In the last chapter of The Great Crash 1929, "Cause and Consequences", JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed from the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the third.
The third cause Galbraith gives for the length and depth of the 1930s depression was that there was a bad banking structure. His words:
[M]any of these [banking] practices were made ludicrous only by the depression. Loans which would have been perfectly good were made perfectly foolish by the collapse of the borrower's prices or the markets for his goods or the value of the collateral he had posted. The most responsible bankers -- those who saw that their debtors were victims of circumstances far beyond their control and sought to help -- were often made to look the worst. The banks yielded, as did others, to the blithe, optimistic, and immoral mood of times but probably not more so. ...
However, although the bankers were not unusually foolish in 1929, the banking structure was inherently weak. The weakness was implicit in the large numbers of independent units. When one bank failed, the assets of others were frozen while depositors elsewhere had a pregnant warning to go and ask for their money. Thus one failure led to other failures, and these spread with a domino effect.The banking structure in 2008 is often characterized as being dominated by the concentration of market share in a few "too big to fail" firms that were able to exploit an implicit government guarantee and thus secure rents. This led these firms to engage in more risk-taking than they would have done absent a guarantee, so the best way to promote future financial stability is to reduce the size of these firms, thus eliminating the implicit government guarantee, thus forcing firms to internalize their risk-taking, thus leading to less risk-taking and more stability. But this was more or less the state of affairs in 1929, according to Galbraith. There were many small firms and no government guarantee. But that led to instability for the opposite reason as 2008: market share was too dispersed throughout the banking sector, with no financial institutions large enough to halt the spread of contagion.
I've blogged similar arguments to Galbraith's before (and before having read the book). A big part of the resolution of the 2008 crisis involved selling illiquid and/or insolvent firms (Bear Stearns, Merrill Lynch, Washington Mutual, Lehman Brothers, Countrywide, etc.). The only possible buyers for firms that large and with that many problems on their balance sheets was to find other large firms that could absorb them, like JP Morgan and Bank of America. This option was mostly not available in 1907 or 1929 but, combined with strong action from the Fed and Treasury, allowed the resolution of the financial crisis much more quickly and comfortably than in those previous crises. Indeed, the actual financial shock in 2008 was worse than in 1929, and possible worse than any in previous history. The fact that since that shock we've merely had a period of slowed growth and a fairly moderate increase in unemployment rather than a Great Depression is perhaps partially attributable to the fact that we dealt with this crisis much better than previous crises.
This line of thinking should give us pause when we consider whether having more small banks rather than fewer large banks would really be a good idea*. One way we might conceptualize this is to think in terms of patterns of financial integration. A financial system in which a relatively small number of firms are central to the system will generally react differently to crises than a system in which the distribution of links is more dispersed. Specifically, according to research on the spread of viruses and other crises through networks, highly-unequal systems are "robust but fragile": they are resilient to shocks in the periphery of the network, but fragile to shocks in the core. In 2008 we had a shock to the core, so the gut reaction is to reduce the importance of the institutions that comprise the core to the broader system. But that may only leave us susceptible to shocks anywhere in the financial system. This, warns Galbraith, is a very real possibility.
That doesn't seem to leave us with many good options. But here we may take some good news from the 2008 crisis: despite being a more severe financial crisis than 1929, the fallout was much less severe. This is obviously due to a number of reasons including the safety net and automatic stabilizers, as well as pretty drastic actions taken by the Fed and other central banks. But the Fed's actions were likely made more effective by the fact that they had to concentrate their efforts towards only a handful of firms at the center of the system. Once those firms were stabilized, the entire system was stabilized. The 1929 Fed didn't have that option.
This "solution" isn't much of one, admittedly. For one thing, it means that we may remain susceptible to types of crises similar to the one in 2008. That's little comfort. Additionally, it maintains the system of rents that these large firms are able to exploit, and that's unfortunate. But there may be ways of using the regulatory code, tax code, or criminal code to eliminate these rents in other ways. It may be possible to use the same tools or others to promote financial stability in other ways. In any case, it isn't obviously clear that a more decentralized financial system would be any more stable. It wasn't in 1929.
*Keep in mind that a stated goal of regulatory policy at both the domestic and international levels is to reduce the size and number of "systemically important financial institutions". These firms are likely to have higher capital requirements under Basel III, and Obama proposed a special tax for these firms. As far as I can tell these policies have had no effect at all on bank behaviors.