Tuesday, October 14, 2008

The Profit Rate during the 1930s Era Bank Panics

As recently as 2008 Q2, corporate earnings were quite high by historical standards. This by itself predicts high rates of economic growth -- the baseline from which we can subtract any adverse growth effect of the today's so-called credit crunch. Moreover, corporate profits are an important substitute for bank loans (see my earlier posts). So an economy with high corporate profits is probably more resilient to banking sector failures than would an economy with low corporate profits.

According to Friedman and Schwartz' A Monetary History of the United States, the first (short) banking crisis of the Great Depression was in November 1930 and, in Professor Lee O'Hanian's words, "The first banking crisis of any national significance didn't occur until the fall of 1931." Regardless of which date you choose, the economy was already in bad shape. Friedman and Schwartz (p. 306) explain how the economy had already declined very significantly by October 1930: "Even if the contraction had come to an end in late 1930 or early 1931 ... it would have been ranked as one of the more severe contractions on record."

The marginal product of capital was above average in 1929 (although not nearly as far above the average as we are today). Maybe that means that, absent crop failures, etc., the economy might have grown well otherwise. Maybe that means that the 1929 economy would have been resilient to a severe bank panic. But I see 1931 as the more relevant comparison, because in the fall of that year the serious bank panics began. The 1931 marginal product of capital was 2.5%/year less than it was in 1929. By 1931, there were not extraordinary corporate profits that could be rolled back into corporations as a substitute for bank funding. The low 1931 marginal product of capital was by itself predicting a low rate of subsequent economic growth.

In summary, the marginal product of capital in the months prior to today's liquidity crisis was much higher than it was in the months prior to the 1931-3 bank panics. This not only raises the growth rate forecast from which to subtract any adverse impact of liquidity crisis, but also reduces the expected magnitude of that impact.

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