Fighting financial crises learning from the past

Fighting Financial Crises Fighting Financial Crises Learning from the Past g a ry b g o r t o n a n d e l l i s w ta l l m a n The University of Chicago Press Chicago and London The University of Chicago Press, Chicago 60637 The University of Chicago Press, Ltd., London © 2018 by The University of Chicago All rights reserved No part of this book may be used or reproduced in any manner whatsoever without written permission, except in the case of brief quotations in critical articles and reviews For more information, contact the University of Chicago Press, 1427 E 60th St., Chicago, IL 60637 Published 2018 Printed in the United States of America 27 26 25 24 23 22 21 20 19 18 isbn-13: 978-0-226-47951-4 (cloth) isbn-13: 978-0-226-47965-1 (e-book) doi: https://doi.org/10.7208/chicago/9780226479651.001.0001 Library of Congress Cataloging-in-Publication Data Names: Gorton, Gary, author | Tallman, Ellis W (Ellis William), 1958 – author Title: Fighting financial crises : learning from the past / Gary B Gorton and Ellis W. Tallman Description: Chicago ; London : The University of Chicago Press, 2018 | Includes bibliographical references and index Identifiers: lccn 2018011958 | isbn 9780226479514 (cloth : alk paper) | isbn 9780226479651 (e-book) Subjects: lcsh: Financial crises | Financial crises—United States—History | New York Clearing House Association | Clearinghouses (Banking)—New York (State)—New York | United States—Economic conditions—1865 –1918 Classification: lcc hb3722 g673 2018 | ddc 338.5/420973 — dc23 lc record available at https://lccn.loc.gov/2018011958 This paper meets the requirements of ansi/niso z39.48-1992 (Permanence of Paper) Contents Preface vii Fighting Financial Crises: Learning from the Past The New York Clearing House Association 12 The Start of a Panic 26 What the New York Clearing House Did during National Banking Era Panics 37 Information Production and Suppression and Emergency Liquidity 57 “Too Big to Fail” before the Fed 72 Certified Checks and the Currency Premium 87 The Change in Depositors’ Beliefs during Suspension 103 Aftermath 125 10 What Ends a Financial Crisis? Historical Reminders 130 11 Modern Crises: Perspectives from History 141 12 Guiding Principles for Fighting Crises 169 Appendixes 189 Notes 211 References 219 Index 231 Preface [The subject of banking panics] is thoroughly understood by few only; and most people, shunning the trouble of patient investigation, form hasty conclusions based on superficial impressions (browning 1869) History is important, especially for understanding financial crises What is a financial crisis? How can we recognize a financial crisis? What should a central actor, like a central bank or a private bank clearinghouse, to restore financial market conditions to normalcy? What does “restore normalcy” actually mean? The Panic of 2007– makes clear that we should know the answers to these critical questions We have been through financial crises before, but history is selectively remembered No committee determines what elements of history should be emphasized and what should be forgotten; rather it is a social process The Panic of 2007– showed that even the most advanced economy in world history is not immune to banking panics, which are bank runs on many institutions Widespread financial distress perceived by investors and depositors compelled them to “get liquid” and caused the potential insolvency of the entire financial system, the collapse of which was prevented only by central bank and fiscal interventions Before 2007 such a crisis was inconceivable to financial market experts, policy makers, and especially the general public Perhaps this was because no one thought that banking would change in important ways, as in, for example, developing wholesale funding as a major source of funds And yet it is a fact that the United States experienced a systemic financial crisis during 2007– At the time, the financial crisis was unexpected, unthinkable, and seemed to come out of nowhere But it did not come out of nowhere It only seemed that way because the financial history of the United States was not commonly known In fact, financial history was not studied, and history was ignored This history was unexploited and is only now being recovered This book is part of that effort The Panic of 2007– was not supposed to happen because panics are viii p r e fac e events of “the past.” Generally, “the past” is viewed as inherently different from “the present,” so much so that the past is viewed as of little use in understanding the present Of course, the line between past and present is a blurry one A recent economics article is typical: “the structure of the economy has of course changed massively since the 1930s Data from a long time ago may not be a good guide to what we expect going forward.” And that statement comes from a paper published in 2013, well after the Panic of 2007– The authors, of course, not explain what “changed massively” means Had we held a different view of history, the Panic of 2007– might not have come as a complete shock Our view is that market economies have inherent structure And part of that structure is that short-term debt is vulnerable to runs— the potential for a widespread demand for cash rather than the short-term debt The Panic of 2007– showed that the past and the present have much more in common than many may have believed Macroeconomics is a field that was born in the Great Depression, and the early macroeconomists who lived through the Great Depression had direct, lived experience of the enormous economic distress it caused Randall Parker (2002) interviewed members of this generation for their memories of the events and the influence of those events upon them Paul Samuelson: “I can remember a knock on the door in the evening when we were at dinner There would be a person or even a child with a note, ‘We are starving, can you give us a potato or ten cents?’” (29) And Moses Abramovitz: “There were sights to be seen in the streets of Manhattan which were very, very disturbing, to say the least The apple sellers, unemployed men trying to pick up a few pennies to help support themselves and their families by buying a little carton of apples, putting it on a folding chair on a street corner, polishing them up and offering them for sale” (64) These experiences inspired them to become economists Milton Friedman: “I guess the major role the Depression played . .  was in leading me to become an economist” (42) This first generation of macroeconomists remembered directly The next generation speaks of the Great Depression more abstractly, perhaps on the basis of stories from those who had experienced it, but they had no firsthand knowledge of the aftermath of the event (see Parker 2008) Nevertheless, in economics the Great Depression is well remembered, and economists have produced a huge and vibrant literature that still illuminates it But the financial crises prior to the Great Depression are less prominent in the research literature and virtually absent in general mainstream macroeconomic discussions And because the earlier financial crises are not commonly known, the Great Depression appears special, to some an aberration defying explanation with an equilibrium model An explicit argument has never been made for p r e fac e ix why financial history prior to the Great Depression should be downplayed or even ignored, except for casual statements about the past being different Usually, the key argument is that pre-Fed panics were ended by the existence of the Federal Reserve, and that the Great Depression panics were different because of the incompetent response of the Fed or the unwieldy structure of the Fed We, however, take the view that market economies have an inherent structure— things like demand curves sloping downward— and that one of these inherent structures is the necessity for short-term debt that is inevitably vulnerable to runs This vulnerability implies that all financial crises are at their root about short-term debt This view makes previous history interpretable with respect to modern events and also relevant for understanding them In the study of financial panics, the period before the Federal Reserve System was in existence offers an excellent laboratory for investigating both the sources of panics and the methods taken to combat them With these goals in mind, we study the US National Banking Era, 1863 – 1913 In that period, firms and households had no expectations about what actions the central bank would take, because there was no central bank Lacking a central bank, firms and households reacted differently than if one had existed and taken actions to intervene In this laboratory, we are able, for example, to differentiate the argument that government policies cause financial crises (e.g., moral hazard, “too big to fail”) from the argument that there are root underlying causes of crises, which government policies aim to address Being able to make such differentiations can help answer our motivating questions about crises This book began as a long paper about how confidence in banks gets restored after runs on banks But we did not submit the paper, or a shortened version of it, to an academic economics journal because we cannot formally establish the causal link between the key actions taken to quell distress during a crisis and the restoration of confidence We provide a narrative of what happens during the period between the loss of confidence (the first bank runs) and the restoration of confidence, which to us is compelling, but we cannot establish a causal link by the high standards of econometric practice Sometimes important questions simply cannot meet those standards Our view is that historical methods can arrive at understanding also; it is not just the province of econometric practice The alternative is to not study crises, and to us, that is unacceptable It is ironic that we should proceed essentially with pure history, because we both received our PhD degrees from the University of Rochester Department of Economics (although we did not overlap) We each studied economic history, either formally or informally, with Professor Stanley Engerman Enger- .. .Fighting Financial Crises Fighting Financial Crises Learning from the Past g a ry b g o r t o n a n d e l l i s w ta l l m a n The University of Chicago Press Chicago and London The University... institutions 1 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... meets the requirements of ansi/niso z39.48-1992 (Permanence of Paper) Contents Preface vii Fighting Financial Crises: Learning from the Past The New York Clearing House Association 12 The Start