Wednesday, October 15, 2008

Are we out of the crisis?

It's too early to say but I happened to be reading Financial Crisis and the Great Depression: A Regime Switching Approach by Patrick Coe and it had some interesting parallels to the current financial crisis.

During 1932 there were two major policy initiatives aimed at alleviating the financial crisis, although neither appears to have had the desired effect. The first was the introduction of the Reconstruction Finance Corporation (RFC) in January 1932 to provide loans to illiquid banks. However, Mason (1996) argues that by overcollateralizing these loans, the RFC actually created a liquidity problem for the very banks it was trying to help. The second response was the Federal Reserve's open market purchases, which began in April 1932, but were abandoned in July of that year. Epstien and Ferguson (1984) argue that this program was abandoned due to pressure from member banks. As banks were substituting away from loans and into short-term government securities the Fed's open market purchases had an adverse effect on their profitability. As a result they became increasingly opposed to the program.

At midnight on March 6th, 1933, the newly inaugurated President Roosevelt declared that there would be a bank holiday from the 6th to the 9th of March. On the 9th of March, Congress passed the Emergency Banking Act (EBA) which was the first of many banking and monetary reforms contained in the New Deal. The EBA gave the RFC power to invest equity in banks without taking collateral, thus solving the problem Mason discusses. The EBA also facilitated the reopening of national banks. Roosevelt promised the public that only "sound" banks would be granted licenses to reopen. These reforms, the program for reopening the banks, and Roosevelt's "fireside chats" were intended to stabilize the financial system. The traditional view emphasizes the success of these measures in restoring stability to the financial sector.

Friedman and Schwartz argue that by restoring confidence in the monetary and economic system the EBA contributed to recovery from the depression. However, they also argue that the introduction of the Federal Deposit Insurance Corporation (FDIC) was the structural change that did the most to restore stability. This occurred in January 1934.

Recall, the RFC was what some commentators wanted to use as a model to buy up the toxic securities in the current crisis. (See here and here for instance.)

Using a Markov switching approach to calculate conditional probability of being in a crisis Coe finds:

Here it is interesting to note that two attempts to alleviate the financial crisis during early 1932, the establishment of the RFC and the open market operations, have no effect on these conditional probabilities.

Perhaps the most interesting feature ... is the implication they have for the ending of the financial crisis. If the reforms discussed in the previous section did have a positive effect on the financial system, this should be reflected in the time series of estimated conditional probabilities over the current state of the financial system. Given that the early 1930s is a period of financial crisis, one would expect the crisis to end in 1933 or 1934. Some combination of the traditional view and Wigmore's view suggests that there would be a regime change in the spring of 1933. On the other hand, the view that the introduction of the FDIC ended the financial crisis dates the regime change as being in early 1934. ... [There is] a fall in the conditional probability of financial crisis to 0.15 in May 1933. However, this is temporary. For the majority of 1933 the probability of financial crisis remains above 0.8, suggesting no change in regime immediately following the reforms of the Spring of 1933. This point is emphasized by looking at the updated probabilities .... This updated probability of financial crisis for May 1933 is 0.88. In fact, for the whole of 1933 it is never below 0.78. This suggests that while the reforms contained in the EBA and the abandonment of the gold standard may have been necessary, they were not sufficient to end to the financial crisis.

The conditional probabilities suggest that the financial crisis ends in February of 1934. This is immediately after the introduction of the FDIC in the previous month and the sharp increase in authorized lending by the RFC in December 1933 and January 1934. This is shown more clearly in the updated probabilities ... a probability of financial crisis of 0.301 in February 1934. This falls to 0.266 in March and is zero for the remainder of 1934. This result is consistent with the view that at least one of the introduction of the FDIC and the increased lending by the RFC was crucial for ending the financial crisis.

So are we in for a relative calm now that the Fed has essentially guaranteed the interbank market and taken (some) small equity stake in the banks? Remains to be seen.

Update: It would be interesting to redo this kind of analysis with some more recent indicators.

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