Jefferson’s curse? Part 2: small means weak
[Continued from yesterday's Part 1.]
In yesterday’s post, exploring the US’s banking history via a well-reasoned and opinionated Wall Street Journal op-ed by banking historian and essayist/ fulminator John Steele Gordon, we had reached the stage of circling liquidity injections and confidence injections as essential responses to financial crises.
Hold still for the liquidity and confidence
It’s no surprise, and a great comfort, that Messrs. Bernanke and Paulson, who know both the history and the market dynamics through and through, have pressed all these liquidity/ confidence buttons continuously since last march, when they first banked on value. As I wrote at the time:
Ten days ago, the Federal Reserve made a bet that economic students will be studying for decades. Under Ben Bernanke, the Fed pushed $200 billion – that’s your money and my money – into the global capital markets pot, in effect making a bet that assets the market won’t buy have the value their originators say they do.
These tickets are valuable
Important for this post’s purposes is that Bernanke and Paulson were in a position to make such a bet.
From my IUHF talk: the Paulson principles
Their predecessors weren’t, because they had no Federal reserve system.
The Federal Reserve was created in 1913. But, again, they fought to make it weaker rather than stronger. Instead of one central bank, they created 12 separate banks located across the country and only weakly coordinated.
After the 1929 crash, the system failed, and propelled us into the Great Depression. Out of that financial catastrophe came the SEC and FDIC, two integral creatures in our modern ecosystem.
[The Fed] was completely reorganized in 1934 and the
The date was Monday, October 19, 1987. As Wikipedia describes it, with commendable factuality and minimal speculation:
In financial markets, Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short period. The crash began in Hong Kong, spread west through international time zones to Europe, hitting the
The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1739 (22.6%).
By the end of October, stock markets in Hong Kong had fallen 45.8%,
The Black Monday decline was the largest one-day percentage decline in stock market history. A degree of mystery is associated with the 1987 crash, and it has been labeled as a black swan event.
It recovered … but nobody knows why
Important assumptions concerning human rationality, the efficient market hypothesis, and economic equilibrium were brought into question by the event. Debate as to the cause of the crash still continues many years after the event, with no firm conclusions reached.
Whatever else we’ve learned through events like these, it’s the need for continuous credible liquidity, and a source of unshakable confidence. That is largely a role for central banks. So is the standardization of money.
While the Constitution gives the federal government control of the money supply, it is silent on the control of banks, which create money. In the early days they created money both through making loans and by issuing banknotes and today do so by extending credit. Had
Counterfactual hypotheses are always tough to refute, but this one is quite plausible. Remarkably, throughout most of the nineteenth century, we had dozens of different banknotes.
From a Maine bank, 1851
From a Connecticut bank, 1850’s
Confederate dollar, 1862 – don’t take that one!
Without it, banking regulation was left to the states. Some states provided firm regulation, others hardly any. Many states, influenced by Jeffersonian notions of the evils of powerful banks, made sure they remained small by forbidding branching. In banking, small means weak.
An important principle.
There were about a thousand banks in the country by 1840, but that does not convey the whole story. Half the banks that opened between 1810 and 1820 had failed by 1825, as did half those founded in the 1830s by 1845.
Recall that a bank is a money store, and like any other store, it can go out of business. When that happens, its creditors — ordinary Americans call them ‘depositors’ – are left out in the cold, having lost their savings. Bank failures were endemic globally in the nineteenth century, particularly in times of war.
Many “wildcat banks,” so called because they were headquartered “out among the wildcats,” were simple frauds, issuing as many banknotes as they could before disappearing.
By dressing up a fraud as a ‘bank,’ one could print money backed by nothing.
By the 1840s there were thousands of issues of banknotes in circulation and publishers did a brisk business in “banknote detectors” to help catch frauds.
Balkanized systems always have, at a minimum, staggering inefficiency, which takes a huge toll on commerce.
The Civil War ended this monetary chaos when Congress passed the National Bank Act, offering federal charters to banks that had enough capital and would submit to strict regulation. Banknotes issued by national banks had to be uniform in design and backed by substantial reserves invested in federal bonds.
In effect, Congress forced banks to backstop their paper. This is quite similar to the dynamics now at play to regulate naked short selling (large bets without capital behind them, in effect financial bluffs), and the inevitable emergence of collateral requirements for complex derivative instruments.
Meanwhile Congress got the state banks out of the banknote business by putting a 10% tax on their issuance.
An interesting example of a patient legislative workaround fix. Rather than bar state banks outright from issuing notes, which presumably would have faced a legal and political challenge, Congress imposed a tax, probably using the entirely reasonable argument that banks need to provide security for their paper.
Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the
Overwhelmingly they were small, “unitary” banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.
Hence the FSLIC, the FDIC, and a slew of other New Deal programs.
From my IUHF talk: once the government is in, it’s never out
But national banks could not branch if their state did not allow it and could not branch across state lines.
Modern readers who never experienced it will find it incomprehensible that the
The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment.
Capital always scales up, particularly as technology advances. Blocking mergers prevented – or, more precisely, deferred for thirty years – a natural consolidation that would have and did benefit consumers (particularly when leavened with the Community Reinvestment Act, the logical consequence of allowing multi-branch banks).
In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size.
But Congress’s attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.
This story – that Congress drove us into excessive lending – is gaining wide circulation among the financial sector’s libertarian and conservative fraternities. I think it completely reverses causality – the banks betook themselves into the space in pursuit of quick profits – but its dismantling would take us away from the theme of this post.
While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.
From my IUHF talk: everyone’s a bank, everyone’s a bank of glass
I buy all of that except the last, wishful modifying clause. One man’s undue influence is another man’s free expression.
“Money is the mother’s milk of politics” – Jesse Unruh
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