Pre-Fed Panics: Their Causes, Cont'd

By Gonzalo Schwarz

By Joseph Salerno

Kudos to Bob Murphy for his incisive exposé and demolition of Krugman’s statistical legerdemain in today’s Mises Daily. It is not only an enlightening piece but also a delightful read.

I have one small but obtrusive nit to pick with Bob, however. Bob links to a blog post by Steve Horwitz, which he praises as “a good job explaining why Krugman’s understanding of US banking history is flawed, because we didn’t have laissez-faire banking in the late 1800s.” Clicking on the link I found that Horwitz started out promisingly enough, arguing, contra Krugman, that late 19th-century America “was emphatically not a land of minimal government in banking” and that “the federal and state governments played a huge role in the banking industry and it was those regulations that were responsible for the pre-Fed panics.” I was excited to read more, but then my heart sank when Horwitz listed the two “most relevant regulations” in generating these panics as:

1) the prohibition on interstate banking, which created overly small and undiversified banks that were highly prone to failure; and 2) the requirement that federally chartered banks back their currency with purchases of US government bonds, which made it prohibitively expensive to issue more currency when the demand rose, leading to the currency shortages and resulting panics that culminated in the Panic of 1907.

Huh? These regulations were of almost no significance in causing the cyclical booms that culminated in the Panics of 1873, 1884 1893, and 1907. Horwitz never mentions the underlying cause of these cyclical fluctuations: the establishment of a quasi-central banking cartel among seven privileged New York banks resulting in the almost complete centralization of U.S. gold reserves in their vaults by the National Bank acts of 1863-1864. This New York City banking cartel was able to expand willy nilly the monetary base and the overall money supply by expanding their own notes and deposits on top of gold reserves. Their notes and deposits were then used as reserves by lower tier banks (Reserve City Banks and Country Banks) on which to pyramid their own notes and deposits. This is well understood even by mainstream monetary historians. For example, John J. Klein (Money and the Economy, 2nd ed., 1970, pp. 145-46) pointed out:

The financial panics of 1873, 1884, 1893, and 1907 were in large part an outgrowth of . . . reserve pyramiding and excessive deposit creation by reserve city and central city [New York City] banks. These panics were triggered by the currency drains that took place in periods of relative prosperity when banks were loaned up.

Moreover, banks, especially the larger ones, were encouraged in their inflationary credit creation by the firmly entrenched expectation that they would be freed from fulfilling their contractual obligations in times of difficulty by the legal suspensions of cash payments to their depositors and note-holders that recurred during panics throughout the 19th century. In addition, under the National Banking system, the New York banking cartel had formed the New York Clearing House which was empowered to issue euphemistically designated “clearing house certificates.” These were in essence extra bank reserves that were created out of thin air to bail out errant banks during panics. Ludwig von Mises identified these cartel certificates as an inspiration for the formation of the later Federal Reserve System as a lender of last resort to over-expanded banks, a function that introduced moral hazard into the banking system. Commenting on the intentions of the advocates of a central bank for the U.S., Mises wrote (p. 126) in 1928:

Among the reasons leading to the significant revision of the American banking system [i.e., the Federal Reserve Act of 1913], the most important was the belief that provisions must be made for times of crisis. In other words, just as the emergency institution of Clearing House Certificates was able to save expanding banks so should technical expedients be used to prevent the breakdown of the banks and bankers whose conduct had led to the crisis. It was usually considered especially important to shield the banks which expanded circulation credit from the consequences of their conduct.

Horwitz seems to imply that the panics were isolated events that were somehow caused by sudden monetary stringency when in fact the very opposite was true. As Rothbard shows in his masterful discussion of the National Banking era in A History of Money and Banking in the United States (pp. 132-79), every panic was preceded by an expansion of the money supply. And during the panic of 1873, there was no contraction of the money supply, while there was a very mild one in 1884. As a free banker, I would have expected Horwitz to counter Krugman’s nonsense by pointing to the inflationary, quasi-central banking cartel that existed during the Gilded Age, rather than carping about minor regulations that may have curbed the ability of banks to inflate their way out of difficulties caused by previous inflation. And why no mention of the banking cartel’s “clearing house certificates” as fostering systemic moral hazard and undue credit expansion among banks? Doesn’t Horwitz ascribe to the oft-repeated free banker doctrine, “Every bank on its own bottom.” Finally, how does Horwitz square his idiosyncratic financial-regulation theory of panics and recessions with the Austrian Theory of the Business Cycle? He sounds like a supply-sider to me.

Getting back to to Bob, I would suggest that for a complete refutation of Krugman’s disingenuous claim that laissez faire banking reigned supreme during the 19th-century, he should direct readers to Rothbard’s discussion mentioned above.

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