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Financial crises

http://www.economist.com//news/essays/

21600451-finance-not-merely-prone-crises-it-shaped-them-five-historical-crises-show-how-aspects-today-s-fina

Finance is not merely prone to crises, it is shaped by them. Five historical

crises show how aspects of today s financial system originated and offer

lessons for today s regulators

What is mankind s greatest invention? Ask people this question and they are

likely to pick familiar technologies such as printing or electricity. They are

unlikely to suggest an innovation that is just as significant: the financial

contract. Widely disliked and often considered grubby, it has nonetheless

played an indispensable role in human development for at least 7,000 years.

At its core, finance does just two simple things. It can act as an economic

time machine, helping savers transport today s surplus income into the future,

or giving borrowers access to future earnings now. It can also act as a safety

net, insuring against floods, fires or illness. By providing these two kinds of

service, a well-tuned financial system smooths away life s sharpest ups and

downs, making an uncertain world more predictable. In addition, as investors

seek out people and companies with the best ideas, finance acts as an engine of

growth.

Yet finance can also terrorise. When bubbles burst and markets crash, plans

paved years into the future can be destroyed. As the impact of the crisis of

2008 subsides, leaving its legacy of unemployment and debt, it is worth asking

if the right things are being done to support what is good about finance, and

to remove what is poisonous.

History is a good place to look for answers. Five devastating slumps starting

with America s first crash, in 1792, and ending with the world s biggest, in

1929 highlight two big trends in financial evolution. The first is that

institutions that enhance people s economic lives, such as central banks,

deposit insurance and stock exchanges, are not the products of careful design

in calm times, but are cobbled together at the bottom of financial cliffs.

Often what starts out as a post-crisis sticking plaster becomes a permanent

feature of the system. If history is any guide, decisions taken now will

reverberate for decades.

This makes the second trend more troubling. The response to a crisis follows a

familiar pattern. It starts with blame. New parts of the financial system are

vilified: a new type of bank, investor or asset is identified as the culprit

and is then banned or regulated out of existence. It ends by entrenching public

backing for private markets: other parts of finance deemed essential are given

more state support. It is an approach that seems sensible and reassuring.

But it is corrosive. Walter Bagehot, editor of this newspaper between 1860 and

1877, argued that financial panics occur when the blind capital of the public

floods into unwise speculative investments. Yet well-intentioned reforms have

made this problem worse. The sight of Britons stuffing Icelandic banks with

sterling, safe in the knowledge that 35,000 of deposits were insured by the

state, would have made Bagehot nervous. The fact that professional investors

can lean on the state would have made him angry.

These five crises reveal where the titans of modern finance the New York Stock

Exchange, the Federal Reserve, Britain s giant banks come from. But they also

highlight the way in which successive reforms have tended to insulate investors

from risk, and thus offer lessons to regulators in the current post-crisis era.

1792: The foundations of modern finance

If one man deserves credit for both the brilliance and the horrors of modern

finance it is Alexander Hamilton, the first Treasury secretary of the United

States. In financial terms the young country was a blank canvas: in 1790, just

14 years after the Declaration of Independence, it had five banks and few

insurers. Hamilton wanted a state-of-the-art financial set-up, like that of

Britain or Holland. That meant a federal debt that would pull together

individual states IOUs. America s new bonds would be traded in open markets,

allowing the government to borrow cheaply. And America would also need a

central bank, the First Bank of the United States (BUS), which would be

publicly owned.

Chart showing prices of US government debt and BUS shares, 1791-92

This new bank was an exciting investment opportunity. Of the $10m in BUS

shares, $8m were made available to the public. The initial auction, in July

1791, went well and was oversubscribed within an hour. This was great news for

Hamilton, because the two pillars of his system the bank and the debt had been

designed to support each other. To get hold of a $400 BUS share, investors had

to buy a $25 share certificate or scrip , and pay three-quarters of the

remainder not in cash, but with federal bonds. The plan therefore stoked demand

for government debt, while also furnishing the bank with a healthy wedge of

safe assets. It was seen as a great deal: scrip prices shot up from $25 to

reach more than $300 in August 1791. The bank opened that December.

Two things put Hamilton s plan at risk. The first was an old friend gone bad,

William Duer. The scheming old Etonian was the first Englishman to be blamed

for an American financial crisis, but would not be the last. Duer and his

accomplices knew that investors needed federal bonds to pay for their BUS

shares, so they tried to corner the market. To fund this scheme Duer borrowed

from wealthy friends and, by issuing personal IOUs, from the public. He also

embezzled from companies he ran.

The other problem was the bank itself. On the day it opened it dwarfed the

nation s other lenders. Already massive, it then ballooned, making almost $2.7m

in new loans in its first two months. Awash with credit, the residents of

Philadelphia and New York were gripped by speculative fever. Markets for short

sales and futures contracts sprang up. As many as 20 carriages a week raced

between the two cities to exploit opportunities for arbitrage.

The jitters began in March 1792. The BUS began to run low on the hard currency

that backed its paper notes. It cut the supply of credit almost as quickly as

it had expanded it, with loans down by 25% between the end of January and

March. As credit tightened, Duer and his cabal, who often took on new debts in

order to repay old ones, started to feel the pinch.

Rumours of Duer s troubles, combined with the tightening of credit by the BUS,

sent America s markets into sharp descent. Prices of government debt, BUS

shares and the stocks of the handful of other traded companies plunged by

almost 25% in two weeks. By March 23rd Duer was in prison. But that did not

stop the contagion, and firms started to fail. As the pain spread, so did the

anger. A mob of angry investors pounded the New York jail where Duer was being

held with stones.

Hamilton knew what was at stake. A student of financial history, he was aware

that France s crash in 1720 had hobbled its financial system for years. And he

knew Thomas Jefferson was waiting in the wings to dismantle all he had built.

His response, as described in a 2007 paper by Richard Sylla of New York

University, was America s first bank bail-out. Hamilton attacked on many

fronts: he used public money to buy federal bonds and pep up their prices,

helping protect the bank and speculators who had bought at inflated prices. He

funnelled cash to troubled lenders. And he ensured that banks with collateral

could borrow as much as they wanted, at a penalty rate of 7% (then the usury

ceiling).

Chart showing how the number of banks and volume of trading increased in the US

after Hamilton's 1792 bail-out

Even as the medicine was taking effect, arguments about how to prevent future

slumps had started. Everyone agreed that finance had become too frothy. Seeking

to protect naive amateurs from risky investments, lawmakers sought outright

bans, with rules passed in New York in April 1792 outlawing public futures

trading. In response to this aggressive regulation a group of 24 traders met on

Wall Street under a Buttonwood tree, the story goes to set up their own private

trading club. That group was the precursor of the New York Stock Exchange.

Hamilton s bail-out worked brilliantly. With confidence restored, finance

flowered. Within half a century New York was a financial superpower: the number

of banks and markets shot up, as did GDP. But the rescue had done something

else too. By bailing out the banking system, Hamilton had set a precedent.

Subsequent crises caused the financial system to become steadily more reliant

on state support.

1825: The first emerging-markets crisis

Crises always start with a new hope. In the 1820s the excitement was over the

newly independent Latin American countries that had broken free from Spain.

Investors were especially keen in Britain, which was booming at the time, with

exports a particular strength. Wales was a source of raw materials, cutting 3m

tonnes of coal a year, and sending pig iron across the globe. Manchester was

becoming the world s first industrial city, refining raw inputs into

higher-value wares like chemicals and machinery. Industrial production grew by

34% between 1820 and 1825.

Chart showing government-bond prices for Peru, Mexico, Colombia and Britain,

1824-29

As a result, cash-rich Britons wanted somewhere to invest their funds.

Government bonds were in plentiful supply given the recent Napoleonic wars, but

with hostilities over (and risks lower) the exchequer was able to reduce its

rates. The 5% return paid on government debt in 1822 had fallen to 3.3% by

1824. With inflation at around 1% between 1820 and 1825 gilts offered only a

modest return in real terms. They were safe but boring.

Luckily investors had a host of exotic new options. By the 1820s London had

displaced Amsterdam as Europe s main financial hub, quickly becoming the place

where foreign governments sought funds. The rise of the new global bond market

was incredibly rapid. In 1820 there was just one foreign bond on the London

market; by 1826 there were 23. Debt issued by Russia, Prussia and Denmark paid

well and was snapped up.

But the really exciting investments were those in the new world. The crumbling

Spanish empire had left former colonies free to set up as independent nations.

Between 1822 and 1825 Colombia, Chile, Peru, Mexico and Guatemala successfully

sold bonds worth 21m ($2.8 billion in today s prices) in London. And there

were other ways to cash in: the shares of British mining firms planning to

explore the new world were popular. The share price of one of them, Anglo

Mexican, went from 33 to 158 in a month.

The big problem with all this was simple: distance. To get to South America and

back in six months was good going, so deals were struck on the basis of

information that was scratchy at best. The starkest example were the Poyais

bonds sold by Gregor MacGregor on behalf of a new country that did not, in

fact, exist. This shocking fraud was symptomatic of a deeper rot. Investors

were not carrying out proper checks. Much of the information about new

countries came from journalists paid to promote them. More discerning savers

would have asked tougher questions: Mexico and Colombia were indeed real

countries, but had only rudimentary tax systems, so they stood little chance of

raising the money to make the interest payments on their new debt.

Investors were also making outlandish assumptions. Everyone knew that rivalry

with Spain meant that Britain s government supported Latin American

independence. But the money men took another step. Because Madrid s enemy was

London s friend, they reasoned, the new countries would surely be able to lean

on Britain for financial backing. With that backstop in place the Mexican and

Colombian bonds, which paid 6%, seemed little more risky than 3% British gilts.

Deciding which to buy was simple.

But there would be no British support for these new countries. In the summer of

1823 it became clear that Spain was on the verge of default. As anxiety spread,

bond prices started to plummet. Research by Marc Flandreau of the Geneva

Graduate Institute and Juan Flores of the University of Geneva shows that by

the end of 1825 Peru s bonds had fallen to 40% of their face value, with others

following them down.

Britain s banks, exposed to the debt and to mining firms, were hit hard.

Depositors began to scramble for cash: by December 1825 there were bank runs.

The Bank of England jumped to provide funds both to crumbling lenders and

directly to firms in a bail-out that Bagehot later regarded as the model for

crisis-mode central banking. Despite this many banks were unable to meet

depositors demands. In 1826 more than 10% of the banks in England and Wales

failed. Britain s response to the crash would change the shape of banking.

The most remarkable thing about the crisis of 1825 was the sharp divergence in

views on what should be done about it. Some blamed investors sloppiness: they

had invested in unknown countries debt, or in mining outfits set up to explore

countries that contained no ores. A natural reaction to this emerging-markets

crisis might have been to demand that investors conduct proper checks before

putting money at risk.

But Britain s financial chiefs, including the Bank of England, blamed the banks

instead. Small private partnerships akin to modern private-equity houses, they

were accused of stoking up the speculative bubble with lax lending. Banking

laws at the time specified that a maximum of six partners could supply the

equity, which ensured that banks were numerous but small. Had they only been

bigger, it was argued, they would have had sufficient heft to have survived the

inevitable bust.

Mulling over what to do, the committees of Westminster and Threadneedle Street

looked north, to Scotland. Its banks were joint stock lenders that could have

as many partners as they wanted, issuing equity to whoever would buy it. The

Scottish lenders had fared much better in the crisis. Parliament passed a new

banking act copying this set-up in 1826. England was already the global hub for

bonds. With ownership restrictions lifted, banks like National Provincial, now

part of RBS, started gobbling up rivals, a process that has continued ever

since.

Chart showing the falling number of banks in England and Wales, 1784-1937

The shift to joint-stock banking is a bittersweet moment in British financial

history. It had big upsides: the ancestors of the modern megabank had been

born, and Britain became a world leader in banking as well as bonds. But the

long chain of mergers it triggered explains why RBS ended up becoming the world

s largest bank and, in 2009, the largest one to fail. Today Britain s big four

banks hold around 75% of the country s deposits, and the failure of any one of

them would still pose a systemic risk to the economy.

1857: Panics go global

By the mid-19th century the world was getting used to financial crises. Britain

seemed to operate on a one-crash-per-decade rule: the crisis of 1825-26 was

followed by panics in 1837 and 1847. To those aware of the pattern, the crash

of 1857 seemed like more of the same. But this time things were different. A

shock in America s Midwest tore across the country and jumped from New York to

Liverpool and Glasgow, and then London. From there it led to crashes in Paris,

Hamburg, Copenhagen and Vienna. Financial collapses were not merely regular now

they were global, too.

Chart showing the share prices of railway companies, the dotcoms of their day,

in 1857

On the surface, Britain was doing well in the 1850s. Exports to the rest of the

world were booming, and resources increased with gold discoveries in Australia.

But beneath the surface two big changes were taking place. Together they would

create what this newspaper, writing in 1857, called a crisis more severe and

more extensive than any which had preceded it .

The first big change was that a web of new economic links had formed. In part,

they were down to trade. By 1857 America was running a $25m current-account

deficit, with Britain and its colonies as its major trading partners. Americans

bought more goods than they sold, with Britain buying American assets to

provide the funds, just as China does today. By the mid-1850s Britain held an

estimated $80m in American stocks and bonds.

Railway companies were a popular investment. Shares of American railway firms

such as the Illinois Central and the Philadelphia and Reading were so widely

held by British investors that Britons sat on their boards. That their earnings

did not justify their valuations did not matter much: they were a bet on future

growth.

The second big change was a burst of financial innovation. As Britain s

aggressive joint-stock banks gobbled up rivals, deposits grew by almost 400%

between 1847 and 1857. And a new type of lender the discount house was

mushrooming in London. These outfits started out as middlemen, matching

investors with firms that needed cash. But as finance flowered the discount

houses morphed, taking in investors cash with the promise that it could be

withdrawn at will, and hunting for firms to lend to. In short, they were banks

in all but name.

Competition was fierce. Because joint-stock banks paid depositors the Bank of

England s rate less one percentage point, any discount house paying less than

this would fail to attract funds. But because the central bank was also an

active lender, discounting the best bills, its rate put a cap on what the

discount houses could charge borrowers. With just one percentage point to play

with, the discount houses had to be lean. Since cash paid zero interest, they

cut their reserves close to zero, relying on the fact that they could always

borrow from the Bank of England if they faced large depositor withdrawals.

Perennially facing the squeeze, London s new financiers trimmed away their

capital buffers.

Meanwhile in America, Edward Ludlow, the manager of Ohio Life, an insurance

company, became caught up in railway fever. New lines were being built to link

eastern cities with new frontier towns. Many invested heavily but Ludlow went

all in, betting $3m of Ohio Life s $4.8m on railway companies. One investment

alone, in the Cleveland and Pittsburgh line, accounted for a quarter of the

insurer s capital.

In late spring 1857, railroad stocks began to drop. Ohio Life, highly leveraged

and overexposed, fell faster, failing on August 24th. As research by Charles

Calomiris of Columbia University and Larry Schweikart of Dayton University

shows, problems spread eastwards, dragging down stockbrokers that had invested

in railways. When banks dumped their stock, prices fell further, magnifying

losses. By October 13th Wall Street was packed with depositors demanding their

money. The banks refused to convert deposits into currency. America s financial

system had failed.

As the financial dominoes continued to topple, the first British cities to

suffer were Glasgow and Liverpool. Merchants who traded with American firms

began to fail in October. There were direct financial links, too. Dennistoun,

Cross and Co., an American bank that had branches in Liverpool, Glasgow, New

York and New Orleans, collapsed on November 7th, taking with it the Western

Bank of Scotland. That made the British crisis systemic: the bank had 98

branches and held 5m in deposits. There was wild panic with troops needed to

calm the crowds.

The discount houses magnified the problem. They had become a vital source of

credit for firms. But investors were suspicious of their balance-sheets. They

were right to be: one reported 10,000 of capital supporting risky loans of

900,000, a leverage ratio that beats even modern excesses. As the discount

houses failed, so did ordinary firms. In the last three months of 1857 there

were 135 bankruptcies, wiping out investor capital of 42m. Britain s

far-reaching economic and financial tentacles meant this caused panics across

Europe.

Map showing the spread of financial contagion from the United States to Europe

during 1857

As well as being global, the crash of 1857 marked another first: the

recognition that financial safety nets can create excessive risk-taking. The

discount houses had acted in a risky way, holding few liquid assets and small

capital buffers in part because they knew they could always borrow from the

Bank of England. Unhappy with this, the Bank changed its policies in 1858.

Discount houses could no longer borrow on a whim. They would have to

self-insure, keeping their own cash reserves, rather than relying on the

central bank as a backstop. That step made the 1857 crisis an all-too-rare

example of the state attempting to dial back its support. It also shows how

unpopular cutting subsidies can be.

The Bank of England was seen to be obsessed by the way discount houses relied

on it, and to have rushed into its reforms. The Economist thought its tougher

lending policy unprincipled: we argued that decisions should be made on a

case-by-case basis, rather than applying blanket bans. Others thought the

central bank lacked credibility, as it would never allow a big discount house

to fail. They were wrong. In 1866 Overend & Gurney, by then a huge lender,

needed emergency cash. The Bank of England refused to rescue it, wiping out its

shareholders. Britain then enjoyed 50 years of financial calm, a fact that some

historians reckon was due to the prudence of a banking sector stripped of moral

hazard.

1907: Emergency money

As the 20th century dawned America and Britain had very different approaches to

banking. The Bank of England was all-powerful, a tough overseer of a banking

system it had helped design. America was the polar opposite. Hamilton s BUS had

closed in 1811 and its replacement, just around the corner in Philadelphia, was

shut down in 1836. An atomised, decentralised system developed. Americans

thought banks could look after themselves until the crisis of 1907.

The absence of a lender of last resort had certainly not crimped the expansion

of banking. The period after the civil war saw an explosion in the number of

banks. By 1907 America had 22,000 banks one for every 4,000 people. In most

towns, there was a choice of local banks or state-owned lenders.

Despite all these options, savvy metropolitan investors tended to go elsewhere

to the trust companies. These outfits appeared in the early 1890s to act as

trustees , holding their customers investments in bonds and stocks. By 1907

they were combining this safehouse role with riskier activities: underwriting

and distributing shares, and owning and managing property and railways. They

also took in deposits. The trust companies had, in short, become banks.

Chart showing deposits at New York trsut companies, 1898-1908

And they were booming. Compared with ordinary banks, they invested in spicier

assets and were more lightly regulated. Whereas banks had to hold 25% of their

assets as cash (in case of sudden depositor demands) the trusts faced a 5%

minimum. Able to pay higher rates of interest to depositors, they became a

favourite place to park large sums. By 1907 they were almost as big as the

national banks, having grown by nearly 250% in ten years.

America was buzzing too. Between 1896 and 1906 its average annual growth rate

was almost 5%. This was extraordinary, given that America faced catastrophes

such as the Baltimore fire of 1904 and San Francisco earthquake of 1906, which

alone wiped out around 2% of GDP. All Americans, you might think, would have

been grateful that things stayed on track.

But two greedy scammers Augustus Heinze and Charles Morse wanted more, as a

1990 paper by Federal Reserve economists Ellis Tallman and Jon Moen shows. The

two bankers had borrowed and embezzled vast sums in an attempt to corner the

market in the shares of United Copper. But the economy started to slow a little

in 1907, depressing the prices of raw materials, including metals. United

Copper s shares fell in response. With the prices of their stocks falling

Heinze and Morse faced losses magnified by their huge leverage. To prop up the

market, they began to tap funds from the banks they ran. This whipped up

trouble for a host of smaller lenders, sparking a chain of losses that

eventually embroiled a trust company, the Knickerbocker Trust.

A Manhattan favourite located on the corner of 34th Street and 5th Avenue, its

deposits had soared from $10m in 1897 to over $60m in 1907, making it the

third-largest trust in America. Its Corinthian columns stood out even alongside

its neighbour, the Waldorf Astoria. The exterior marble was from Vermont; the

interior marble was from Norway. It was a picture of wealth and solidity.

Yet on the morning of October 22nd the Knickerbocker might as well have been a

tin shack. When news emerged that it was caught up in the Heinze-Morse

financial contagion, depositors lined the street demanding cash. The

Knickerbocker paid out $8m in less than a day, but had to refuse some demands,

casting a pall over other trusts. The Trust Company of America was the next to

suffer a depositor run, followed by the Lincoln Trust. Some New Yorkers moved

cash from one trust to another as they toppled. When it became clear that the

financial system was unsafe, Americans began to hoard cash at home.

For a while it looked as though the crisis could be nipped in the bud. After

all, the economic slowdown had been small, with GDP still growing by 1.9% in

1907. And although there were crooks like Heinze and Morse causing trouble,

titans like John Pierpont Morgan sat on the other side of the ledger. As the

panic spread and interest rates spiked to 125%, Morgan stepped in, organising

pools of cash to help ease the strain. At one point he locked the entire New

York banking community in his library until a $25m bail-out fund had been

agreed.

But it was not enough. Depositors across the country began runs on their banks.

Sensing imminent collapse, states declared emergency holidays. Those that

remained open limited withdrawals. Despite the robust economy, the crash in New

York led to a nationwide shortage of money. This hit business hard, with

national output dropping a staggering 11% between 1907 and 1908.

With legal tender so scarce alternatives quickly sprang up. In close to half of

America s large towns and cities, cash substitutes started to circulate. These

included cheques and small-denomination IOUs written by banks. The total value

of this private-sector emergency cash all of it illegal was around $500m, far

bigger than the Morgan bail-out. It did the trick, and by 1909 the American

economy was growing again.

The earliest proposals for reform followed naturally from the cash shortage. A

plan for $500m of official emergency money was quickly put together. But the

emergency-money plan had a much longer-lasting impact. The new currency laws

included a clause to set up a committee the National Monetary Commission that

would discuss the way America s money worked. The NMC sat for four years,

examining evidence from around the world on how best to reshape the system. It

concluded that a proper lender of last resort was needed. The result was the

1913 Federal Reserve Act, which established America s third central bank in

December that year. Hamilton had belatedly got his way after all.

Map showing US cities that imposed restrictions on money use

1929-33: The big one

Until the eve of the 1929 slump the worst America has ever faced things were

rosy. Cars and construction thrived in the roaring 1920s, and solid jobs in

both industries helped lift wages and consumption. Ford was making 9,000 of its

Model T cars a day, and spending on new-build homes hit $5 billion in 1925.

There were bumps along the way (1923 and 1926 saw slowdowns) but momentum was

strong.

Banks looked good, too. By 1929 the combined balance-sheets of America s 25,000

lenders stood at $60 billion. The assets they held seemed prudent: just 60%

were loans, with 15% held as cash. Even the 20% made up by investment

securities seemed sensible: the lion s share of holdings were bonds, with

ultra-safe government bonds making up more than half. With assets of such high

quality the banks allowed the capital buffers that protected them from losses

to dwindle.

Chart showing the Dow Jones Industrial Average, 1925-60

But as the 1920s wore on the young Federal Reserve faced a conundrum: share

prices and prices in the shops started to move in opposite directions. Markets

were booming, with the shares of firms exploiting new technologies radios,

aluminium and aeroplanes particularly popular. But few of these new outfits had

any record of dividend payments, and investors piled into their shares in the

hope that they would continue to increase in value. At the same time

established businesses were looking weaker as consumer prices fell. For a time

the puzzle whether to raise rates to slow markets, or cut them to help the

economy paralysed the Fed. In the end the market-watchers won and the central

bank raised rates in 1928.

It was a catastrophic error. The increase, from 3.5% to 5%, was too small to

blunt the market rally: share prices soared until September 1929, with the Dow

Jones index hitting a high of 381. But it hurt America s flagging industries.

By late summer industrial production was falling at an annualised rate of 45%.

Adding to the domestic woes came bad news from abroad. In September the London

Stock Exchange crashed when Clarence Hatry, a fraudulent financier, was

arrested. A sell-off was coming. It was huge: over just two days, October 28th

and 29th, the Dow lost close to 25%. By November 13th it was at 198, down 45%

in two months.

Worse was to come. Bank failures came in waves. The first, in 1930, began with

bank runs in agricultural states such as Arkansas, Illinois and Missouri. A

total of 1,350 banks failed that year. Then a second wave hit Chicago,

Cleveland and Philadelphia in April 1931. External pressure worsened the

domestic worries. As Britain dumped the Gold Standard its exchange rate

dropped, putting pressure on American exporters. There were banking panics in

Austria and Germany. As public confidence evaporated, Americans again began to

hoard currency. A bond-buying campaign by the Federal Reserve brought only

temporary respite, because the surviving banks were in such bad shape.

This became clear in February 1933. A final panic, this time national, began to

force more emergency bank holidays, with lenders in Nevada, Iowa, Louisiana and

Michigan the first to shut their doors. The inland banks called in inter-bank

deposits placed with New York lenders, stripping them of $760m in February 1933

alone. Naturally the city bankers turned to their new backstop, the Federal

Reserve. But the unthinkable happened. On March 4th the central bank did

exactly what it had been set up to prevent. It refused to lend and shut its

doors. In its mission to act as a source of funds in all emergencies, the

Federal Reserve had failed. A week-long bank holiday was called across the

nation.

It was the blackest week in the darkest period of American finance. Regulators

examined banks books, and more than 2,000 banks that closed that week never

opened again. After this low, things started to improve. Nearly 11,000 banks

had failed between 1929 and 1933, and the money supply dropped by over 30%.

Unemployment, just 3.2% on the eve of the crisis, rose to more than 25%; it

would not return to its previous lows until the early 1940s. It took more than

25 years for the Dow to reclaim its peak in 1929.

Reform was clearly needed. The first step was to de-risk the system. In the

short term this was done through a massive injection of publicly supplied

capital. The $1 billion boost a third of the system s existing equity went to

more than 6,000 of the remaining 14,000 banks. Future risks were to be

neutralised by new legislation, the Glass-Steagall rules that separated

stockmarket operations from more mundane lending and gave the Fed new powers to

regulate banks whose customers used credit for investment.

A new government body was set up to deal with bank runs once and for all: the

Federal Deposit Insurance Commission (FDIC), established on January 1st 1934.

By protecting $2,500 of deposits per customer it aimed to reduce the costs of

bank failure. Limiting depositor losses would protect income, the money supply

and buying power. And because depositors could trust the FDIC, they would not

queue up at banks at the slightest financial wobble.

In a way, it worked brilliantly. Banks quickly started advertising the fact

that they were FDIC insured, and customers came to see deposits as risk-free.

For 70 years, bank runs became a thing of the past. Banks were able to reduce

costly liquidity and equity buffers, which fell year on year. An inefficient

system of self-insurance fell away, replaced by low-cost risk-sharing, with

central banks and deposit insurance as the backstop.

Yet this was not at all what Hamilton had hoped for. He wanted a financial

system that made government more stable, and banks and markets that supported

public debt to allow infrastructure and military spending at low rates of

interest. By 1934 the opposite system had been created: it was now the state s

job to ensure that the financial system was stable, rather than vice versa. By

loading risk onto the taxpayer, the evolution of finance had created a

distorting subsidy at the heart of capitalism.

The recent fate of the largest banks in America and Britain shows the true cost

of these subsidies. In 2008 Citigroup and RBS Group were enormous, with

combined assets of nearly $6 trillion, greater than the combined GDP of the

world s 150 smallest countries. Their capital buffers were tiny. When they ran

out of capital, the bail-out ran to over $100 billion. The overall cost of the

banking crisis is even greater in the form of slower growth, higher debt and

poorer employment prospects that may last decades in some countries.

But the bail-outs were not a mistake: letting banks of this size fail would

have been even more costly. The problem is not what the state does, but that

its hand is forced. Knowing that governments must bail out banks means parts of

finance have become a one-way bet. Banks debt is a prime example. The IMF

recently estimated that the world s largest banks benefited from implicit

government subsidies worth a total of $630 billion in the year 2011-12. This

makes debt cheap, and promotes leverage. In America, meanwhile, there are

proposals for the government to act as a backstop for the mortgage market,

covering 90% of losses in a crisis. Again, this pins risk on the public purse.

It is the same old pattern.

Chart showing the number of banks and banks' credit ratios, 1930-2012

To solve this problem means putting risk back into the private sector. That

will require tough choices. Removing the subsidies banks enjoy will make their

debt more expensive, meaning equity holders will lose out on dividends and the

cost of credit could rise. Cutting excessive deposit insurance means credulous

investors who put their nest-eggs into dodgy banks could see big losses.

As regulators implement a new round of reforms in the wake of the latest

crisis, they have an opportunity to reverse the trend towards ever-greater

entrenchment of the state s role in finance. But weaning the industry off

government support will not be easy. As the stories of these crises show,

hundreds of years of financial history have been pushing in the other

direction.