 1, 1931, about 8 months after the beginning of the crisis. On that day, 132 banks were open in the Eighth District and 121 were open in the Sixth District, a deficit of 11 banks in the Sixth District. This suggests easy money was counterproductive. But look again: the Sixth and Eighth Districts were similar but not identical. We see this in the fact that the number of banks operating in the two districts differed markedly across districts on July 1, 1930, well before the Caldwell crisis, with 135 banks open in the Sixth District and 165 banks open in the Eighth. To adjust for this difference across districts in the pre-treatment period, we analyze the Mississippi experiment using a tool called differences-in-differences, or DD for short.

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