Central Banking and the Incidence of Financial Crises

20 FINANCIAL HISTORY | Fall 2013 | www.MoAF.org By Richard Sylla with some inconsistency, the critics have for the protection of its rights and claimed that the central has too interests, and the latter facilitates The centennial anniversary in 2013– much power and that its quantitative eas- and extends the operations of com- 2014 of the founding of the Federal Reserve ing policies have proven ineffective. Con- merce among individuals. Industry System, America’s central bank, is a fitting gress responded to the first charge by is increased, commodities are multi- occasion to consider the question: Why do reining in some of the Fed’s powers in plied, agriculture and manufactures we have a central bank? To many people, the Dodd-Frank Act of 2010. But that did flourish, and herein consist the true the answer is far from obvious. Here I want not go far enough to please a vociferous wealth and prosperity of a state. Most to discuss in particular one good reason why critic of the Fed such as former congress- commercial nations have found it nec- we have a central bank, namely that our man Ron Paul, who in 2009 published a essary to institute , and they have history as a nation shows that central banks book entitled End the Fed, a not-so-thinly- proved to be the happiest engines ever reduce the incidence of financial crises. veiled policy recommendation. invented for advancing trade. Venice, Genoa, Hamburg, Holland and Eng- The Fed and Its Critics Deja Vous land are examples of their utility. in the Recent Crisis Remarkably, Hamilton had not been If the Fed’s actions during the recent crisis to Europe (and never would), and when During the of 2007–2008, were unprecedented, Ron Paul’s recom- he wrote Morris neither the colonies nor the Fed acted dramatically to prevent mendation to get rid of it was not. Early in the new nation had ever had a modern a financial meltdown. It made currency US history, Americans got rid of not one, bank of any kind. Shortly after Hamil- swaps with other countries’ central banks but two central banks. So our country has ton’s letter, Morris would recommend to alleviate dollar shortages overseas. It some experience in ending central banks. that Congress create the country’s first made , often termed “bailouts,” to It also has even more experience in creat- modern bank, the Bank of North America. US and foreign financial institutions to ing new central banks. We have created It opened at the beginning of 1782. prevent them in one way or another from three, and ended only two. Ten years later, Hamilton persuaded failing. It more than doubled the size of its Congress chartered our first central Congress to charter, and President Wash- balance sheet in 2008–2009 by purchasing bank, the Bank of the United States, in 1791 ington to approve, his far larger Bank of government and mortgage-backed securi- on the recommendation of the first Secre- the United States (BUS). The BUS, along ties with the intent of providing ample tary of the Treasury, . with a restructured national debt and the liquidity and keeping interest rates low A decade earlier, while he was serving as specie-based dollar, became a component to promote recovery from the economic an officer in the Continental Army, Ham- of the new nation’s financial architecture. triggered by the financial crisis. ilton had already (at age 24) made himself Owned 20% by the United States, the BUS In the aftermath of the crisis, the Fed an expert on modern finance in a new lent to the government and to the private again has nearly doubled the size of its nation whose financial arrangements were economy, established a branch network balance sheet through further securities decidedly pre-modern. In 1781, during what throughout the nation giving the country purchases, termed “quantitative easing.” turned out to be the late stages of the War nationwide banking facilities and acted Despite these actions, the recovery from of Independence, Hamilton wrote a long to regulate the expansion of by the crisis has been protracted and rather letter to Robert Morris. Morris had just state-chartered banks. Economically, by anemic. So the Fed announced in Septem- been appointed by Congress to clean up the all accounts, the BUS was a great success. ber, to Wall Street’s and others’ surprise, financial mess created by over-issuing paper Politically, it was a different matter. that it intended to keep on pursuing its Continental currency to the point that it Those who opposed its creation in 1791 low interest policies as long as unemploy- became worthless. That problem had virtu- continued to regard it as unconstitu- ment remained too high and ally destroyed the credit of the United States tional. Two decades later, when the BUS’s showed no signs of rearing its ugly head. with foreign supporters of the American 20-year charter came up for renewal, they The Fed’s unprecedented actions have cause and with its own citizens. were joined in the opposition by state produced a backlash. Its critics charge the Hamilton’s solution, based on European legislative and banking interests. If these central bank with creating the financial precedents, was to create a national or cen- interests could get rid of the central bank, crisis by keeping interest rates too low tral bank — one he already had termed the they would get rid of a competitor and a from 2001 to 2006, thereby underwrit- “Bank of the United States” — that would regulator, and they would likely get the ing the housing bubble that collapsed in create a sound currency, attract foreign US government’s banking business. It was 2007 and 2008. In recent years, possibly loans, lend money to Congress to finance a win, win, win proposition. Despite the the war effort and stimulate the growth of support of President Madison, who had the American economy. He told Morris: opposed the BUS as a congressman in Illustration titled “Run on the Union Trust The tendency of a national bank is 1791, and also that of Treasury Secretary Company,” from the October 11, 1837 to increase public and private credit. Gallatin, the BUS lost its bid for re-char- issue of Harper’s Weekly. The former gives power to the state tering by one vote in the Senate.

www.MoAF.org | Fall 2013 | FINANCIAL HISTORY 21 That was in 1811. A year later came the New York City national banks, which in War of 1812 with Great Britain, and with- that sense served as the central reserves of out a central bank the Treasury encoun- the expanding US banking system. tered a host of problems in financing the The financial , a major war. Chastened, when the war was over Collection of the Museum of American Finance embarrassment because the United States Congress chartered a second Bank of the by then had become the world’s leading United States in 1816, an enlarged ver- and most dynamic economy, revealed that sion of the first BUS. Like its predecessor, none of the substitutes for a central bank, the second BUS was an effective central or even all of them together, could prevent bank for most of the period of its 20-year or do much to alleviate such panics. In the charter. It stabilized domestic and foreign panic’s wake, Congress studied the world’s exchange rates, managed a rapid down- financial systems and determined to create sizing of the US national debt, established a new central bank, the Federal Reserve. an even larger nationwide branch network President Woodrow Wilson signed the than that of the first BUS, and presided bill late in 1913, and the Reserve Banks and

over a happy period of marked, non- Collection of the Museum of American Finance System came on stream a year later. inflationary economic growth. But such achievements were not suf- Are Central Banks a Bad Idea? ficient to placate the second BUS’s political foes, who resurrected the very same coali- Economists, like other social scientists, tion of principle (a strict construction of find it difficult, if not impossible, to rep- constitutionality) and interest (state banks licate the controlled laboratory experi- had much to gain from ridding themselves ments that foster so much progress in the of a competitor and regulator) that had natural sciences. But history can help, for been raised in 1811 debates on re-chartering it demonstrates a variety of experiences. the first BUS. The political opposition to In the case at hand, we have a country, the the second BUS had a powerful cham- © Rudy Sulgan/Corbis United States, which had three periods of pion in the popular President, Democrat The three central banks in the nation’s history central banking in its history, and a couple Andrew Jackson, who said he had long- (top to bottom): The Bank of the US, the Second of periods without a central bank. standing suspicions about banks and bank- Bank of the US and the Federal Reserve. One of the main arguments given by ing in general since he had read about the proponents of central banking is that a 1720 South Sea Bubble crisis in England. central bank can prevent financial crises Jackson’s Whig Party opposition from occurring, as well as alleviate the attempted to embarrass him before he Fed, opened for business, the United States negative economic effects of such crises if came up for re-election in 1832 by pushing was without a central bank. Attempts early they do occur. To test that hypothesis as a through Congress a bill to give the BUS in this eight-decade period to charter a natural scientist might do in a laboratory an early renewal of its federal charter, new one failed. Congress, in 1846, enacted experiment, the main requisite would be which would not expire until 1836. The a so-called “Independent Treasury System” evidence on the incidence of financial cri- bill passed both the House and the Sen- in which the government would keep its ses from the laboratory of history. ate with comfortable majorities, but the funds apart from the country’s banking The accompanying table of US financial strategy backfired when Jackson vetoed system. But over time the Treasury adopted crises from 1792 to 2007–08 provides such it in the summer of 1832. His veto failed the practice of moving its funds into banks evidence. It lists 15 financial crises over to be over-ridden by the supermajorities during financial stringencies, so the Inde- the course of US history taken from the required, and when Jackson won re-elec- pendent Treasury became something of a accounts of several reputable historical tion that fall he felt he had a mandate to substitute for a central bank. Bank clear- sources. A good scientist tries to be careful begin scuttling the second BUS well before inghouses were another such partial substi- to include evidence that works against the its charter expired in 1836. Thus came to tute; by issuing clearinghouse certifi- hypothesis he suspects has validity. Since I an end America’s second central bank. cates to their members during stringencies, suspect that central banks do indeed pre- bank reserves could be extended to meet vent or alleviate the incidence of financial Enter the Fed the public’s demands for cash. Finally, after crises, I chose the sources for the table Congress created the National Banking in part because they identify crises in From 1836, when the second BUS charter System during the Civil War, its pyramided the central-banking periods of US his- expired, to 1914 when the third BUS, the reserve system concentrated reserves in tory that are not widely considered to be

22 FINANCIAL HISTORY | Fall 2013 | www.MoAF.org US Financial Crises, 1789–2013

Year(s) Related to: 1792 in new US debt major crises. Thus, during the Fed era the 1814 British invasion and bank experience was similar, with differences in table lists crises as occurring in 1973–75, suspensions timing, to that of the United States. Finan- 1979–82 and 1982–87, even though those 1819 Postwar economic cial crises were more frequent without years are not usually regarded as periods adjustments than with a central bank. when bank failures and/or market 1837–39 Speculation in public lands, As we observe the centenary of the Fed- crashes did substantial damage to the US problems with state debts eral Reserve System, we would do well to economy. In fact, during and after the remember that one of the main theoretical 1857 Public lands, railroads recent 2007–08 crisis, it was sometimes arguments for a central bank has always remarked that the crisis was shocking in 1873 Railroads been that by acting as a part because the United States had not 1884* Brokerage house failures to other banks and financial institutions, experienced a comparable financial crisis 1890* Fallout from in such a bank can both prevent crises and since the of the 1930s. Britain alleviate their economic damage if they do Such views would exclude the three crises occur. More than two centuries of experi- 1893 Run on Treasury gold I have included. ence with and without central bank on both reserves How should we analyze and interpret sides of the Atlantic provides substantial the evidence from history? A simple first 1907 Trust company failures empirical support for that argument. pass at this is revealing. From the first 1929–33 Stock crash and bank financial crisis in 1792 to the present is a failures period of 222 years. For 140 of those years, 1973–75 OPEC and currency crises Dr. Richard Sylla, Chairman of the the country had a central bank: the first 1979–82 Double-digit inflation, LDC Museum of American Finance, is the BUS in the 20 years from 1792 to 1811; the debts, OPEC, real estate Henry Kaufman Professor of the History second BUS in the 20 years from 1817 to and farmland of Financial Institutions and Markets 1836; and the Fed for the most recent 100 and a professor of economics, entrepre- years, 1914–2013. During the 140 years of 1982–87 Real estate, stock crash, neurship and innovation at the New central banking there were seven crises, or S&L problems York University Stern School of Business. one in every 20 years on average. 2007–08 Subprime real estate loans The periods of US history without a and securitization central bank were 1812-16 (five years) and Source: Charles P. Kindleberger and Robert Sources 1837–1913 (77 years), for a total of 82 years. Z. Aliber, Manias, Panics, and Crashes (6th During those 82 years there were eight ed., 2011), Appendix A, with additional US Capie, Forrest. “Financial Crises in the UK financial crises, or one crisis every 10.25 crises not noted by Kindleberger, but noted during the 19th and 20th Centuries,” Bank­ years on average. by O.M.W. Sprague, History of Crises under historisches Archiv 47 (2009), pp. 31–42. Thus a lesson of US history is that finan- the National Banking System (1910) and Elmus Wicker, Banking Panics of the Gilded Cowen, David J. The Origins and Economic cial crises were roughly twice as frequent Age (2000) designated by *. Impact of the First Bank of the United States, when the country did not have a central 1791–1797. Garland, 2000. bank as they were when it did. If we were Hamilton, Alexander. The Papers of Alexander to exclude the three crises of the 1970s Hamilton, H. Syrett, ed. 27 volumes. Colum- and 1980s that are not widely regarded as bia University Press, 1961–87. particularly damaging — perhaps because entire period, so it would seem one is not Hammond, Bray. Banks and Politics in Amer- there was a central bank to counteract able to compare periods with and without ica, from the Revolution to the Civil War. them — then the results would be even a central bank, as we can for the United Princeton University Press, 1957. more lopsided. The central banking eras States. But Forrest Capie, the official his- would then have had five crises in 140 torian of the Bank of England, and other Sylla, Richard. “Comparing the UK and US years, or one every 28 years on average, British financial historians argue that the Financial Systems, 1790–1830,” in J. Atack instead of one every 10-plus years without Bank of England did not assume central and L. Neal, eds., The Origin and Develop- a central bank. banking responsibilities until the 1860s, ment of Financial Markets and Institutions. Is the US experience exceptional? For just before a major crisis in 1866. Cambridge University Press, 2009. the United Kingdom, the Kindleberger- Accepting that argument, the UK expe- Sylla, Richard, Robert E. Wright and David Aliber source cited in the table identifies rienced nine crises in the 73 years from J. Cowen. “Alexander Hamilton, Central 16 financial crises from 1793 to 2008, rather 1793 to 1865, or one every eight years. Banker: Crisis Management and the Lender similar to the US experience. A potential From 1866 to 2013, the UK had seven of Last Resort in the US Panic of 1792.” complication is that the UK’s central bank, crises in 148 years, or a crisis on average Business History Review 83 (Spring 2009), the Bank of England, was present for that once every 21 years. Thus the UK’s overall pp. 61–86.

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