Bryan Caplan  

How Banking Panics Worked Before the Fed

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Who Fails to Comprehend?... Mankiw, Tyler, and Me...

Princeton has re-released Friedman and Schwartz's The Great Contraction. Ben Bernanke's speech in honor of Friedman's 90th birthday is now the book's epilogue. The highlight, for me, is Bernanke explaining how banks dealt with panics before the Fed existed:

Before the creation of the Federal Reserve, Friedman and Schwartz noted, bank panics were typically handled by banks themselves--for example, through urban consortiums of private banks called clearinghouses. If a run on one or more banks in a city began, the clearinghouse might declare a suspension of payments, meaning that, temporarily, deposits would not be convertible into cash. Larger, stronger banks would then take the lead, first, in determining that the banks under attack were in fact fundamentally solvent, and second, in lending cash to those banks that needed to meet withdrawals. Though not an entirely satisfactory solution--the suspension of payments for several weeks was a significant hardship for the public--the system of suspension of payments usually prevented local banking panics from spreading or persisting...
The Fed was created, of course, to improve upon this system. But after pushing aside the market's traditional response to financial crisis, the Fed proved unable to equal it:
It was in large part to improve the management of banking panics that the Federal Reserve was created in 1913. However, as Friedman and Schwartz discuss in some detail, in the early 1930s the Federal Reserve did not serve that function... At the same time, the large banks--which would have intervened before the founding of the Fed--felt that protecting their smaller brethren was no longer their responsibility. Indeed, since the large banks felt confident that the Fed would protect them if necessary, the weeding out of small competitors was a positive good, from their point of view.
Just to be clear, Bernanke isn't just explaining the Friedman-Schwartz view; he's endorsing it with a few caveats.

One point I wish Bernanke made: The U.S. banking system's "not entirely satisfactory" approach to crisis operated under a major handicap: The branch banking laws. Until then 1990s, an array of state and local regulations prevented banks from geographically diversifying. As a result, the U.S. banking system was unusually vulnerable to regional economic shocks. Thus, even without the benefit of hindsight, the creation of the Fed was poorly conceived. If Americans wanted to increase the stability of their banking system, they could simply have abolished the laws that made it so unstable.


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COMMENTS (7 to date)
Steve Horwitz writes:

I addressed precisely this set of issues in my early work on the origins of the Fed and the problems of the National Banking System. For example: “Competitive Currencies, Legal Restrictions, and the Origins of the Fed: Some Evidence from the Panic of 1907,” Southern Economic Journal, 56 (3), January 1990, pp. 639-49.

I also make the argument that this system worked pretty well.

Bryan is also quite right about the important role of limits on branch banking. They are a primary reason that while thousands of US banks were failing during the early 30s, Canada saw only 1 bank failure during the whole period of the 20s and 30s. Canada allowed nationwide banking. Yes, branches closed, but only one bank actually failed.

dearieme writes:

Just yesterday in Britain it was announced that the biggest of our Building Societies (i.e. "thrifts" or "mutuals"), the Nationwide, is doing a rescue takeover of two smaller ones, the Derbyshire and the Cheshire. Could there be a clue in those names?

David J. Balan writes:

Does Bernanke think that the Fed should be abolished?

David writes:

Canada had no central bank during the Great Depression, but it did have extensive branch banking. Consequently, not one of its banks shut down during that time.

Bryan Caplan writes:
David J. Balan writes:

Does Bernanke think that the Fed should be abolished?

Of course not, David! :-) As I wrote a while back:
Bernanke is admittedly a mainstream economist - and I'm not.
Steve Roth writes:

Bryan: "after pushing aside the market's traditional response to financial crisis, the Fed proved unable to equal it."

This displays and perpetuates the fundamental logical flaw of the Friedman-inspired Depression narrative.

In The Great Contraction he asserts that the Fed should have loosened monetary policy. (From our current perspective--to quote my 15-year-old daughter--"no duh.")

But he implies, there and elsewhere--without actually saying it--that if there had been no Fed, there would have been no Great Depression, or it would have ended much sooner.

This post is just the latest continuation of that logical non-sequitur.

The fed wasn't "unable" to respond. It responded badly by hewing to the "creative destruction" orthodoxy. Friedman stipulates to this.

If it had responded well (doing basically what it's been doing this time--which no private "consortium" could or would have done--tragedy of the commons and all that), the Great Depression would, as he says, probably have ended by '31.

If The Great Moderation is any evidence, the Fed has become far more competent and pragmatic in recent decades.

In the Depression, at least, government was not the problem. Bad government--based on rigid free-market orthodoxy--was the problem.

I hope the irony is apparent.

David J. Balan writes:

I'm confused. It sounds like (and let me make the caveat that I know next to nothing about this stuff) you're saying that Bernanke is endorsing the view that before the Fed there was an effective mechanism in place to prevent financial crises, but that the Fed came along, eliminated that mechanism, and replaced it with something worse. Is that right? If so, how does he square that with the conviction that the Fed should continue to exist? Is it that the Fed used to be worse than the alternative, but has now improved to the point where it is better? Is it that the Fed does something else that he thinks is good? Something other reason?

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