RDP 1999-06: Two Depressions, One Banking Collapse 1. Introduction

Over the past 150 years, Australia has experienced two macroeconomic depressions, both of which coincided with worldwide depressions.^[1] The first of these was in the 1890s and the second in the 1930s. These were also times of financial distress both domestically and in the rest of the world. For Australia there were many similarities across both depressions. Indeed Sinclair (1965, p. 85) suggests: ‘There is such an obvious similarity between the economic depressions which occurred in Australia in the 1890s and the 1930s that it is tempting to suggest that history was repeating itself in the latter case’.^[2] However, in this paper we highlight one of the major differences between the two depressions. Namely, the 1890s involved the collapse of a significant proportion of the Australian financial system, whereas the disruption to the financial system in the 1930s was comparatively mild.

The fact that Australia did not experience a major financial crisis during the 1930s is remarkable in a number of respects. First, the initial fall in real output during the 1930s was just as large as the initial fall during the 1890s – that is, around 10 per cent during the first year of each depression. Second, the world depression was worse, and the Australian terms of trade fell further, during the 1930s than during the 1890s. Third, both the United States and, to a lesser extent, the United Kingdom experienced more severe financial crises during the 1930s than during the 1890s.^[3]

The central argument of this paper is that variation in the performance of the financial system across the two depressions was primarily due to variation in the condition of the financial system prior to each depression. We show this by examining the behaviour of a range of indicators of financial stability over the decade prior to each depression.^[4] These indicators are:

1. the level and nature of investment;
2. property market speculation;
3. credit growth;
4. capital inflows;
5. degree of risk management within the financial system; and
6. competitive pressures in the financial sector.

Each indicator suggests that the financial system during the 1880s was becoming increasingly vulnerable to adverse shocks. During that period there was a sustained increase in private investment associated with extraordinary levels of building activity and intense speculation in the property market. This was accompanied by rapid credit growth, fuelled in part by substantial capital inflows (much of which appears to have been channelled through financial intermediaries). At the same time, banks allowed their level of risk to increase in an attempt to maintain market share in the face of greater competition from a proliferation of new non-bank financial institutions.

In contrast, if anything there was only a moderate decline in measures of financial system stability during the 1920s compared with the 1880s experience. It is therefore not surprising that whereas the financial system essentially collapsed following the substantial shock to real output in the first year of the 1890s depression, a shock of at least the same magnitude during the first year of the 1930s depression had relatively little impact on what was clearly a more robust financial system.

An alternative to our pre-conditions hypothesis is that the variation in the performance of the financial sector across the two depressions was due to variation in a range of factors external to the financial system. External factors such as shocks to world output or government policies, for example, may have caused the 1890s depression to be deeper in terms of real output, which may in turn have contributed to the 1890s financial crisis. If this were true, it would reduce the significance of the financial pre-conditions in explaining variation in the performance of the financial system. For this reason we consider the role of those factors outside the financial system which may have directly contributed to variation in the behaviour of real output across the two depressions.

The paper proceeds as follows. Section 2 begins with an overview of the timing and nature of the two depressions in terms of the real sector of the economy, and then outlines the variation in the performance of the financial system across the two depressions. Section 3 suggests that these different financial outcomes followed naturally from differences in the degree of financial stability in the years leading up to each of the two depressions. In Section 4 we consider the role of external factors which may have affected the performance of the real sector, including government policies and real shocks emanating from overseas. Section 5 summarises the main findings of the paper.

Footnotes

Before these, there was a severe depression in the 1840s. [1]

Sinclair actually concludes that one major difference was the relative influence of internal and external factors in terms of the underlying causes of the depressions. He shows that internal factors were more relevant to the 1890s depression while external factors were more relevant to the 1930s depression. [2]

For a description of the world depression see Kindelberger (1973; 1989) and for discussion of the problems in the US financial system see Chandler (1970). [3]

Shann (1927) makes one of the earliest comparisons of the stability of the financial system of the 1880s with the 1920s. This took the form of a reminder for readers in the late 1920s of the problems that had developed through the 1880s. [4]