Wednesday, May 23, 2012

Nine Paragraphs that will Help You Understand the Financial Panics of 1873, 1884 1893, and 1907

During the Q&A period following my speech at the New York Federal Reserve, a Federal Reserve economist suggested that business cycles in the United States were much more severe before the Federal Reserve came into existence.

I commented on this in a summary of the Q&A this way:
...a Fed economist [stated] that there had been worse crashes in the economy before the start of the Fed. (Side note, this is a regular argument used by those supporting the Fed, they will claim that crises were worse before the Fed. I have seen fragmented work demolishing this view, but I think there is the opportunity for some economics student to delve into the pre-Fed period in America and delve into the crashes from an Austrian business cycle viewpoint and point out clearly how government was involved in such crises, if they were--which I suspect they were. Such a study would be extremely valuable in knocking a peg out from under the Fed supporters who attempt to justify the Fed by this argument)
Since, I wrote this an annonymous commenter here at EPJ has pointed me to Murray Rothbard's A History of Money and Banking in the United States.

I ordered the book and just received it. A quick perusal of the book gives me the sense that the amazing Rothbard did somehow find the time to study and report on the early history of banking in America. I'll provide a full review of the book once I finish reading it.

That said, I want to point to an important quick summary  of 19th & 20th century  pre-Federal Reserve banking, written up by  Joe Salerno at The Circle Bastiat at If you want to understand this pre-Fed banking period  in nine paragraphs, read this:

2.98 Cheers for Bob Murphy

Kudos to Bob Murphy for his incisive exposé and demolition of Krugman’s statistical legerdemain in today’s Mises Daily.  It is not only an enlightening piece but also a delightful read.
I have one small but obtrusive nit to pick with Bob, however.  Bob links to a blog post by Steve Horwitz, which he praises as “a good job explaining why Krugman’s understanding of US banking history is flawed, because we didn’t have laissez-faire banking in the late 1800s.”  Clicking on the link I found that Horwitz started out promising enough, arguing, contra Krugman, that late 19th-century America “was emphatically not a land of minimal government in banking” and that “the federal and state governments played a huge role in the banking industry and it was those regulations that  were responsible for the pre-Fed panics.”  I was excited to read more, but then my heart sank when Horwitz listed the two “most relevant regulations” in generating these panics as:
 1) the prohibition on interstate banking, which created overly small and undiversified banks that were highly prone to failure; and 2) the requirement that federally chartered banks back their currency with purchases of US government bonds, which made it prohibitively expensive to issue more currency when the demand rose, leading to the currency shortages and resulting panics that culminated in the Panic of 1907.
Huh?  These regulations were of almost no significance in causing the cyclical booms that culminated in the Panics of 1873, 1884 1893, and 1907.  Horwitz never mentions the underlying cause of these cyclical fluctuations: the establishment of a quasi-central banking cartel among seven privileged New York banks resulting in the almost complete centralization of U.S. gold reserves in their vaults by the National Bank acts of 1863-1864.  This New York City banking cartel was able to expand willy nilly the monetary base and the overall money supply by expanding their own  notes and deposits on top of gold reserves.   Their notes and deposits were then used as reserves by lower tier banks (Reserve City Banks and Country Banks) on which  to  pyramid their own notes and deposits. This is well understood even by mainstream monetary historians.  For example,  John J. Klein (Money and the Economy, 2nd ed., 1970, pp. 145-46) pointed out:
The financial panics of 1873, 1884, 1893, and 1907 were in large part an outgrowth of . . . reserve pyramiding and excessive deposit creation by reserve city and central city [New York City] banks.  These panics were triggered by the currency drains that took place in periods of relative prosperity when banks were loaned up.
Moreover, banks, especially the larger ones, were encouraged in their inflationary credit creation by the firmly entrenched expectation that they would be freed from fulfilling their contractual obligations in times of difficulty by the legal suspensions of cash payments to their depositors and note-holders that recurred during panics throughout the 19th century.  In addition, under the National Banking system,  the New York banking cartel had formed the New York Clearing House which was empowered to issue euphemistically designated “clearing house certificates.”  These were in essence extra bank reserves that were created out of thin air to bail out errant banks during panics.  Ludwig von Mises identified these cartel certificates as an inspiration for the formation of the later Federal Reserve System as a lender of last resort to over-expanded banks, a function that introduced moral hazard into the banking system.  Commenting on the intentions of the advocates of a central bank for the U.S., Mises wrote (p. 126)  in 1928:
Among the reasons leading to the significant revision of the American banking system [i.e., the Federal Reserve Act of 1913], the most important was the belief that provisions must be made for times of crisis.  In other words, just as the  emergency institution of Clearing House Certificates was able to save expanding banks so should technical expedients be used to prevent the breakdown of the banks and bankers whose conduct had led to the crisis.  It was usually considered especially important to shield the banks which expanded circulation credit from the consequences of their conduct.
Horwitz seems to imply that the panics were  isolated events that were somehow caused by sudden monetary stringency when in fact the very opposite was true.  As Rothbard shows in his masterful discussion of the National Banking era in A History of Money and Banking in the United States (pp. 132-79), every panic was preceded by an expansion of the money supply. And during the panic of 1873, there was no contraction of the money supply, while there was a very mild one in 1884. 


  1. I would also recommend these two papers for a comparison of pre to post fed economic performance.

  2. That is one great book! I don't remember if that's book where he mentions the Suffolk Bank, but it's certainly worth researching if not..

  3. What about Friedman and Schwartz's A Monetary History of the United States, 1867-1960?

  4. It always seems to come back to Rothbard.
    What a little GIANT!

  5. The Coming Battle: A Complete History of the National Banking Money Power in the United States (1899)

  6. Wow, I knew there was some work done regarding financial panics in the 19th century, but I had no idea it was this extensive. As Bob Roddis pointed out, the Austrians have already won.

    1. How does one battle cognitive dissonance? The more someone's beliefs are challenged, the stronger their beliefs.

    2. Eh, weak. Neither you nor him presented logic.