1

US: 1933

UK: 2007

The great panics of American history

1819

• Speculation in railroads and land was the tech boom-and-bust of the 19th century. In 1819, at the end of several prosperous years known as the "era of good feelings," a large number of Americans were invested in a land boom that had seen prices of frontier lands skyrocket. Numerous "wildcat" banks had opened in order to finance loans for these purchases. When the Bank of the United States called in these loans, the land boom collapsed, leading to a sudden drop in prices and thousands of foreclosures. The resulting collapse was soon named the Panic of 1819.

1837

• In 1837, at the beginning of Martin Van Buren's presidency, the country was in a get-rich-quick frenzy. Land speculation was again rampant, but this time wildcat banks lent money for the purchase of shares in canal companies, railroad companies and even slaves. British banks—among the primary lenders to those shaky wildcat banks—called in some loans, triggering a near-complete meltdown of the American financial system. People sold land for any price they could, and banks seized assets indiscriminately before they too went bankrupt. Van Buren, trying to stay above the panic, declared that it was not the role of the federal government to aid investors in distress. His laissez-faire attitude alienated his own party, and he slunk away from office in 1841.

1857

• Unlike the previous two panics, the Panic of 1857 was triggered by the influx of hard currency, in this case gold from the California gold rush. The discovery of significant amounts of gold had led to an inflated currency, which in turn facilitated speculation in land and railroads. When the New York branch of the Ohio Life and Trust Company failed, it sparked a reaction that led to the bankruptcy of nearly 5,000 businesses. [Note that there were thousands of different kinds of currencies under “wildcat banking” of this era.]

Discount on Distant Notes in NYC in 1857

Panic here

= suspension

Security Prices in Panic of 1857

1873

• The Panic of 1873, during the disastrously corrupt and inept administration of Ulysses Grant, followed a now-familiar pattern of over-speculation in highly risky investments. Again, western lands and railroads were the prime culprits. Like previous panics, 1873 was marked by bank failures, because banks were heavily exposed in these speculative investments and they rarely had sufficient deposits to manage the demand for withdrawals during periods of panic. In 1873, the bank of Jay Cooke and Company collapsed, and in its wake, another 5,000 businesses went under.

1893

• The Panic of 1893 began as a stock market panic. It started in February, when rumor spread of the collapse of the Philadelphia and Reading Railroad, leading investors to dump more than one million shares of the company in one afternoon. That set off a chain reaction, as people fled from stocks and tried to lock up their assets in more stable investments such as gold. As U.S. gold reserves were siphoned away, business confidence all but disappeared, and in early May the market collapsed. By the end of 1893, nearly 20,000 businesses had closed their doors, millions were out of work and armies of unemployed workers had descended on Washington demanding food and aid.

1907

• The Panic of 1907 was more sedate, but the country came close to a financial meltdown. Known as "the rich man's panic," the 1907 crisis was largely centered on the stock and international currency markets. Once again, stock investors began to dump shares en masse, but there was insufficient currency to meet their demands for safe investments. Led by the legendary J. P. Morgan, a consortium of businessmen convinced the secretary of the U.S. Treasury to deposit $25 million in New York banks. Morgan and his group then raised $100 million more in gold from Europe. This was a rich man’s private central bank used to defend the dollar on the gold standard. [Note: the US currency operated under the Gold Standard, in which currency was convertible into gold at a fixed rate.

Details of the Panic in 1907Basic data mid-1907 Stock

[millions] Gold cover

Gold $1,466Silver 441High-powered money 2,818 52%M2 11,552 13%

- October 14: some banks required assistance- October 21: Knickerbocker Trust balances down- October 22: Knickerbocker Trust suspended payments, followed by runs

on other trust companies- October 24: Treasury deposited $25 million; Morgan and others round

up money.- October 28: NY banks suspended convertibility of D into Cu (G). - Interest rates soared (call loans up to 100 % per annum)- Currency went to a premium of up to 4 percent over deposits.- High interest rates plus premium of Cu led to gold inflows, increasing H.- Restrictions lifted in Jan 1908.- Business cycle peak in May 1907, trough in June 1908: lagged crisis by

6-9 months

Currency Premium in 1907

Cycles, Panics, and Bank Runs

Bank runs and panics were endemic in American capitalism from 1812 to 1933.Definition of panic:

A panic occurs when bank debt holders (depositors) at all or many banks in the banking system suddenly demand that their banks convert their debt claims into cash (at par) to such an extent that banks cannot jointly honor these demands and suspend convertibility.

Frequency:– six before 1865– seven during the National Banking era (1865-1914)– five during the Great Depression (1929-33)– no major panic since 1933

Financial crises are always based on three factors

1. The banking and financial system “create liquidity” – transform illiquid assets into liquid liabilities.*

2. Banks do not have sufficient liquid assets to “back” all their liquid claims (see next slide)

3. The banks promise to redeem liabilities at fixed prices or exchange rates (dollar for dollar)

Therefore, when the public attempts a “flight to safety,” there is a crisis because of a shortage of illiquid assets and the requirement to maintain fixed exchange rates

*Liquid means that you can convert an asset into the medium of exchange (money, gold) at its “fundamental” value quickly without loss of value. (PW gymnasium v. Treasury bond)

Balance Sheet of Commercial Banks

Assets Liabilities

Reserves 59.5

Checkable deposits 568

Loans 6108Savings accounts 5544

Securities and other 4025.5 Other 4103

NW -22

Total 10193 Total 10193

Locally stable; globally unstable

Small shock

Large shock

Three equilibria

Some Issues to Consider• Multiple equilibria: Non-linear systems often

have multiple equilibria– Have “good equilibrium” and “bad equilibrium”

(panic)– Many similar situations (honest or dishonest culture,

segregation, snowball earth, dead v. alive, …)

• Unstable dynamics. With multiple equilibria, often have unstable dynamics and “tipping points”– Bad news or rumor (war fever, subprime mess) leads

to bank run, panic, and bad equilibrium– High-sigma stress can topple a system (World Trade

Towers, New Orleans levees)– Epidemics, riots, technology adoption.

Diamond-Dybvig model of bank runs

1. Productive investments are fundamentally “illiquid”

2. The role of banks and the financial system is to “create money” or “liquidity” by turning illiquid assets into liquid assets.

3. Bank runs force liquidation of productive assets at below long-term value.

Example of illiquid asset: forest

• Take as example my forest with its timber assets.• The value of my timber is the volume of its trees.• Cutting early reduces present value of asset.

Volume of timber as function of age

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20

40

60

80

100

120

0 10 20 30 40 50 60 70 80 90 100

Age (years)

Vo

lum

e

Basic Runs Theory• Banks have liquid assets (G) and illiquid assets (K), might be

timber assets or mortgages.• Bank balance sheet is A = G + K; L = D + NW. NW very small.• During normal times, G = (convertible gold or dollars) is sufficient

to service random flows of deposits.• However, suppose that there are shocks:

– fundamental shocks such as forest fires– psychological shocks such as rumor of forest fires.

• Then depositors will fear that the bank cannot redeem their deposits.

• Depositors “run” to the banks and try to redeem D > G.• Banks then liquidate forests, but the short-term value (= qK) is

less than fundamental value (trees are small and have little timber).

• q = liquidation value of timber or other illiquid bank assets• So the depositors get G+qK, which is less than par value, and the

run is a self-fulfilling destruction of value.

Bank Assets (G, K, qK)

Market value of bank assets in good times

45o

G K

G+K

Bank Assets (G, K, qK)

Market value of bank assets in bad times (q = liquidation ratio < 1)

45o

G K

D=G+qK

qK

D=G+K

Loss fromIlliquidity

Bank Assets (G, K, qK)

Different regions

45o

G

Loss fromIlliquidity

K

D=G+qK

qK

D=G+K

Region A: D>K. Bank insolvent.

Region B: qK<D<K. Bank solvent in good times but illiquid and fails in panic.

Region C: D<qK. Bank always ok.

Generality of Analysis• Banks in early banking systems with fractional reserves• Banks under Federal Reserve before deposit guarantees• All financial institutions on uninsured deposits

– large banks in 1980s– Long Term Capital Management in 1998

• Countries maintaining fixed exchange rates (because $ assets less than domestic current liabilities)– Again and again and again– Most recent example was Argentina in 2002

• Incipient panic in August/Sept 2007

•  Bagehot on panics (Lombard Street):

“A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready … to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.”

• Bagehot rule for panics:

“Very large loans at very high rates are the best remedy for the worst malady of the money market…. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness.”

• Generally, governments guarantee small bank deposits (< $100,000). But large deposits and non-bank liabilities (e.g., mortgages) are not guaranteed. – This stabilizes against panic of “little guys.”

• Modern central bank wants to ensure solvent banks do not go bankrupt because of liquidity crisis, but do not bail out insolvent banks. – An unwritten rule is that some financial institutions are

“too big to fail,” i.e., the central bank will prevent their bankruptcy.

• The current question is: When we see runs on non-bank financial institutions, such as Long-term Capital Management (1987), Countrywide (US, 2007), Northern Rock (UK, 2007), should central bank serve as “lender of last resort.” – What to do about runs on non-bank runs (including runs

on countries) is the biggest unsolved problem of modern central banking!

Modern bank runs: foreign exchange

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1.0

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94 95 96 97 98 99 00 01 02

US$ price of Argentine peso

Bank run and Argentina’scurrency board ran out ofUS dollars, floating currency.

Heard, “The Bulls and Bears in the Market,” 1879, NYHS