Aug

24

 What is now completely forgotten is that banks used to be on their own. Neither the U.S. Treasury nor the full faith and credit of the Congress nor the Federal Reserve system stood behind them; yet somehow commerce flourished, panics were short, and - wonder of wonders - the paper currency people held was literally as good as gold. The risks of that system were the ones J.P. Morgan explained to Congress in his testimony before the Pujo Committee - one was always dependent on "the character of the borrower". And that character could and would fail, sometimes badly. What distinguishes the period before 1912 from what came afterwards is that the risks of failed character were not socialized. It was not the world we have now where everyone is everyone else's counter-party and savings=investment because that is how the equations work out. Yet it was, very much, a world of Physics and Politics.

The late 19th century financial system operated on Walter Bagehot's principles. It was assumed that, in the event of a crisis, the primary dealers in credit and money would come to the rescue but they would do so according to Morgan's hard rule. Bagehot's famous advice, "Discount freely", would be followed, but it was assumed that bad characters would not receive loans at all because their word was no good. That would be "cruel" (sic) to the depositors who trusted those bad characters, but such cruelty was an essential part of the system. Liars and cheats could not be rewarded, and neither could the fools who trusted them. One of the many things admirable about Ulysses Grant is that, when his son was swindled by a Bernie Madoff of the 19th century, he took the loss as being entirely his own. Neither he nor his family ever suggested that anyone else, besides the fraudulent partner, was to blame. Under such a system "sound" banks were the very ones that seemed most awful; they would only lend to people they knew and would always demand solid security.

This nasty truth seemed horribly undemocratic, as undemocratic (small or large D, take your pick) as the idea that people should have a sufficient down payment and prospects of reasonable income before being given a loan to buy a house. The Federal Reserve Act was promoted by Progressives as a solution to this problem. With the added security of interlinked banks and the implicit guarantee of the Treasury (the Treasury's currency was to become the Federal Reserve's), banks could cease to be so stingy. It is easy in retrospect to create conspiracy theories about "the Fed"; but there is very little justification for that. There was nothing at all radical in the actual language of the Act itself; its terms merely put in place a permanent Clearing House system that would be available at will in times of distress. The Clearing House system had worked during the Panic of 1907, but its very success had alarmed people who feared the Money Trust. Better to put the system in the hands of a quasi-public institution like the Bank of England than to leave it up to the Morgan Bank. (Note: The 1907 Panic had scared people in banking precisely because it had been a "Rich Man's Panic". The country had been fine; indeed, the "country" banks had remained sound. What was troubling was that, after the failure of the Knickerbocker Trust, those country banks had decided that the New York bank's character was less sound than had been supposed.

 So, having the Federal Reserve system serve as a banker's bank, an intermediary between the members, would not by itself be a great change. None of the supporters of the Act - Progressive or otherwise - presumed that the system would abandon the discipline of Bagehot's doctrine - no lending to bad characters. No one in the country supposed that the Act would change the currency - i.e. abandon the Constitutional gold standard. All the Act would do was create a formal authority that would have the "flexibility" to discount freely in times of crisis and thereby prevent people of "good" character from being wrongly slandered by the market. That was, of course, the beginning of a devil's bargain, but only a few cranks anticipated that it would be the beginning of the permanent destruction of the currency. 

What those cranks anticipated was that the Fed and the U.S. Treasury would decided that the Constitutional gold standard was not really a standard but only a guideline. That came in 1914, when war broke out in 1914, and the Secretary of the Treasury decided that, in the name of national security, he had the authority to shut down the New York Stock Exchange for 6 months.

That default by the government of the United States is the major part of the devil's bargain that we are still paying for. Shutting down the Exchange not only prevented the European holders of U.S. securities from selling up and asking for their bank drafts to be exchanged by the Treasury for bullion, it also destroyed overnight the private intermediaries for the bulk of world trade. The factors, dealers in commercial paper, and others who acted as the actual risk takers for payments for the greatest part of the volume of imports and exports were shut down. Trade finance ceased to be the dealings of private parties and became, instead, part of the official dealings of national treasuries and their respective central banks. The check and balance provided by those commercial dealers was literally abolished. The European governments whom Woodrow Wilson and the Congress favored - Britain and, to a lesser extent, France - were allowed to write checks for imports of food and war materials that their own pre-war banks would not have cashed. The financial tyranny of the Presidential executive order that Scott and others have so justly complained about did happen, but the author was not a 19th century Illinois Republican but a pair of modern, 20th century Virginia Democrats.

If you have no problem with any of this - and a majority of Americans and all but a few professional economists - do not, then you still have to explain why, in every financial crisis, from 1930 to 1971 to 2008, the Federal Reserve has ended up protecting the interest the banks and the banks' counter-parties and lenders and their mercantilist certainties at the expense of the savers and depositors and holders of the currency. The very hoard of gold acquired by the Treasury and the Fed in WW I was not used to "bail out" (sic) the depositors of the U.S. banks in 1930, 1931 and 1932 even though the system had been sold on the promise that "a systematic revision of banking laws in ways that would provide relief from financial panics, unemployment and business depression, and would protect the public from the domination by what is known as the Money Trust." 

In 1930, 1931 and 1932 the depositors lost their money outright; this time their money has been "protected" but its very value has been destroyed in the name of lowering real interest rates. That, of course, ignores the last part of Bagehot's doctrine - the central bank is to lend freely but only at high rates.
 


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3 Comments so far

  1. Nick Pribus on August 25, 2011 9:31 am

    Brilliantly said. In my long years investing in Russia I often said the average Russian cannot distinguish properly between a loan and a gift, what can more properly be said of the average American homeowner anymore, or average American business. But our investments in Russia were for the most part a stunning success as the fundamental investment criteria was not the business plan, the market, the sector, or the strategy. The fundamental criterion was the character of the man at the other side of the table. My Chairman was a master at assessing that key factor believing all the useless reams of paper generated by due diligence experts and transaction lawyers to be not worth (insert expletive here) if the counterparty could not be trusted. Trust and judgment become less necessary when Robin Hood is around to bailout the foolish.

  2. Alec Misra on August 25, 2011 8:10 pm

    the problem was that the failure of the Knicerbocker bank (the bad bank) was deemed, by Morgan himself no less, to be a threat to the many “good” banks still standing. thus he personally drew a line and saved the rest. And it was Morgan in the wake of this who called for the founding of the Fed so that the pressure of acting as the lender of last resort would not fall entirely onto private bankers such as himself. The problem with the nineteenth century approach you favour was that contagion effects were just as active back then as the ‘07 panic showed and people were not happy with it.
    The subsequent problem with the Fed lay in the temptation to use artificially low interest rates as a stimulus for political reasons. But market forces (notably bond market signals) could be utilized in a purely mechanical fashion to avoid such debauchery as I argue in my book on economics available at my website: sicsemperliberalis.wordpress.com
    The basic point is that it is possible to have sound market driven monetary and fiscal policy and a lender of last resort without relying on a nineteenth century free-banking or gold standard model of the sort that was shown to repeatedly fail.

  3. Alice Allen on August 25, 2011 9:51 pm

    I really appreciate your detailed post on this period in banking history. So many threads to pursue futher. Thank you!

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