The Anatomy of a Credit Crisis

Raghuram Rajan is Professor of Finance at the University of Chicago.

How important is the role of credit availability in inflating asset prices? And what are the consequences of past greater credit availability when perceived fundamentals turn? In our recent NBER paper, The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s, my co-author, Rodney Ramcharan, and I broach answers to these questions by examining the rise (and fall) of farm land prices in the United States in the early twentieth century, attempting to identify the separate effects of changes in fundamentals and changes in the availability of credit on land prices. This period allows us to use the exogenous boom and bust in world commodity prices, inflated by World War I and the Russian Revolution and then unexpectedly deflated by the rapid recovery of European agricultural production, to identify an exogenous shock to local agricultural fundamentals. The ban on interstate banking and the cross-state variation in deposit insurance and ceilings on interest rates are important regulatory features of the time that allow us to identify the effects of credit availability that we incorporate in the empirical strategy.

Of course, the influence of credit availability on the asset price boom need not have implied it would exacerbate the bust. Continued easy availability of credit in an area could in fact have cushioned the bust. However, our evidence suggests that the rise in asset prices and the build-up in associated leverage was so high that bank failures (resulting from farm loan losses) were significantly more in areas with greater ex ante credit availability. Moreover, the areas that had greater credit availability during the commodity price boom had depressed land prices for a number of subsequent decades – probably because farm loan losses resulted in the failure of banks that lent to farmers, and depressed agricultural credit in subsequent decades.

Given that we do not know whether expectations of price increases were appropriate ex ante or overly optimistic, and whether credit availability influenced those expectations, it is hard to conclude on the basis of the evidence we have that credit availability should be restricted. With the benefit of hindsight, it should have, but hindsight is not a luxury that regulators have. We do seem to find that greater credit availability increases the relationship between the perceived change in fundamentals and asset prices. This suggests credit availability might have improved allocations if indeed the shock to fundamentals turned out to be permanent. Our focus on a shock that was not permanent biases our findings against a positive role for credit availability.

A more reasonable interpretation then is that greater credit availability tends to make the system more sensitive to all fundamental shocks, whether temporary or permanent. Prudent risk management might then suggest regulators could “lean against the wind” in areas where the perceived shocks to fundamentals are seen to be extreme, so as to dampen the long run fallout if the shock happens to be temporary.

The full paper is available for download here.

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