Monday, June 21, 2021

Raghuram Rajan on The Boom and Bust in Farm Land Prices in the United States in the 1920s

From the former head of the Reserve Bank of India, now hanging his hat at the University of Chicago's Booth School of Business (comfy endowed chair):
 
The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s (with Rodney Ramcharan), American Economic Review , April 2015
How important is the role of credit availability in inflating asset prices? And does greater credit availability make the economy more sensitive to changes in sentiment or fundamentals?  In this paper we address 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. We find that credit availability likely had a direct effect on inflating land prices. Credit availability may have also amplified the relationship between the perceived improvement in fundamentals and land prices. When fundamentals turned down, however, areas with higher ex ante credit availability suffered a greater fall in land prices, and experienced higher bank failure rates. We draw lessons for regulatory policy.
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Does credit availability exacerbate asset price inflation? Are there long-run consequences? During the farm land price boom and bust before the Great Depression, we find that credit availability directly inflated land prices. Credit also amplified the relationship between positive fundamentals and land prices, leading to greater indebtedness. When fundamentals soured, areas with higher credit availability suffered a greater fall in land prices and had more bank failures. Land prices and credit availability also remained disproportionately low for decades in these areas, suggesting that leverage might render tem-porary credit-induced booms and busts persistent. We draw lessons for regulatory policy. (JEL E31, G21, G28, N22, N52, Q12, Q14 )
Asset price booms and busts often center around changes in credit availability (see, for example, the descriptions in Minsky 1986 and Kindleberger and Aliber 2005; theories such as Geanakoplos 2010; and the evidence in Borio and Lowe 2002, Mian and Sufi 2008, and Schularick and Taylor 2009). Some economists, however, claim that the availability of credit plays little role in asset price movements (e.g., see Glaeser, Gottlieb, and Gyourko 2010).

In this paper, we examine the boom (and bust) of farm land prices in the United States in the early twentieth century, using the variation in credit availability across counties in the United States to tease out the short- and long-run effects of the availability of credit on asset prices.The usual difficulty in drawing general lessons from episodes of booms and busts in different countries is that each crisis is sui generis, driven by differences in a broad range of hard-to-control-for factors.

The advantage of focusing on farm lending in the United States in the early twentieth century is that lending was local. So in effect, we have a large number of distinctive sub-economies, specifically, counties within each state, with some common (and thus constant) broad influences such as monetary policy and federal fiscal policy. Ceteris paribus, the more the banks in a county, the greater is the competition for depositor funds as well as the competition to offer credit, and closer is any bank to a potential customer, hence greater is the potential supply of intermediated funds. So our proxy for credit availability, through much of the paper, will be the log number of banks in a county. We rely on differences in bank regulations across states and Federal Reserve districts to allow us to isolate exogenous differences in credit availability.In addition, we have an exogenous boom and bust in agricultural commodity prices in the years 1917–1920, to which counties were differentially exposed.

The reasons for the commodity price rise are well documented. The emergence of the United States as an economic power helped foster a worldwide boom in commod-ities in the early twentieth century. The boom, especially in the prices of wheat and other grains, accelerated as World War I disrupted European agriculture, even while demand in the United States was strong. The Russian Revolution in 1917 fur-ther exacerbated the uncertainty about supply, and intensified the commodity price boom. However, European agricultural production resumed faster than expected after the war’s sudden end, and desperate for hard currency, the new Russian gov-ernment soon recommenced wheat and other commodity exports.
As a result, agricultural commodity prices plummeted starting in 1920 and declined through much of the 1920s (Yergin 1992; Blattman, Hwang, and Williamson 2007).1 Because different counties differed in the kind of crops they were most suited to produce, and each crop was affected to a different extent by the events in Europe, we have county by county variation in the perceived shock to fundamentals. Correcting for differences in the positive shock to fundamentals, we can tease out the effect of the availability of credit on land prices in 1920 (the peak of the boom).
We find that both fundamentals and credit availability mattered, but there was also a positive interaction effect; the shock generally boosted land prices even more in counties that had greater credit availability. We also explore the channels through which credit might have operated—whether it allowed marginal land to be brought into opera-tion, facilitated the more intensive use of existing land, allowed more investment in machinery, improved crop yields, or facilitated more leverage.
Credit availability seems to be primarily associated with higher leverage at the peak of the boom.The post-1920 collapse in commodity prices, induced by the resumption of European production, also allows us to examine the aftermath of the boom. Importantly, agricultural incomes fell, but only to levels before the acceleration in commodity price growth that started in 1917. This allows us to focus on the role of the financial leverage—both at the farm level and at the bank level—that built up in the boom years.
If the role of credit is relatively benign—borrowers simply sell the assets they had bought and repay credit—we should see relatively little independent effect of the prior availability of credit on asset prices, other than what rises the most falls the most. But if purchased assets are illiquid and hard to sell, and leverage cannot be brought down easily, we should see prices fall even more in areas that had easy access to credit. Also, distress, as evidenced in bank failures, should be more pronounced....
....MUCH MORE (39 page PDF)
 
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