Fighting Financial Crises

Learning from the Past

Gary B. Gorton, Ellis W. Tallman

• Publisher: University of Chicago Press
• Year: 2018
• ISBN:
  9780226479651
• Topic: Negocios y empresa
• Subtopic: Negocios en general

If you've got money in the bank, chances are you've never seriously worried about not being able to withdraw it. But there was a time in the United States, an era that ended just over a hundred years ago, when bank customers had to pay close attention to the solvency of the banking system, knowing they might have to rush to retrieve their savings before the bank collapsed. During the National Banking Era (1863–1913), before the establishment of the Federal Reserve, widespread banking panics were indeed rather common.Yet these pre-Fed banking panics, as Gary B. Gorton and Ellis W. Tallman show, bear striking similarities to our recent financial crisis. Fighting Financial Crises thus turns to the past to better understand our uncertain present, investigating how panics during the National Banking Era played out and how they were eventually quelled and prevented. The authors then consider the Fed's and the SEC's reactions to the recent crisis, building an informative new perspective on how the modern economy works.

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Fighting Financial Crises: Learning from the Past

Of course, it would be best not to have financial crises. Then there would be no reason to think about how to fight them. But the naive view that advanced economies are no longer vulnerable to financial crises was exploded by the Panic of 2007–8. So it is necessary to think (again) about fighting crises.

Financial crises are devastating events that have long plagued market economies and continue to be a problem. Indeed, crises like the Panic of 2007–8 are certainly not rare in US history (or, for that matter, in the history of all market economies). Before the Panic of 2007–8, the United States endured what might be perceived as a recurrent pattern of financial crises, with panics in 1797, 1814, 1819, 1825, 1833, 1837, 1857, 1861, 1864, 1873, 1884, 1890, 1893, 1907, 1914, and 1929–33. Each event combined financial distress with economic contraction; the final date in the list is the Great Depression, a monolithic enigma for economists. The depression—a watershed event for policy responses to crises and the aftermath—stimulated extensive inquiries into its causes. The social distress observed in the depression—unemployment rates above 25 percent and the contraction of real output by more than 30 percent—left an indelible impression on many of those who lived through it. As that population has dwindled over time, the social memory of the event faded and it was assumed that such an event could not happen in the world’s most advanced economy.

Financial crises are runs on short-term debt—bank money. Through history, the runs have been on various forms of bank money, private banknotes and demand deposits, and then in 2007–8 on short-term debt like sale and repurchase agreements (repo), various forms of commercial paper, and money market funds. All these forms of short-term debt issued by banks are money-like. They are used for transactions and as very short-term stores of value. As such, they have the common feature that they are designed to be information-insensitive; that is, their value does not change when information arrives. And no one spends resources to try to determine something about the debt that others do not know. The reason for this is that it is most efficient if the short-term bank debt is always viewed as being worth par, that is, $10 is worth $10.

Market economies allocate resources via the price system. Prices go up or down and consumers and producers respond. In Adam Smith’s “invisible hand” allegory, the price summarizes the supply and demand for the good. Similarly, stock prices are thought to be “efficient,” meaning that they embed all the relevant information. New information arrives about each company, and their stock prices respond, going up or down. The stock market is a reasonable contrast to the case for bank money. We want stock prices to reveal information because the value of the stock is meant to reflect the value of the company that issued it. Bank money is different—the value of money should not move, and it is meant to be a numeraire—the medium used to determine prices for other goods. Bank money is best if the price system does not work. This is its defining characteristic. The price should not change so that transactions are straightforward. If the price of bank money does not change, it is not sensitive to new information. Then there are no arguments over the value of the money: $10 is $10. But the problem is that such debt is vulnerable to runs, situations where the debt becomes information-sensitive. This happens when holders of the debt suspect that the backing portfolio of loans or the backing bond collateral value has deteriorated. Suddenly, the price of bank money changes, but no one knows what it should be—a crisis. This structural commonality is the root of financial crises. To be clear, financial crises are always about short-term debt that debt holders no longer want. To be safe, they want cash, and what we mean here is whatever form of payment is indisputable.

The history of market economies is replete with many, many instances of financial crises. Crises occur in countries with and without central banks, with and without deposit insurance. They occur in emerging markets and they occur in developed economies. Central banks are supposed to fight crises, and the US Federal Reserve System took actions in 2007–8 to combat the crisis. And before the Federal Reserve System was established in 1913, private bank clearinghouses fought crises as best they could with the limited powers they had available.

At the center of a financial crisis or banking panic is a widespread scramble for cash. Something happens to make depositors “act differently” and find reasons to question the value of their deposits or other short-term bank debt. In a run on a single bank, depositor withdrawals threaten the viability of only one bank. Financial crises are events that spread beyond a few banks and affect the entire system. Hence the term “systemic.” In crises, the holders of short-term debt seek to withdraw their money. In the standard case of bank checking accounts, depositors want to exchange their deposits for cash. In a historical context, holders of private banknotes, as in the antebellum banking system, want to exchange the banknotes for specie, that is, gold or silver coin. In the case of sale and repurchase agreements (repo) or commercial paper, as in the 2007–8 crisis, holders of short-term debt instruments simply refused to redeposit their money. Or in the subtler case, the holders of short-term debt would have engaged in such a mass run had not explicit or implicit government or central bank intervention occurred or was expected to occur.

A financial crisis is a systemic event; in a banking panic all banks are at risk, and the financial system is about to collapse. For example, during the 2007–8 crisis Ben Bernanke in his testimony before the US Financial Crisis Inquiry Commission (2011, 354) said that of the thirteen most important financial institutions in the United States, “12 were on the verge of failure within a week or two [after Lehman].” One hundred and eighty years earlier, the United States had experienced the Panic of 1837, and the situation was the same, as described by William Gouge (1837, 5):

At the present moment [during the Panic of 1837], all the Banks in the United States are bankrupt; and, not only they, but all the Insurance Companies, all the Railroad Companies, all the Canal Companies, all the City Governments, all the County Governments, all the State Governments, the General Government, and a great number of people. This is literally true. The only legal tender is gold and silver. Whoever cannot pay, on demand, in the authorized coin of the country, a debt actually due, is, in point of fact, bankrupt: although he may be at the very moment in possession of immense wealth, and although, on the winding up of his affairs, he may be shown to be worth millions. (emphasis in original)

So a financial crisis is not just a bad event. The 1987 stock market crash or the US Savings and Loan mess would not qualify as financial crises because these events never threatened the entire financial system. Stock market crashes alone do not threaten the solvency of the banking system.

In a financial crisis, holders of short-term bank debt, like demand deposits, but also other forms of short-term debt, like sale and repurchase agreements (repo), want cash instead of their bank debt, because they have doubts about whether the issuing bank will be in business all that long. Further, unlike a bank run on one institution, depositors are unsure about the solvency of any bank and that is why cash and not a deposit in another bank is what depositors are after. Yet sometime later the very same lenders/depositors are comfortable and ready to hold short-term bank debt again. Why do depositors’ (or, synonymously, lenders’) beliefs switch from panic to not panic? Causing such a change in beliefs is called “restoring confidence.” With renewed confidence, short-term bank debt can again be used as usual. But how does this happen? How can depositors be convinced that the banking system is solvent and viable?

This book is about fighting financial crises. Why is such a book necessary? Don’t we already know how to fight crises? We have Bagehot’s rule. This is the time-honored way to fight crises. The rule was stated by Walter Bagehot in 1873 and says that to end a financial crisis, the central bank needs to lend freely, against good collateral, at a high rate. In the recent crisis, the heads of central banks said that they followed Bagehot’s advice (see King 2010; Draghi 2013; and Bernanke 2014a, 2014b). It is not known why this rule should restore confidence or, in fact, that it does. Everyone pays lip service to Bagehot’s rule. Is Bagehot’s rule useful because it encapsulates everything we need to know about fighting crises? Or, is it that nothing has been learned about fighting crises since 1873? Opening emergency lending facilities has never in itself ended a financial crisis. So the reality is that no lessons have been distilled for fighting crises since 1873. We will see that there is more to restoring confidence than Bagehot’s rule.

The gist of Bagehot’s rule is to provide cash to banks with high-interest loans from the central bank that are collateralized with the borrowing bank’s assets. The relatively high interest rate on the borrowed cash prevents banks from taking advantage of the emergency lending opportunity. The banks can then hand out the cash to depositors who withdraw it, and other depositors see that their cash is available. There is a crucial piece of this rule that is implicit and missing from the rule as typically expressed. Bagehot failed to mention it because he was English. The financial structure of banks in Britain kept the identity of borrowing banks secret. This is the crucial missing piece: secrecy. Secrecy about the borrowing banks’ identities hides weak banks, preventing runs against them, which would lead to runs against the next weakest, and so on. This secrecy focuses the attention of households and firms on the key question; is the banking system solvent? In a systemic event, convincing bank debt holders that the system is solvent is what reestablishing confidence means.

To understand a crisis and how to fight a crisis, we focus on the US National Banking Era (1863–1913). There are three reasons for this. First, once the Civil War ended and the National Banking Acts had fuller impact, it is a homogeneous period during which there were five notable banking panics. Three were very serious events. So we can study the experience of multiple panics occurring in the same system. Of course, many casually dismiss the past as irrelevant, but how else do we learn if not from history? With respect to financial crises, it really is, as Marx put it, a case where “History repeats itself, first as tragedy, second as farce.” The reality is that financial crises have occurred throughout the history of market economies. There is a common root problem: short-term debt. Short-term debt is necessary for the economy to work, but it is vulnerable to runs. This is clearest to see during the National Banking Era.

Second, this period is particularly interesting because there was no deposit insurance and no central bank, and so expectations of possible future central bank interventions during a crisis are not an issue. During modern crises, firms and households expect the central bank or government (Treasury) to intervene by, for example, issuing blanket guarantees against bank debt, nationalizing the banks, bailing out banks, and so on. In most mode...