Sunday, May 13, 2012

What Causes Economic Panics?

In  support of the Fed, Paul Krugman blogs this point:
 Apropos something I’m working on, there’s a very widespread belief on the right that banking crises only happen because either the Fed or Barney Frank cause them; go back to a gold standard, and there would be no need for financial regulation or anything like that.
This is, of course, nonsense; Walter Bagehot knew all about financial crises, which have been a constant feature of modern economies since at least the early 19th century. Just to drive the point home, I thought it might be worth posting Gary Gorton’s chart (pdf) of “panics” before the Fed went into operation:
Panics will happen; the question is how they are contained.

It should be noted that listing business cycle downturns doesn't prove that those downturns weren't caused by some type of government activity.

 Indeed, a compilation of essays written by Rothbard,  A History of Money and Banking in the United States: The Colonial Era to World War II, discusses many of the downturns listed by Krugman and points to the role of government in causing them.

This compilation has just come to my attention, so I have the book on order, but haven't read it.

But this comes from the Amazon blurb:
In what is sure to become the standard account, Rothbard traces inflations, banking panics, and money meltdowns from the Colonial Period through the mid-20th century to show how government's systematic war on sound money is the hidden force behind nearly all major economic calamities in American history.

Never has the story of money and banking been told with such rhetorical power and theoretical vigor. You will treasure this volume. 
From the introduction by Joseph Salerno: 
"Rothbard employs the Misesian approach to economic history consistently and dazzlingly throughout the volume to unravel the causes and consequences of events and institutions ranging over the course of U.S. monetary history, from the colonial times through the New Deal era. One of the important benefits of Rothbard's unique approach is that it naturally leads to an account of the development of the U.S. monetary system in terms of a compelling narrative linking human motives and plans that often-times are hidden, and devious, leading to outcomes that sometimes are tragic. And one will learn much more about monetary history from reading this exciting story than from poring over reams of statistical analysis. Although its five parts were written separately, this volume presents a relative integrated narrative, with very little overlap, that sweeps across three hundreds years of U.S. monetary history."
This tale that the business cycle is a natural occurrence, with Fed supporters pointing to downturns occurring before the establishment of the Federal Reserve is a regular occurrence. I pointed out that a Fed economist raised this point during the Q&A following my speech at the Fed.

In my recap of the speech, I wrote:
As soon as I finished my speech and to defuse the tension, I asked an immediate question as to whether the economists present believed that Austrian Theory had a legitimate case to make. The eventual response came down to the statement by a Fed economist 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) 

I suspect the Rothbard compilation advances the proof that pre-Fed downturns weren't a "natural occurrence" but the result of government interventions of one sort or another. But, I suspect more work coukd to be done to fully take this argument away from Krugman and the other Fed supporters, by covering in detail the entire banking history of the period.

Given what we know from the deductive science of economics, that business cycles are not a "natural occurrence" in the economy, but that they are the result of money printing shenanigans, what needs to be done from here is to discover and report on the money printing shenanigans of the pre-Fed United States, so that we can entirely demolish the Krugman, pro-Fed argument from this direction.


  1. From listening to Murray Rothbard's lessons I learned that fractional reserve banking was sanctioned by the government before the Fed and that the government protected the banks by suspending species payment in moments of crisis. No wonder there were business cycles.

  2. Poor Paul Krugman the Nobel Prize winner. He uses the straw man of "the Right" as a premise to his argument and it's all downhill from there.

    Paul Krugman is not an economist.

    1. Larry, I think that Krugman's strawman was that "the Fed creates business cycles." The real position that he needed to refute was that "government intervention creates business cycles" (which includes the government sanctioning fractional reserve banking, regulations, a central bank, Greenbacks, the Continental dollar etc...)

      It is possible, of course, that Krugman doesn't know the claim and was only responding to what he thought the claim was.

    2. Anon@5:50PM,

      You make some valid points. It's just that I couldn't help notice the intellectual deficiency of his use of a false paradigm at the top of his post.

  3. I'm surprised you haven't History of Money and Banking in the US Bob, its one of my favorite Rothbard books.

  4. Rothbard points to fractional reserve banking generally as the culprit for business cycle downturns. They are amplified by the cartel now more by the FED, in that all the banks inflate at the same time causing distortions throughout the economy.

  5. Economic Cycles Before the Fed

  6. A great book. Rothbard actually addresses most of the bank panics and the book by Friedman and I forget the other author's name. He talks about the wild cat banks, how most of the panics were caused by fractional reserve banking and pyramid banking. I certainly recommend it. Also the free audiobook is on itunes university through the Mises Institute. I think this book might be a long lost and under utilized weapon against the Keynesian ideologues who love to ignore the evidence. Especially important was the 1890's when the growth in the economy happened during a "recession" that although prices were falling the production in the economy was doing more than ever.

  7. Is Krugman this dumb or is he an example of pure dishonesty? I’ve known the Austrian narrative since 1973 and it has always been:

    Pre-Fed fractional reserve banking caused panics. The banksters didn’t suddenly become moral and decide to get rid of FRB. No. Instead, they created The Fed to bail them out of their FRB schemes when things went badly.

    Didn’t Rothbard write “The Panic of 1819” in 1962 when Krugman was nine years old? Didn’t offer for free chapter two of “End the Fed” back in 2009?

    The institution of fractional reserves mixes these two functions, such that warehousing becomes a source for lending. The bank loans out money that has been warehoused — and stands ready to use in checking accounts or other forms of checkable deposits — and that newly loaned money is deposited yet again in checkable deposits. It is loaned out again and deposited, with each depositor treating the loan money as an asset on the books.

    We’ve won. The debate is over. Our opponents have nothing left to offer but the throwing of sand into the gears of debate via obfuscation and outright dishonesty.

  8. What is interesting is how little these proponents of a "wide open unregulated market caused cycles" like krugman claim is that there were extreme regulations placed on banks in the 1800s. For one thing, branch banking regulations often meant a bank could have one or just a very few branches for an entire state. This meant one disaster or regional issue could and did bankrupt the bank because it was unable to diversify with a lot of branches. Branches were also typically granted for each specific state, not across the board to further diversify.

    Lastly, state governments often required banks to purchase the equivalent of junk bonds in the form of state and local govt bonds just to exist, which of course led to econ disaster. As much as he can be obnoxious at times like in dealing with murray rothbard vs friedman, george selgin actually has put out some good material on this very issue.

    And then we have what Tom Woods has referenced, that Obama's own economist took a look at the 1873 stuff that is commonly cited and determined that there actually was no crisis. Deflation took place, but that was because of huge gain in productivity (sort of like computers since the 90s), not a lack of demand.

  9. Bob,
    Having read Rothbard's book, I can say with confidence that it is a beautiful deconstruction of every banking panic and economic crisis until WW2 into their root causes. Reading the book left me with little doubt that the panics were artifacts of extremely short-sighted government monetary policy. The book even demonstrates that certain supposed depressions of the 19th century were not depressions at all. In some cases modern economic "scholars" simply assume that times were bad based on statistics that showed price deflation and/or a falling money supply, when in fact real incomes were rising substantIally. It's one of my favorite books by any economist.


  11. It seems to me that "it was the Fed" is not the correct cause, but that fractional reserve banking is actually the cause of panics by way of currency manipulation--the Fed just being a crutch of fractional reserve banking. There was, of course, fractional reserve banking in the the days before the Fed.

  12. 90% of that fight is explaining how fractional reserve banking causes the underlying imbalance between savings and investment.
    The definitive work on that subject:

  13. Kruggie published my comment:

    1. Man, major finger slip. After reading that comment, it's pretty obvious Krugman was trying to press the reject button.

  14. If you thought this post was good, please read his updated follow up where he shows data that describes much worse post fed recessions. Then he says today is worse than 1907, but "not that much worse" .... meanwhile his own estimates are that todays "not that much worse" numbers are 50% worse. I feel like I'm taking crazy pills.

  15. I think the real argument to be made here isn't that there were "panics" before the Fed was created, but that they continued after the Fed was created, even though avoiding "panics" was one of the main justifications of the Fed.

    1929 and 2008 were very much worse than anything before 1913. Ergo, the idea that the Fed could prevent these was proven false.

  16. If Krugman were to pull this kind of dishonesty as an attorney arguing before tribunal, he would arguably be sanctioned for unethical behavior. This New York rule is generally the same in all states.

    New York Rules of Professional Conduct Rule 3.3

    Conduct Before a Tribunal

    (a) A lawyer shall not knowingly:

    (1) make a false statement of fact or law to a tribunal or fail to correct a false statement of material fact or law previously made to the tribunal by the lawyer;

    (2) fail to disclose to the tribunal controlling legal authority known to the lawyer to be directly adverse to the position of the client and not disclosed by opposing counsel;

  17. The pre-Fed banking panics were caused by government-PROPPED-UP fractional-reserve banking. Also, we must remember that the U.S. government and the state governments intervened heavily in the banking industry in the nineteenth century. Artificial monetary expansion was caused by the quasi-central banks -- the first and second banks of the United States -- as well as government-run banks at the state level.

    In nineteenth-century America, there was no "unregulated" banking industry, and it is absurd to claim there was. In fact, Canada's government intervened far less in its banking industry in the nineteenth century, and what was the result? No panics.

  18. I have read Rothbard's book. Another I want to read is Lane's book "Money and Banking in Medieval and Renaissance Venice"

  19. " Apropos something I’m working on, there’s a very widespread belief on the right that banking crises only happen because either the Fed or Barney Frank cause them; go back to a gold standard, and there would be no need for financial regulation or anything like that."

    Krugman is responding to an argument that no one is making. This is a classic Krugman strawman. That somehow if he can show banking crises occurred during an era when the Fed didn't exist, it just justifies somehow the existence of the Fed or against the gold standard.

    An easy response to Krugman would be to say something very simple: "bank runs do not concern banks that are well-capitalized." Though the Fed can provide liquidity in a time of crisis, the capital shortfall remains. The Fed is simply providing liquidity until the demand for cash subsidizes.

  20. Rothbard's book is free on-line. Just downloaded it to Kindle.

  21. Surprisingly, I learned about the wild cat banks of the 1800's and how they blew up due to goberment regulations (among other things discussed here) way back in the 9th grade in a public school! Learned about crony capitalism too.

    Yeesh. Did Krugman and his co-horts skip 9th grade history class or were they just not taught history?

    Now if the info in this thread was nicely woven into one article that would be cool.

  22. For the entire era that Kruggy is referencing, America was under a NATIONAL BANKING SYSTEM, which replaced the decentralized (though still not completely free market) system of 1836-1861. The national banking system was enacted by Republicans during the Civil War, as I hear those guys were big on centralizing things.

    What is really amusing is that Kruggy hasn't gotten the news on the so-called "Long Depression", which was not only refuted by Rothbard but by many recent ecnometricians as well. There was a brief recession in 1873, followed by a decade of phenomenal and sustained growth.

    Kruggy is a very poor economist.

  23. If you want to have your mind really fried when you get done with Rothbard's book, check out "A Short History of Paper Money and Banking in the United States" by economic observer and hard money advocate William M. Gouge, which was written in--get this--1833. It doesn't include everything the later works do but what it gets right it gets spectacularly so. There are passages where you can't tell him from Rothbard.

    I am continually amazed, when pondering works like Mises' "Theory of Money and Credit" and "Socialism" that the answers have been out there for over a century now, and they are steadfastly ignored.

    The truth is that some people have always seen things for what they are. Doubtless there are observers who correctly warned against the Roman debasements for the correct reasons.