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1907 Lessons Learned The Panic of Lessons Learned from the Market’s Perfect Storm 1907 By Robert F. Bruner and Sean D. Carr To understand fully the crash and had disturbed the equilibrium of the panici of 1907, one must consider its nation’s fragile financial system. As context: it was a time somewhat like Mark Twain supposedly said, “His- the present. A Republican moralist tory may not repeat itself, but it occa- was in the White House. War was sionally rhymes.” fresh in mind. Immigration was fuel- Exactly 100 years ago the United ing dramatic changes in society. New States was teetering on the edge of technologies were changing people’s economic collapse. Markets were in everyday lives. Business consolidators disarray, anxious depositors were and their Wall Street advisers were cre- forming long lines in front of banks, ating large, new combinations through and Wall Street investors were ner- mergers and acquisitions, while the vous and distressed. By November government was investigating and 1907 a major market crash had prosecuting prominent executives—led resulted in a 37 percent decline in by an aggressive young prosecutor from the value of all listed stocks, affect- New York. The public’s attitude toward ing nearly every industrial sector. business leaders, fueled by a muckrak- During the sharpest part of this ing press, was largely negative. The downturn, a banking panic led to government itself was becoming the failure of at least 25 banks and increasingly interventionist in society 17 trust companies.ii Money was and, in some ways, more intrusive in increasingly scarce, brokerages were individual life. Much of this was stim- forced to close, and the City of New ulated by a postwar economic expan- York was twice unable to find buy- sion that, with brief interruptions, had ers for its bonds, forcing the munic- lasted about 50 years, although in ipal government to the brink of recent months a major natural disaster bankruptcy. Financial History ~ Fall 200720 www.financialhistory.org Despite its severity, the 1907 crisis was mercifully short. Altogether it lasted 15 months, from the market’s peak in September 1906 to its trough in November 1907. From then until now, many observers have credited the relative brevity of this crisis to the actions of private bankers whose heroic interventions averted absolute catastrophe. In 1907, the United States lacked a central bank and the federal government possessed little A authority to address widespread eco- P g n i nomic distress. Moreover, at the very l r e t nadir of the crisis, the trust-busting S , s r U.S. President, Theodore Roosevelt, e h t o was literally hunting for bear in the r B n canebrakes of Louisiana. w o r Under these circumstances, as the B market crash and banking panic spun Lines in front of the Lincoln Trust Company during the Panic of 1907. wildly out of control, J. Pierpont Mor- gan, the colossus of American finance, information, and management theory. A ably asserted himself as the nation’s de pluralistic interpretation of the panic facto central banker. Using his personal and crash of 1907 that draws from these influence among other leading financiers, diverse intellectual perspectives suggests Morgan and a small circle of his peers that financial crises may result from a raised the funds necessary to relieve the powerful convergence of seven overlap- nation’s credit anorexia and support her ping and interrelated forces—a “perfect faltering financial institutions–all within storm”iii in the financial markets. the span of a few weeks. Reflecting on the 1907 crisis, then, let us The bold intervention of Morgan, consider the elements of the storm and however, does not tell the whole story. how they may gather force: A P The significance of Morgan’s leadership g System-like architecture. A financial n i l r e is undeniable, and his actions deserve system has two vitally important char- t S , s continued consideration as scholars acteristics that can serve as the foun- r e h t and practitioners draw innumerable dations for crises. First, various finan- o r lessons from his temerity, judgment, B cial institutions may be controlled by n w o and resolve. However, a thorough the same investors, and these interme- r understanding of America’s first finan- B diaries (banks, trust companies, bro- J.P. Morgan at the Pujo Hearings, 1912. cial crisis of the 20th century would be kerage firms) may be lenders and cred- incomplete were we only to study its itors to each other by virtue of the cash In 1907, the financial system in the remediation. Morgan’s dramatic reso- transfers they facilitate. The very exis- United States was highly fractional- lution of the 1907 crisis should not tence of such a network means that ized, localized, and complex. All told, blind us to the lessons that can be trouble can travel quickly, and the dif- the system held about 16,000 financial learned from a deeper examination of ficulties of one financial intermediary institutionsv (compared to about 7,500 its underlying causes. can spread to others. Second, the very in 2007), and the vast majority of them Over the years the causes of large and complexity of a financial system also were small “unit” banks having no systemic financial crises have been the means that it is difficult for all partici- branches. In 1907, the systemic nature focus of considerable research—both pants in the financial system to be of financial crises can be seen in the directly and through varied intellectual equally well informed — thus an chain of linkages as the panic spread, streams: macroeconomics, game theory, “information asymmetry” may moti- beginning on October 16, from one group psychology, financial economics, vate perverse behavior that can trigger institution to many others in New complexity theory, the economics of or worsen a financial crisis.iv York City and beyond (see Figure 1). www.financialhistory.org21 Financial History ~ Fall 2007 As for the effects of information Figure 1: Some Linkages Among Financial Institutions in 1907. asymmetry, one is struck by how lit- tle the average depositor in 1907 — Central Actors: NY Related: NY Unrelated: NY Unrelated: Distant L or even J. P. Morgan himself — could Failure of Otto Heinze & Co. L Mercantile Bank, Trust Company of L Correspondent banks and Gross & Kleeberg State Savings Bank of Butte America; and other Trust in the “interior”: money know about the condition of financial National Bank of North America; companies; New York centers and small local institutions. To resolve this asymme- New Amsterdam Bank; Mechanics Stock Exchange; Moore banks; foreign financial & Traders Bank; Knickerbocker Trust. & Schley. institutions. try, Morgan had privately chartered audits of the assets of various institu- tions and debtors. But he must have process of credit expansion and con- the risk of crisis. Like rapid growth known that the more serious asym- traction that significantly amplifies and inadequate safety buffers, the mis- metry lay not between him and the changes in markets and economic takes of leadership can help to foster institutions, but between the public growth. The boom part of the credit an environment vulnerable to shocks. and the institutions — therefore, Mor- cycle erodes the shock absorbers that In 1907, Theodore Roosevelt was on gan attempted to use the press, and cushion the financial system in the the warpath against anticompetitive even the pulpits, to shape public per- slump. Some banks, eager to make business practices. He wielded the ceptions about the safety and sound- profits, unwisely expand their lending power of the Department of Justice ness of the financial system. to less and less creditworthy clients as and the Sherman Antitrust Act, and he Buoyant growth. As lightning pre- the boom proceeds. Then some exter- used the bully pulpit to excoriate the cedes thunder, a volatile environment nal shock occurs and the bank direc- “malefactors of great wealth.” is a precursor to financial instability. tors awaken to the inadequacy of State governments followed suit Indeed, volatility in the form of buoy- their capitalization relative to the with new legislation to limit railroad ant economic growth may be espe- credit risks they have taken; banks rates; New York State employed a cially pernicious since it engenders reduce or cut off the new loans avail- young prosecutor, Charles Evans false optimism about the stability of able to their clients. This triggers a Hughes, to investigate the insurance markets and institutions. Every major liquidity crisis that drives both a stock industry. The Supreme Court financial panic has occurred after an market crash and a depositor panic. famously imposed a massive fine on episode of rapid economic growthvi The fragility of such a system stems Standard Oil for rate fixing. though not all panics are associated not only from the behavior of some Should Roosevelt and the Progres- with recessions.vii Of special interest is banks. It also grows from the struc- sives really be implicated in the crash? not the fact of growth, but rather the ture of the industry. A system with Financial markets withstand political cause of the inflection, the downturn many small and undiversified banks bluster fairly well — were Roosevelt’s from boom to slump. Rapid economic — such as existed in the United States speeches just empty rhetoric, we growth creates a demand for money in 1907 — is more prone to panics.x might absolve him. But markets are that eventually imposes liquidity In addition, the economists Ellis highly sensitive to changes in govern- strains on the financial system. Tallman and Jon Moen (1990) found ment policy (such as rate regulation, The crash and panic of 1907 punc- that the emergence of trust compa- taxation, and antitrust enforcement) tuated a period of very rapid eco- nies — a relatively new and lightly reg- that affect the underlying drivers of nomic growth in the United States.
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