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 ▲ or even J. P. Morgan himself — could Failure of Otto Heinze & Co. ▲ Mercantile Bank, Trust Company of ▲ 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. ulated financial institution — intro- value. By late 1906, the radical shift This growth created a massive duced a key source of instability in government policy was apparent. demand for external finance and leading up to the panic of 1907. In Roosevelt’s speeches only confirmed meant the financial system within the part, the unequal regulation of banks the shift. He was both messenger and U.S. had a low level of capital relative and trust companies contributed to a message and thus deserves a place to the recent rate of demand.viii New concentration of riskier assets in among the drivers of these events. capital — nearly $100 million in gold trusts; the trusts took advantage of Real economic shock. Research on imported in 1907 — was obtained opportunities from which the banks financial crises acknowledges the role from Europe, through borrowings were restricted. Moreover, the trusts of some triggering event. Financial denominated not in U.S. dollars, but were able to concentrate their portfo- crises require a spark. The history of in sterling, francs, and marks. Large lios more.xi 1907 suggests there may be several borrowings denominated in foreign Adverse leadership. Adding to the candidates. Adverse court rulings, currencies have also been associated stew of uncertainty that leads up to rising regulation, and outlandish with financial crises.ix the financial crisis is the action of rhetoric affected the atmosphere of Inadequate safety buffers. The political and economic leaders who business confidence. But most notably, business cycle is associated with a advertently or inadvertently elevate the San Francisco earthquake and fire

Financial History ~ Fall 200722 www.financialhistory.org have been. It seems reasonable to guess that the panic of 1907 would have been much worse without the collective action by Morgan and others. The events of 1907 suggest that these seven factors are mutually rein- forcing. Rapid growth leads to opti- mism that for a time may stimulate more growth. Insufficient information fuels optimism and delays collective A P action. Imperfect information and g n i l

r optimism promote a tendency to dis- e t S

, count the effect of real shocks to the s r e

h system when they occur. Real shocks, t o r

B absence of shock absorbers, and lack n

w of collective action may amplify the o r B conditions of instability. These factors Depositors and messengers at the Trust Company of America, 1907. come and go in the economy; at any point in time, a few of them are almost in April 1906 triggered a global liq- Failure of collective action. The certainly present, and their presence uidity crunch. Then, in the summer of events of 1907 illustrate how collec- individually is insufficient to cause 1907, the Bank of England com- tive action might address a bank financial market instability. Rather, it pounded problems by dramatically panic. Most vividly, we see J.P. Mor- is the convergence of some or all of the curtailing the acceptance of American gan and his circle of influential New forces that produces the crisis. The finance bills in London. York bankers forcing the chief execu- panic of 1907 thus offers us lessons, These two events, the natural disas- tives of the largest New York banks but also insights for action: the impor- ter in California and the reduction in and trust companies to form their tance of transparency, feedback to American finance bills, stand out for own association to aid their failing decision makers, encouragement of having been real,xii large, costly, unam- institutions. Likewise, throughout collective action, the establishment of biguous, and surprising. When they hit the United States in 1907, bank clear- safety buffers in the global financial the economy and the financial system, ing houses functioned to monitor system, and the duty of leaders to they caused a sudden reversal in the their members and assure depositors serve their constituencies. FH outlook of investors and depositors. of convertibility. If it were necessary Undue fear, greed, and other to suspend convertibility, the clearing Robert F. Bruner and Sean D. Carr of behavioral aberrations. Beyond a houses issued scrip. Ultimately, the the University of Virginia’s Darden change in the rational economic out- legacy of the crash and panic was to School of Business are the co-authors of look is a shift from optimism to pes- nationalize collective action by The Panic of 1907: Lessons Learned simism that creates a self-reinforcing means of founding the Federal from the Market’s Perfect Storm (2007), downward spiral. The more bad news, Reserve System. Several scholars from which this article was adapted. the more behavior that generates bad have highlighted the important role news. The events of 1907 suggest an of collective action as a brake on the Sources emotional influence on the occurrence severity of financial crises.xiii and severity of the financial crisis. The Was the collective action in 1907 a Bordo, Michael D., and Christopher M. Meissner. 2005, “Financial Crises, history of the panic includes suicides, success? The panic of 1907 was 1880–1913: The Role of Foreign letters describing overly buoyant or among the worst on record, hardly Currency Debt.” Cambridge, Mass.: depressed markets, anxiety among consistent with successful collective National Bureau of Economic depositors and bank executives, ani- action. The major events of the panic Research, working paper 11173. mated crowds in the streets of New were largely guided by a small circle of Calomiris, Charles W., and Gary York’s financial district, and the use of leaders in the New York City financial Gorton. 1991. “The Origins of public relations and the press in an community, but the panic extended to Banking Panics: Models, Facts, and attempt to build investor confidence all commercial centers in the United Bank Regulation.” In R. Glenn Hub- — indeed, the very word “panic” sug- States. The true benchmark for collec- bard (ed.), Financial Markets and gests a suspension of rationality. tive action is the outcome that might Financial Crises. Chicago: Univer-

continued on page 34

www.financialhistory.org23 Financial History ~ Fall 2007 were found guilty. The presiding judge Preston Smith returned to business “Former Commish Hits the Jackpot,” sentenced them to five years probation. and civic activities in Lubbock. He Insurance Journal, September 25, 2000. died in 2003. http://www.tsha.utexas.edu/handbook/o The Summing Up Ben Barnes went into a real estate nline/articles/SS/mqs1_print.html. In the 1972 statewide elections, two- partnership with former Texas Gover- term Governor Preston Smith was Herskowitz, Mickey. Sharpstown Revis- nor John Connally. During a 1987 real defeated, garnering about eight per- ited: Frank Sharp and a Tale of Dirty estate bust, they went bankrupt. In cent of the vote. Lieutenant Governor Politics in Texas. Austin, Texas: Eakin 1997, after becoming a successful lob- Ben Barnes, 32 years old, the man Press, 1994. byist, Barnes accepted a $23 million Lyndon B. Johnson had said could be Johnson, John G. “The Dirty Thirty,” buyout of his lucrative contract with the next president from Texas, saw The Handbook of Texas Online. Gtech, the Texas lottery subcontractor. his political career end when he fin- http://www.tsha.utexas.edu/hand- In September 2000, John Osorio, ished third in the governor’s race. book/online/articles/DD/wmdsh.html. the only person to serve time in the Approximately half the membership Sharpstown scandal, and a girlfriend Kinch, Sam Jr. “Sharpstown Stock-Fraud of the house was either voted out or won $60 million in the Texas lottery. Scandal,” The Handbook of Texas Online. did not run again, and a higher than It was the largest Texas lottery ever http://www.tsha.utexas.edu/hand- average number of senators turned won by a single ticket. FH book/online/articles/SS/mqs1_print.html. over. The Democratic party in Texas suffered a body blow from which it Kinch, Sam Jr. and Ben Proctor. Texas Ron Hunka is a freelance writer of has never entirely recovered. Under a Cloud. Austin and New York: historical subjects, who lives in In the legislative session of 1973, Jenkins Publishing Co., 1972. Austin. From 1977 to 1981, he was a lawmakers passed a series of reforms Ponte, Lowell. “Ben Barnes: John Kerry’s merit system employee in the Office of in which state officials were required Unbelievable Last-Ditch Weapon,” the Governor in the administrations to disclose their sources of income and FRONTPAGEMAG.COM. September of Dolph Briscoe, Preston Smith’s suc- reveal more about their campaign 8, 2004. cessor after Sharpstown, and Bill finances. Most governmental records Clements, the first Republican gover- Texas State Library & Archives Commis- were opened to the public, and further nor since Reconstruction. The author sion.“Preston Smith,” Portraits of the open meetings requirements for pol- met Gus Mutscher on state business in Governors. http://www.tsl.state.tx.us/ icy-making agencies were established. 1981 after Mutscher had become governors/modern/index.html#Smith. New disclosure rules were passed for county judge of Washington County. “The Founder,” Time, February 15, 1971. paid lobbyists. After the scandal, Frank Sharp main- Sources The University of Texas at Austin: The tained a low profile. His financial losses Barnes, Ben. Barn Burning Barn Building. Center for American History. “Gus were more than $120 million. He died With Lisa Dickey. Albany, Texas: Mutscher,” Texas House Speakers Oral in Houston in 1993. Bright Sky Press, 2006. History Project.

The Panic of 1907: Lessons Learned from the Market’s Perfect Storm continued from page 23 sity of Chicago Press. This was also United States, 1867–1960. Princeton: Chicago Press. published as a chapter by the same Princeton University Press. Moen, Jon, and Ellis W. Tallman. 1992. title in Charles W. Calomiris (ed.). Gorton, Gary, and Lixim Huang. 2002. “The Bank Panic of 1907: The Role of 2000. U.S. Bank Regulation in His- “Banking Panics and the Origin of Cen- Trust Companies.” Journal of Eco- torical Perspective. Cambridge, tral Banking,” Cambridge, Mass.: nomic History 52:611–630. U.K.: Cambridge University Press. National Bureau of Economic Research, Ranciere, Romain, Aaron Tornell, and Davis, Joseph H. 2004. “A Quantity- working paper 9137. Frank Westermann. 2005. “Systemic Based Annual Index of U.S. Industrial Mishkin, Federic S. 1990. “Asymmetric Crises and Growth.” CESifo work- Production, 1790–1915,” Quarterly Information and Financial Crises: A ing paper 1451. Downloaded from Journal of Economics 119:1177–1215. Historical Perspective,” Cambridge, http://SSRN.com/abstract=708994. Donaldson, R. Glenn. 1992. “Sources of Pan- MA: National Bureau of Economic Sprague, O. M. W. 1908. “The American ics: Evidence from the Weekly Data.” Jour- Research, working paper 3400; and Crisis of 1907,” Economic Journal nal of Monetary Economics 31:277–305. in R. Glenn Hubbard (ed.). 1991. (September):353–372. Friedman, Milton, and Anna Schwartz. Financial Markets and Financial Tallman, Ellis W., and Jon R. Moen. 1990. 1963. A Monetary History of the Crises. Chicago: University of “Lessons from the Panic of 1907.”

Financial History ~ Fall 200734 www.financialhistory.org