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VOL. 73 NO. 3 BERNANKE: GREAT DEPRESSION 265 credit conditions reported that "During 1930, the shrinkage of commercial loans no more than reflected business recession. During 1931 and the first half of 1932 (the period studied), it unquestionably represented pres- sure by banks on customers for repayment of loans and refusal by banks to grant new loans" (p. 28). Other contemporary sources tended to agree (see, for example, Chandler, 1971, pp. 233-39, for references). Two other observations about the contrac- tion of bank credit can be made. First, the class of borrowers most affected by credit reductions were households, farmers, unin- corporated businesses, and small corpora- tions; this group had the highest direct or indirect reliance on bank credit. Second, the contraction of bank credit was twice as large as that of other major countries, even those which experienced comparable output de- clines (Klebaner, p. 145). The fall in bank loans outstanding was partly offset by the relative expansion of alternative forms of credit. In the area of consumer finance, retail merchants, service creditors, and nonbank lending agencies im- proved their position relative to banks and primarily bank-supported installment fi- nance companies (Rolf Nugent, 1939, pp. 114-16). Small firms during this period sig- nificantly reduced their traditional reliance on banks in favor of trade credit (Charles Merwin, 1942, pp. 5 and 75). But, as argued above, in a world with transactions costs and the need to discriminate among borrowers, these shifts in the loci of credit intermedia- tion must have at least temporarily reduced the efficiency of the credit allocation process, thereby raising the effective cost of credit to potential borrowers. B. The Effect of Bankruptcies on the CCI I turn now to a brief discussion of the impact of the increase in defaults and bank- ruptcies during this period on the cost of credit intermediation. The very existence of bankruptcy proceed- ings, rather than being an obvious or natural phenomenon, raises deep questions of eco- nomic theory. Why, for example, do the creditor and defaulted debtor make the pay- ments to third parties (lawyers, administra- tors) that these proceedings entail, instead of somehow agreeing to divide those payments between themselves? In a complete-markets world, bankruptcy would never be observed; this is because complete state-contingent loan agreements would uniquely define each party's obligations in all possible circum- stances, rendering third-party arbitration un- necessary. That we do observe bankruptcies, in our incomplete-markets world, suggests that creditors and debtors have found the combination of simple loan arrangements and ex post adjudication by bankruptcy (when necessary) to be cheaper than attempt- ing to write and enforce complete state-con- tingent contracts.
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