The Slumps That Shaped Modern Finance (Digest Summary)

Crises have shaped the financial industry through the ages. The author talks about five historical crises and the roles each has played in shaping today’s financial industry. The crises also provide regulators with guidance on how to handle future crises.

In 1792, Alexander Hamilton, the first Treasury secretary of the United States, wanted to build a sophisticated financial system like those in England or Holland. He began by creating the United States’ first central bank. Significantly larger than any other bank, it started extending large amounts of credit, spurring speculation in short sales and futures contracts. In March 1792, a decline in hard currency led to a 25% cut in lending. This sharp decline in credit caused a market crash and slowed the economy. Fearing a prolonged crisis, Hamilton successfully arranged the first US bailout. Legislators banned public futures trading to protect investors, in response to which 24 traders met on Wall Street to start their own private trading club that eventually became the New York Stock Exchange.

In the early 1800s, new countries were formed in Latin America. England was booming because of strong exports and had displaced Amsterdam as Europe’s leading financial hub. Cash-rich Britons eagerly bought government bonds issued by the new Latin American countries, along with shares of English mining firms that planned to mine the new area. But these countries were far away and not well capitalized. In addition, investors did not carry out sufficient due diligence and made unrealistic assumptions. Once the risks became clear, financial panic ensued. In 1826, more than 10% of the banks in England and Wales failed. The Bank of England lifted the restriction on banks having a maximum of six partners, leading the way to the creation of larger financial institutions.

The 1857 crisis could be considered the first global crisis, spreading more widely because of the formation of new economic links as a result of the growth in trade. The United States’ trade deficit increased mainly as a result of imports from the United Kingdom, which, in turn, invested its surplus in US assets—particularly in speculative railroad shares. “Discount houses,” a new type of lender that kept cash reserves at a minimum because of the perceived guarantee from the Bank of England as a lender of last resort, emerged in England. In early 1857, railroad shares started to decline, quickly affecting banks and spreading to stock brokers and merchants who traded with the United States. Banks refused to pay depositors their funds, and the financial system failed in the United States and Europe. In England, troops were needed to calm the crowds. The Bank of England refused to bail out the failing discount houses, thus taking away the implicit state backing. After this crisis, England enjoyed 50 years of financial calm as a result of increased financial discipline.

At the start of the 20th century, the United States implemented a decentralized system without a lender of last resort. The number of banks grew significantly after the Civil War, including a new type of bank called a “trust company.” Initially created to hold clients’ investments, trust companies also branched out into lending. With lower capital requirements, less regulation, and higher interest rates paid, they attracted a lot of money, and in 1907, they were almost as big as the national banks. One of the largest trust companies, the Knickerbocker Trust Company, became involved in a scandal that led to depositors demanding their money. The trust paid out $8 million in one day but had to refuse some depositors, which set off a panic and bank runs across the country. The $25 million bailout organized by James Pierpont Morgan was not enough. As banks closed and states declared emergency holidays, the nation faced a shortage of money; substitutes in the form of checks and small denomination IOUs totaling close to $500 million began to circulate. The substitute “money” worked to end the downward spiral. In 1913, the Federal Reserve Board was created as a lender of last resort.

The United States prospered in the 1920s, with the stock market booming along with the economy, but it started to decouple in the late 1920s. In 1928, the Fed decided to increase rates to curb stock speculation. The increased rates softened economic growth, which was damaging for domestic industries, but share prices continued to rise. In October 1929, the stock market crashed, driving the Dow Jones down by 25% in two days and 45% in two months. The number of US bank failures was significant—nearly 11,000 banks failing between 1929 and 1933. In 1933, the Fed refused to act as a lender of last resort but supplied $1 billion of public capital to 6,000 of the remaining 14,000 banks, and new regulation and agencies were created, including the Federal Deposit Insurance Corporation, to help neutralize risks and protect depositors.

The modern financial system is not what Hamilton had in mind. In fact, it is the opposite. He wanted to create a system of banks and markets supporting public debt, but now it is the government’s job to ensure that the financial system is stable. This system creates a distorting subsidy at the heart of capitalism. The recent fate of the largest banks in the United States and United Kingdom shows the true cost of this subsidy. The bailout of Citigroup and RBS was more than $100 billion. And the overall cost of the banking crisis is even greater in the form of slower growth, higher debt, and poorer employment prospects that may last for decades in some countries.