The city of Chicago had the highest urban bank rate failure during the Great Depression. A new study by Dr. Natacha Postel-Vinay just published in the prestigious Journal of Economic History uncovers the link between Chicago’s huge real estate boom and bust during the 1920s and the failure of the majority of Chicago’s banks in the early 1930s. In her article “What Caused Chicago Bank Failures in the Great Depression?” Dr. Postel-Vinay establishes that it was mortgage lending that caused the majority of Chicago banks to fail. Her most significant finding is that the mass bank failure was not caused by imprudent lending and the poor quality of the mortgages. The mortgages were small relative to property prices and losses suffered by banks on their mortgages were insignificant. Rather, banks failed because mortgage lending rendered banks inherently illiquid and unable to withstand the mass withdrawal of deposits during the depression. In other words, Chicago’s fractional-reserve banks failed en masse while behaving prudently and going about their regular business: borrowing short and lending long.
By highlighting the role of fractional-reserve banks and financial distortions in the 1920s in explaining the severity of the the Great Depression, Postel-Vinay’s study further undermines the Friedman-Schwartz explanation which focuses almost exclusively on movements in the money supply, and completely ignores interventions in both labor markets and financial markets.
