The Root of Financial Panics

Exclusive to STR

September 10, 2007

Imagine for a moment the dark days of banking when banks had to redeem gold coin for the money substitutes they issued, which were either bank notes or deposit accounts. Folks were generally happy to keep their gold locked up in a safe place and found it more convenient to use the substitutes. Very importantly, most of them were also either stockholders of the bank or in debt to it {pdf, p. 82), so they had little incentive to confront the bank for redemption. But this very fact enticed banks to create substitutes well beyond the amount of gold they held in their vaults, a practice considered normal and not the least fraudulent.

Occasionally, of course, someone would ask for their gold, and the bank on those occasions complied. The transaction produced no strife, and life went on.

For the bank, life went on until hordes of people came in clamoring for the same thing. It is said the customers of the bank had panicked, driven by a fear their substitutes would not be honored. Their fear, of course, was well-founded, and the bank would either close down for good or ask the people to come back some other time, perhaps in a few years.

Panics: Bank Insolvency Exposed

In the 19th Century there were five major financial crises or panics in which bank stampedes of this nature occurred: 1819, 1837, 1857, 1873, and 1893. In each case the panics were preceded by periods of spectacular growth in the money supply, through a combination of unbacked note issue and credit expansion. In some panics there was also a pronounced increase in specie, either gold or silver coin. The Panic of 1837, for example, was preceded by rapid growth in silver coin from Mexico, where Santa Ana's government was financing its deficits with nearly-worthless copper coin (pdf, p. 98), which drove gold and silver out of the country.

Some economists maintain that the tremendous increase of specie in U.S. banks was the primary cause of the monetary expansion preceding the Panic of 1837, but banks then were inflating at a rate of roughly 7:1, credit to reserve specie. Thus, the surge in U.S. banks' silver coin deposits prior to 1837 only made the money growth worse in absolute terms, due to the money multiplier of fractional reserve banking.

While bank failures and unemployment are endemic to panics, some banks did quite well. Officially or informally, they were able to postpone redemption while remaining in business (pdf, p.80), meaning that while they no longer honored their obligation to pay note-holders or customers in gold or silver, they required their debtors to pay them at par in specie.

Panics happen when banks have inflated so much they lose public confidence. With whom does the fault lie ' the bank's note-holders and customers who panic and demand specie payment or the bank for committing a hoax?

Here's how London South East Company defines a financial panic:

Financial Panic: A self-fulfilling prophecy. If people believe that the bank will be unable to pay, they will all attempt to withdraw their money. This in itself will ensure that the bank cannot pay, and it will go bankrupt.

Their 'definition' has some revealing features. First, it admits the bank is truly insolvent because it 'cannot pay' all its depositors. But it also suggests that being insolvent isn't bad as long as people don't panic and ask for their money.

Should we look at banks as we might any other business that takes risks? Or are there important distinctions we need to make?

When people deposit gold in a bank, Rothbard (pdf, p. 26) argues,

the bank isn't borrowing from [them]; it doesn't pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time, on demand. In short, the bank note or deposit is not an IOU, or debt; it is a warehouse receipt for other people's property. Further, when a businessman borrows or lends money, he does not add to the money supply. The loaned funds are saved funds, part of the existing money supply being transferred from saver to borrower. Bank issues, on the other hand, artificially increase the money supply since pseudo-receipts are injected into the market. (emphasis added)

Whether they agreed with this view or not, bankers continued to issue unbacked money substitutes. When they brought on the infamous panic of 100 years ago, big bankers and politicians accelerated their push for more control over money and banking and shackled the country with a central bank, the Federal Reserve System, in 1913.

The new Fed would provide all the money a robust economy and an 'active' government demanded without those embarrassing panics. Economic dips would be history; growth would be an upward slope only.

Well, not quite. For the first 19 years of its existence, the Fed still had to contend with the gold standard. Following a 1917 amendment to the original act, the Fed managed to centralize much of the gold stock of the commercial banks, making it more difficult for people to get their hands on what was rightfully theirs.

It took the Great Depression and massive bank failures to eliminate gold domestically as a check on bank inflation. During the early years of the Depression, people were withdrawing gold from the banks, as they had every right to do, but politicians, including President Hoover, condemned them for 'traitorous hoarding' (pdf, p. 296) and keeping banks from bringing about a recovery. Withdrawing gold reduced the money supply, which lowered prices. Politicians and their Ivy League advisors considered low prices the cause of the Depression. Roosevelt agreed and took the country off the gold standard soon after he took office in 1933.

With gold banished as money, the Fed had finally succeeded in preventing panics. What would be the point of a run if there was only fiat money in the vaults? If people insisted on holding cash, the Fed could simply instruct the Treasury to print whatever was necessary.

Money had been removed from the people and placed in the care of politicians. And political money didn't require the expense and labor of mining ore. It required only ink and the will to print. Thereafter, there would be no such thing as a scarcity of money. Strife was history, and life would go on.

But there was a catch. As Alan Greenspan noted in 2002,

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money.

That kind of persistence created havoc in the 19th Century. What is it doing today?

The Same Thing in Different Clothing

The Fed controls the money supply by controlling the reserves of its member banks. It controls reserves mostly by raising or lowering the federal funds target rate, which is usually close to the market rate banks charge one another for overnight loans. It can also control reserves through its discount window, which is the rate set by the Fed on funds it loans to members. Normally, the discount rate is a full percentage point above the federal funds target rate.

Since June 29, 2006 the target rate for federal funds has held steady at 5.25 percent, reflecting a modest tight-money policy the Fed has pursued to stem price inflation. Any change in the target rate is normally announced at the Fed's monthly FOMC meeting rather than done on the fly. Among other things, monthly rate reviews give the impression that the economy is in the Fed's steady hands. No need to panic. In fact, St. Louis Fed president and FOMC member Bill Poole stated publicly recently that he sees no need 'to make a decision before the next [FOMC] meeting' on September 18.

For those addicted to Fed liquidity, that was the last thing they wanted to hear. Seeming to speak for all Fed dependents, stock trader Jim Cramer appeared on CNBC last month and went ballistic. 'Bernanke needs to open the discount window!' he roared. 'He has no idea how bad it is out there! He has no idea! He has no idea! . . . And Bill Poole has no idea what it's like out there! . . . They're nuts! They're nuts! They know nothing! . . . THE FED IS ASLEEP!'

Ten days after Cramer's plea, the Fed announced a drop in the discount rate from 6.25 percent to 5.75 percent. Cramer barked, and Bernanke tossed him a bone. Then on August 22, five days after the rate drop, the Wall Street Journal had this to report:

The four biggest U.S. banks said they borrowed a total $2 billion from the Federal Reserve, falling in with the central bank's efforts to stanch turmoil in financial markets by encouraging borrowing from the Fed.

It was unclear how much the move would calm tense credit markets . . .

'Tense credit markets'? Wasn't the Fed supposed to be the cure for this sort of thing? 'Jiggling its interest rate,' James Grant wrote, 'the Fed can impose the appearance of stability today, but only at the cost of instability tomorrow. By the looks of things, tomorrow is upon us already.'

'Tomorrow' was upon Americans in 1929 when the 1920s expansionist policy of the New York Fed's Ben Strong caught up with them. And the day after that 'tomorrow,' a period of suffering began that lasted nearly two decades, counting the war. But does the Fed get blamed for inflating us into the crash? Except for the Austrians (pdf, p. 169-171), no. Instead, it takes responsibility for failing to inflate us out of the depression. The cause of the crack-up is seen as the cure.

'Tomorrow' is upon us now, was upon us then, has been upon us throughout out history because banks have been inflating throughout theirs.

Only when we put a stop to it will our financial tomorrow seem genuinely bright.

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George F. Smith's picture
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George F. Smith is the author of The Flight of The Barbarous Relic, a novel about a renegade Fed chairman.  Visit his website.