Before The Fed: JP Morgan & The Panic of 1907- Risk & Government Intervention, Part 2

On Monday, I wrote this post, the first of the series focusing on poor financial sector risk management and government intervention.


Recently, I've been reading about JP Morgan's role as the orchestrator of a resolution of the Panic of 1907.

This website discusses some of the details of that Panic. The author, Fred Foldvary, teaches economics at the University of Santa Clara. Written in May of 2007, well before the first shot of the 2008 financial crisis, which was the failure of two Bear Stearns funds which invested in CDOs.

Salient passages from his piece on the Panic of 1907 include,


"One hundred years ago, there was a financial panic in the United States. There were runs on the banks as depositors rushed to take out their money before they ran out of currency. The stock market dropped to half its peak 1906 average.

The financial crisis began in New York City, home of most of the financial “trust” companies. The panic induced Congress to create the Federal Reserve System (the “Fed”) in 1913 to prevent any more such financial crises. But the Fed failed to prevent the even worse bank failures of the Great Depression.

The fundamental causes of the Panic of 1907 were the flawed monetary and fiscal systems of the United States. The federal government’s control of the money during and after the Civil War created a rigid money supply that did not respond to the demand for money. During that era, agriculture dominated the economy, and the inflexible money supply created a crunch and a spike up in interest rates whenever farmers and others need to borrow funds.

Federal taxes fell mostly on the sale of goods, with high tariffs and excise taxes on goods. The great expansion of state-subsidized infrastructure such as canals, railroads, and highways, along with other government services, pumped up land values, subsidizing land ownership. Economic booms were accompanied with land speculation as land values rose, and the speculation was financed with borrowed money. Real estate was a major asset of companies such as the railroads, whose shares rose in value as real estate prices escalated, and speculators also borrowed to buy the shares of stock. The stock market bubble rested on the real estate bubble, and then high interest rates and high real estate prices dried up investment, causing a recession and fall in stock market shares, resulting in bank failures as loans turned bad. Depositors would then panic and rush to take out their money.

The same story happened again and again, but after 18 years, new speculators had no experience with the previous panic, and older investors kept hoping to recover past losses and make a killing before the crash. The establishment of the Fed did create a more flexible money supply, as the Fed can expand the money without limit. Federal deposit insurance, starting in 1933, ended bank panics, but this only shifted the financial risks to the government and thus to taxpayers and bond owners. The fundamental policy of federal control of the money remained, and the fiscal system of taxing production while subsidizing land value also has remained.

The Panic of 1907 shook confidence in the U.S. financial system, but the people and the government officials learned the wrong lessons. The problem with the banking system was the federal control of the money supply, and the effective remedy would have been free market banking, where the banks and other private firms would issue private currency backed by gold. With competitive banking, the private bank notes and deposited funds would expand flexibly in accord with the demand for money and borrowing, while the redemption into gold would prevent inflation. That is how the Scottish free banking system worked previously. But instead, Congress moved towards greater federal control of money and banking, a policy which failed to prevent the Great Depression and which led to the continuous inflation since World War II and also to more recessions.

The effective policy to end panics and depressions is free banking and land-value tappation, the tapping of land value and rent for public revenue, which would prevent speculative excess. The institutional details are different today than one hundred years ago, but the fundamental structural causes of depression have not changed. The current real estate boom has peaked out, and with much of financial collateral based on real estate loans, the economy is headed towards the same end, a crash. This time, rather than a panic focused on financial institutions, federal policies have spread the risk to the entire economy, so the next crash will be much worse than the brief panic of 1907, and this time, a clique of bankers will not save us."

Foldvary points out that the creation of the Fed didn't remove any risk from the US financial system. It simply allowed the federal government to occasionally shift risk from the private sector to all taxpayers.

Again, we see how risk is conserved, never eliminated, when assets are simply sold or insured.

Further, I think it's noteworthy that Morgan's role as the ramrod among fellow financiers resulted in both contribution of capital by all parties, as well as the elimination of some banking houses. Foldvary doesn't provide details, but other sources you can Google on the subject do.

Here are the points I wish to make.

In the Panic of 1907, informed participants in the financial markets moved to clean up the mess. Being involved in the business, they had intimate knowledge of who should fail, what should be shored up, and how much money it would take. Their realization that further delay or failure to resolve the crisis might cause all of them more losses motivated them to resolution in the most efficient manner they could devise.

Somehow, without a Fed, printing more money, quantitative easing, or the federal government buying mortgages, the US and its economy managed to survive and prosper.

In 2008, just over one hundred years later, with a functioning Fed, the crisis that actually began in mid-2007 still isn't over. The Fed still has enormous amounts of private financial instruments on its balance sheet. It has printed billions of dollars, though for exactly what, has yet to be explained.

Rather than guide weak financial institutions to failure, the Fed and Treasury intervened to prop up failed banking managements and models. As a result, many inept management teams continue to populate the financial sector.

Additionally, despite 100 years of government oversight of the financial sector, the creation of the Fed, hundreds of rules and many regulatory agencies, the very same causes of financial panic which humans created in 1907 reappeared in 2007-08.

Does this not point out the futility of regulation which claims to reassure and insure the public against their own, innate behaviors? And didn't this regulation basically fail to avoid the same sort of crisis which occurred a century ago?

Rather than heavy-up regulatory oversight and further complicate operations of the financial sector, maybe it's time we admitted that natural human behaviors in a free society will lead to occasional panics. Central banks can't eliminate them. And the financial risks created on the way to panics can't be magically eliminated by a federal government or central bank, either.

Perhaps the best we can do is to magnify the penalties of excessive risk taking by making institutional failure the clear outcome. After setting margin requirements for loans and leverage, I think the best government can do is to oversee those simple safeguards, then get out of the way, and let those who imprudently take risks suffer the consequences.

That includes those who unwisely choose counterparties which fail, e.g., Goldman Sachs. Or banks which overpay for mortgage finance companies, e.g., Wachovia and BofA. Or mismanaged behemoths, e.g., Citigroup.

Our financial system survived prior panics in which the weak and inept were not saved. Why would it be any different today?