Financial or banking panics were a recurrent theme in 19th-century U.S. economic history.
Episodes such as the Panic of 1857, Panic of 1873, Panic of 1893, Panic of 1896, and Panic of 1907 were marked by a sudden rise in short-term interest rates and an increase in the yield spread between safe and risky assets, as borrowers scrambled to find a source for short-term loans and depositors tried to get their money back from banks. These episodes were invariably followed by significant economic downturns.
There are two factors that could make some institutions a poor credit risk in such circumstances. The first is solvency problems– if the value of gross assets of a bank is less than its liabilities, there is no way for creditors to get all their money back. In this case, the sooner you get your deposits out of the bank, the better off you will be. The second issue is liquidity problems– the bank may have assets in excess of its liabilities, but trying to convert these assets into immediate cash could be very costly.
There is obviously a potential for liquidity problems, in times of financial panic, to turn into a problem of solvency. It may be that the bank’s assets, if sold in an orderly market, would exceed its liabilities, whereas if forced to sell immediately at fire sale prices, they would not. A big economic downturn will also reduce the probability that the bank will be repaid in full for its loans, further eroding the value of its assets. There is substantial unnecessary economic loss when liquidity problems are allowed to create insolvencies that would otherwise not arise.
With the establishment of the Federal Reserve in 1913, the United States obtained an institution with the power to create as much liquidity as might be needed to completely eliminate the second and most damaging element of historical financial panics. When you look in the graph above at the behavior of short-term interest rates before and after 1913, it is like comparing night and day. Certainly there have been any number of mistakes made by the Fed, biggest of which were the collapse of the money supply and bank failures in the early 1930s. But none of those episodes were characterized by the kind of extreme spike in short-term interest rates that had been such a common fact of life of the pre-Fed era.
One of the most recent and dramatic illustrations of the usefulness of this power went unnoticed by many Americans. Along with the loss of life and property when the World Trade Center towers collapsed on September 11, many of the financial institutions that played a key role in trades of government securities and interbank loans were wiped out or incapacitated, posing potentially huge liquidity problems. The Fed reacted with an extremely aggressive temporary creation of reserves, which prevented those liquidity disruptions from having major consequences. Americans were appropriately focused on other concerns that day. But we can thank the Fed that among those concerns was not a financial panic.
Although what was commonplace in the nineteenth century has since essentially vanished, at least as far as the United States is concerned, other countries continue to experience a closely related phenomenon, exemplified by the currency and financial crises of 1997. If you’re a smaller country like Korea for which a lot of the short-term debt is denominated in dollars, your central bank does not have the power to create extra dollars if everybody suddenly demands their payment and refuses to extend credit. Trying to flood the market with more of your own currency is just going to make the outflow of capital more severe.
So does this have anything to do with current concerns about subprime mortgages and interlayered hedge fund risk? I would take away two points from this discussion. First, insofar as we are talking about solvency problems, there is little the Fed is able to do to prevent those– some subprime mortgages are going to default, and that’s that. However, the Fed can and will prevent these from cascading into broader liquidity problems, by which I mean insolvencies created solely because of forced liquidation or unavailability of short-term credit. Even so, the Fed’s capacity to move aggressively on this front is potentially limited by the need to avoid a precipitous collapse in the value of the dollar. Whether the outcome would look more like the U.S. in 2001 or Korea in 1997 remains to be seen.