2014-04-15 06:49:15
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.