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The Panic of 1907

23 Dec 2008


This book is very well done–academic enough to satisfy my need for information, and enough flair of the characters involved to make a good yarn. It traces the banking panic of 1907, in which a few New York banks failed and caused a worldwide run on some institutions. It’s the proximate cause of the creation of the federal reserve.

The book is important to free-marketers such as myself, as it shows that a world without a fed was not a rosy place. Bank failures and panics were common, especially before the fed, and this one, in particular, was handled by JP Morgan, who basically acted as the Fed. He put up enough of his own money, and more or less coerced the other banks and trusts to put up enough of their money, to save the system as a whole.

The story is the usual: a proximate cause, a credit bubble, and everyone wants their money at once. Some interesting points arise, however.

First, there’s a lot of problems in a world where everyone has a central bank but you. One proximate cause of this run was the Bank of England’s banning of American finance bills, which were paper that was exchanged for gold in London and brought to America and later converted back into dollars by selling pounds. This was essentially arbitrage against seasonal weaknesses of currencies, and harmless, but the BoE banned it in 1907 and the result was a shortage of money in the states (and an artificially strong pound). One can imagine how difficult it would be for an American bank to compete in such an environment.

The authors do a survey of literature and attempt to discuss what causes bank panics in the last third of the book. It’s pretty striking how detached from reality most of the economics on this is. None address the issue that it’s completely rational to try and get your money out of a bank in a hurry at the first sign of trouble: everyone knows it only has a small percentage of funds on hand. Instead, economists seem to believe that if everyone just behaved, it would all be okay. There are serious epistemological problems with a field that can believe a large-scale game of spanish prisoner will not be subject to occasional panic. This is to say nothing of the fact that banks all borrow short and lend long. In an equilibrium–what economists love to talk about but is impossible to achieve–this would be fine. But since life changes, this will simply fail every so often. Big surprise.

Austrians love to hate fractional reserve banking and the fed, and I’m generally with them. The fed has had a century to prove that it hasn’t really helped a lick in dealing with the evil business cycle, and even if things sucked before it, it’s time to get rid of it. But it’s still important to remember why the fed came about in the first place. Combatively low interest rates by central banks make for a much more elegant and understated form of economic warfare, and we know how governments like war. Still, if I ran a country, I’d turn out my central bank overnight. My currency would appreciate a hundredfold overnight and my citizens would enjoy a dramatically improved standard of living. If the rest of the world wants to be so clever as to debase their currencies so that my people can take all of their useful goods, who am I to tell them no?