Why Are Banking-Crisis Recessions So Bad?

It’s not difficult to see why banking crises normally lead to recessions. There are three main reasons: a credit crunch arising from reduced availability of credit, financial distress caused by a debt overhang, and the loss of monetary policy effectiveness.

1. Credit crunch. The disruption of the banking system typically leads to a reduction in the availability of credit called a credit crunch, in which potential borrowers either can’t get credit at all or must pay very high interest rates. Unable to borrow or unwilling to pay higher interest rates, businesses and consumers cut back on spending, pushing the economy into a recession.

   In a credit crunch, potential borrowers either can’t get credit at all or must pay very high interest rates.

2. Debt overhang. A banking crisis typically pushes down the prices of many assets through a vicious circle of deleveraging, as distressed borrowers try to sell assets to raise cash, pushing down asset prices and causing further financial distress. As we have already seen, deleveraging is a factor in the spread of the crisis, lowering the value of the assets banks hold on their balance sheets and so undermining their solvency. It also creates problems for other players in the economy. To take an example all too familiar from recent events, falling housing prices can leave consumers substantially poorer, especially because they are still stuck with the debt they incurred to buy their homes. A banking crisis, then, tends to leave consumers and businesses with a debt overhang: high debt but diminished assets. Like a credit crunch, this also leads to a fall in spending and a recession as consumers and businesses cut back in order to reduce their debt and rebuild their assets.

   A debt overhang occurs when a vicious circle of deleveraging leaves a borrower with high debt but diminished assets.

3. Loss of monetary policy effectiveness. A key feature of banking-crisis recessions is that when they occur, monetary policy—the main tool of policy makers for fighting negative demand shocks caused by a fall in consumer and investment spending—loses much of its effectiveness. The ineffectiveness of monetary policy makes banking-crisis recessions especially severe and long-lasting.

Recall how the Fed normally responds to a recession: it engages in open-market operations, purchasing short-term government debt from banks. This leaves banks with excess reserves, which they lend out, leading to a fall in interest rates and causing an economic expansion through increased consumer and investment spending.

Under normal conditions, this policy response is highly effective. In the aftermath of a banking crisis, though, the whole process tends to break down. Banks, fearing runs by depositors or a loss of confidence by their creditors, tend to hold on to excess reserves rather than lend them out. Meanwhile, businesses and consumers, finding themselves in financial difficulty due to the plunge in asset prices, may be unwilling to borrow even if interest rates fall. As a result, even very low interest rates may not be enough to push the economy back to full employment.

In Chapter 17 we discussed the fact that interest rates can’t go below zero—called the zero bound for interest rates. A situation in which conventional monetary policy, such as cutting interest rates, can’t be used to fight a slump because nominal interest rates are up against the zero bound is known as a liquidity trap. In fact, all the historical episodes in which the zero bound for interest rates became an important constraint on policy—the 1930s, Japan in the 1990s, and a number of countries after 2008—have occurred after a major banking crisis.

The inability of the usual tools of monetary policy to offset the macroeconomic devastation caused by banking crises is the major reason such crises produce deep, prolonged slumps. The obvious solution is to look for other policy tools. In fact, governments do typically take a variety of special steps when banks are in crisis.