Marcus Nunes sent me a very interesting talk by Ben Bernanke, which discusses the 1907 banking crisis:
But even as the banks stabilized, concerns intensified about the financial health of a number of so-called trust companies–financial institutions that were less heavily regulated than national or state banks and which were not members of the Clearinghouse. As the runs on the trust companies worsened, the companies needed cash to meet the demand for withdrawals. In the absence of a central bank, New York’s leading financiers, led by J.P. Morgan, considered providing liquidity. However, Morgan and his colleagues decided that they did not have sufficient information to judge the solvency of the affected institutions, so they declined to lend. Overwhelmed by a run, the Knickerbocker Trust Company failed on October 22, undermining public confidence in the remaining trust companies.
To satisfy their depositors’ demands for cash, the trust companies began to sell or liquidate assets, including loans made to finance stock purchases. The selloff of shares and other assets, in what today we would call a fire sale, precipitated a sharp decline in the stock market and widespread disruptions in other financial markets. Increasingly concerned, Morgan and other financiers (including the future governor of the Federal Reserve Bank of New York, Benjamin Strong) led a coordinated response that included the provision of liquidity through the Clearinghouse and the imposition of temporary limits on depositor withdrawals, including withdrawals by correspondent banks in the interior of the country. These efforts eventually calmed the panic. By then, however, the U.S. financial system had been severely disrupted, and the economy contracted through the middle of 1908.
The recent crisis echoed many aspects of the 1907 panic.
Bernanke’s right that the crises were similar. He also discusses the advances in policy that have occurred since 1907, such as FDIC, which prevented a run on deposits, and the Federal Reserve, which pumped in massive quantities of base money. This might partly explain why RGDP only declined slightly over 4% from 2007:4 to 2009:2, as compared to 12% between 1907:2 and 1908:1 (using Gordon and Balke). But the recovery from the 1907 crisis was also very swift (which that shows financial crises are not inevitably followed by slow recoveries.) By 1909:4 RGDP was up by nearly 19% from its 1908 low point.
Why was the recovery from the 1907 crisis so swift? The proximate cause is obvious, monetary policy was much more expansionary in 1908-09 than in 2009-13. NGDP soared by nearly 28% between 1908:1 and 1909:4. But why was that?
I believe the gold standard helps explain the rapid recovery in 1908-09. The international gold standard was a very crude sort of “level targeting” regime. It didn’t necessarily work when there were international shocks to the real value of gold, due to changes in the supply or demand for gold. Price levels tended to move in a sort of random walk. You could have fairly long periods of deflation, as in the 1870s and the 1890s and the early 1930s. But when the international gold market was relatively stable, a sharp domestic shock that greatly depressed prices and output was likely to be quickly reversed, as prices and output recovered to their original trend line. In contrast, the Fed made a decision in 2009 to avoid going back to the original trend line, and instead to start a new and lower trend line. This explains the slow growth in NGDP, and also the slow recovery in RGDP.
I still think that fiat money is better than a gold standard, but it’s also clear that fiat money policymakers could learn something by studying the cyclical properties of the international gold standard.
[Marcus Nunes has a post with some graphs comparing the two episodes.]