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Were the Pre-Federal Reserve Days So Bad?

"In the next few days the situation would grow much worse, and the interconnected nature of the relationships among the nation's financial institutions would only enable the contagion to spread."

The question I pose is which set of circumstances is the author of this passage describing? Was it in March 2008 immediately after the problems were discovered at Bear Stearns and the Federal Reserve rushed to the rescue? Was it during September 2008 that month that saw the meltdown of Fannie Mae and Freddie Mac followed by Lehman Brothers, followed by AIG and Wachovia? Was it in November 2008 as Citigroup approached failure? Or was it during an earlier financial crisis, maybe during the 1980s when Continental Illinois was bailed out by the Federal Reserve and then the FDIC.

The passage is actually from a book by Robert F. Bruner and Sean D. Carr of the University of Virginia: The Panic of 1907: Lessons Learned from the Market’s Perfect Storm. Having listened to Timothy “Chicken Little” Geithner and Hank “I’m prepared to do anything” Paulson tell us how the troubles they faced during 2008 were absolutely unprecedented in nature, this may be surprising. But this passage actually describes the financial crisis that preceded the creation of the Federal Reserve and led to its creation.

During the Panic of 1907 there were discussions of bailouts. However, these were bailouts by private parties that were contemplated, not governments. JP Morgan (the man, not the financial institution) and the private, voluntary clearinghouses were the ‘lenders of last resort’ back then. They considered giving a bailout to a large troubled financial institution: Knickerbocker Trust Company. The clearinghouse committee denied a loan through an intermediary bank on behalf of Knickerbocker. JP Morgan commissioned an assessment of the trust companies to determine which should be supported and which should be allowed to fail. He had two bankers, one of whom was Benjamin Strong who later would become the first President of the New York Fed, examine Knickerbocker. If they determined Knickerbocker was sound, Morgan committed to finding money for it. Ultimately they determined that it was not solvent and that there were other more sound institutions that were better candidates for funding. Knickerbocker was allowed to fail (see Bruner and Carr pages 72 to 76, 84, 87).

It is useful to think about what happened in this pre-Federal Reserve crisis. The impetus was on these private financial players to assess the soundness of Knickerbocker, as well as any collateral that might have been available and determine if they wanted to put up their own money to save it. They knew about the possible adverse consequences of letting Knickerbocker fail and they had an interest in assuring that the financial system did not collapse. Yet they decided to not provide any funding to Knickerbocker.

Contrast the situation in 1907 with the most recent crisis and the alignment of interests. The three bailout agencies (the Federal Reserve, Treasury Department and the FDIC) were all dealing with public funds involving handing out other people’s money, so of course it is easier to make the decision to hand out public funds than one’s own funds. They felt they had to do “something” and could not just let these financial institutions that were on the brink of failure simply collapse. They had what former FDIC Chairman Bill Seidman called the “not on my watch” mentality.  They wanted to avoid a large failure on their watch at all costs, with Lehman Brothers being the singular exception. These policymakers probably recognized the possibility that there were moral hazard costs to such bailouts, but those costs would come home to roost in the future, on someone else’s watch. They acted in their own self-interest rather than the public’s interest in effectively using public funds.

This description of the reality of the response of public officials contrasts with what was anticipated when the Federal Reserve was under development. From the comments of Senator Claude Swanson, Democrat of Virginia, who was President Wilson’s point person in securing passage of the Federal Reserve Act (51 Cong Rec 428, 430 – 432— December 8, 1913):

“The benefits which will accrue from these regional, or, as named in this bill, Federal reserve banks are great and many. The reserves of this Nation, which are needed in times of financial distress and stringency, will be held by those who have a public responsibility for their just and proper use, and not as now, by those who have such responsibility and no purpose of public benefit in their use…I am satisfied that the Federal reserve board when constituted will wisely, faithfully, fearlessly, and patriotically discharge the duties conferred upon them to the benefit of the whole of the country and without favoritism to any…I believe the present President of the United States, animated by only lofty and noble principles in all of his work, will select as members of this Federal reserve board men fully equipped, men with noble purposes and whose administration of their office will redound to the great betterment of this Nation.”


    1. Hi Steve, interesting article. When you said on page 643 that "most currency substitutes were illegal," I assume you mean they were never given legal tender status by Congress. Is this correct, and am I correct in assuming that any prospective free banks will need to seek legal status for its notes? (I'm starting to wonder if I'm in the right blog. So far, it appears to me that free banking means every bank should have power to charter itself, invent its own currency and then declare their own notes to be legal tender.)

      1. Rick,

        No I mean they were illegal because the National Currency Act required that all bank notes issued by federally chartered banks be backed by 2% federal government bonds, which the currency substitutes were not. It wasn't about legal tender at all.

        Free banking needs no legal tender laws. Banks should indeed be free to open their doors and create their own liabilities (notes and deposits) and persuade the public to accept them. They cannot "declare" their notes legal tender – only governments can do that. All banks can do is what they do today with their deposits: persuade you to deposit money there and use their liabilities as media of exchange.

        1. Thanks, Steve. That confirms my doubts about belonging and contributing here. There's no way I can mentally discard 200+ years of U.S. legal history …. because I DO want Constitutional institutions and representatives to "declare" what is legal tender. If anyone here understands my perspective and can suggest other sites or blogs, please do.

          1. If you think what free bankers are talking about is somehow unconstitutional, I think you've misunderstood the constitution, but good luck to you.

        2. Frankly, Steve, if the above description is an accurate description of free banking, I do believe it to be unconstitutional, and excuse me, but I presently find it disturbing as well. Free banking has been represented to me as a return to the "pre-Federal Reserve days" and the National Banks Era (1863-1913), as a way to make improvements to that era, not to make radical changes that alienate the money-creation power from its Constitutional purpose.

          To my knowledge, most if not all of the currencies of that era were legal tender, not to mention that a large percentage of transactions were in coin, so that the legal tender usually effected a "PAYMENT of all debts public and private," and did not seek to keep us enslaved to debt by using only legal tender "FOR all debts public and private." As I mentioned earlier, there was even at least one PAPER currency, the Treasury Coin Note, that was "legal tender IN PAYMENT of all debts public and private." Few, if any, rights that advance personal liberty can be claimed if we have no legal means of disengaging from debt obligation.

  1. 1800s Canada is a gold mine for examples of this.

    The Federal Bank case shows Canadian private bankers acting as both lenders of last resort, and finally, FDIC-style liquidators. In 1884 a run began on the Federal Bank. Together the larger banks acted as lenders of last resort and, on the security of "approved" paper, advanced enough to the bank to tide it over.

    In late 1887 a panic swept Canada and again a run developed on the Federal. Realizing that this time the Federal was insolvent, a committee of Toronto-area banks, led by the Commerce Bank (the modern day Canadian Imperial Bank of Commerce), organized an "open door" liquidation of Federal Bank, the purported first of its kind in Canada. The coalition of banks promised to guarantee all of the Federal's deposits while the bank's assets were sold off, thereby preventing a bank closure and the resulting inconvenience to customers that might lead to a more widespread distrust of the banking system itself. It also gave liquidators time to sell of the assets in a reasonable way rather than throwing them on the market.

  2. Speaking of the Pre-FED days, can the Site please post Dr. Selgin's brilliant Sept 2010 presentation to the Mises Circle at Furman University? Everyone here would enjoy it. Thanks.

  3. First, I'd like to thank Vern and Steve for bringing the Panic of 1907 to my attention. This event really does appear to have culminated in ratification of the Federal Reserve Act, and thereafter, to have increasingly contributed to the widespread use of substitute money or "fiduciary media" (checks, credit & debit cards, electronic payment systems, fiat money, etc.).

    But did we leave something behind? And wasn't the acceptability of fiduciary media after 1907 resting on the foundation of certain unique post-Civil War attributes that U.S. Treasury-Direct "base" money possessed?

    If I may, and of course subject to corroboration by other lawyers who may be listening in, I'd like to propose that we define certain terms with greater specificity.

    I'm proposing this because I see a potential problem with continuing to use terms like "base money" or "fiduciary media" or "legal tender" without being able to to distinguish between different kinds of money that may be included within those terms, some money of which I believe should be subject to full reserve restrictions — and the other to responsible fractional reserve practices (which I believe includes deposit insurance and a regulatory income tax, so that the public is safeguarded against a practice that is inherently susceptible to over-exploitation).

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