The History of Financial Crashes

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Nouriel Roubini is continuing his mad streak of tweets attacking those who see dangers in central banking, in general, and the Federal Reserve in particular. His tweets distort the history of banking and crashes from the 1700′s to modern day. He begins:

Happy/stable bucolic world before the Fed: Panic/Crisis of 1772, ’92, ’96-97, 1819, ’25, ’37, ’47, ’57, ’68, ’73, ’84, ’90, 1901,’07, ’10-11 Financial crises be4 the Fed was created: Panic/Crisis of 1772, ’92, ’96-97, 1819, ’25, ’37, ’47, ’57, ’68, ’73, ’84, ’90, 1901,’07, ’10-11

I’m not going to conduct a financial history of the last three centuries in this post, but lets take a look at the first two dates Roubini lists 1772 and 1792.

In the first case,1772, there was a bank that attempted to inflate in Scotland, but it was a private bank and it didn’t get very far. As Murray Rothbard suggested when private banks inflate damage is extremely limited. Ron Paul explained what happened in the period surrounding the 1772 bank collapse in Scotland:

In 1769 the Ayr Bank in Scotland was founded on the inflationist schemes which the Scotsman John Law had tried unsuccessfully to get the Bank of Scotland to adopt in 1705.

In a mere three years, the Ayr Bank managed to create a tremendous amount of unbacked paper, and when it finally collapsed in 1772 losses amounted to two-thirds of a million pounds, a staggering amount for those days.

But the intriguing thing is that the Ayr Bank’s collapse had limited repercussions. It took with it only eight small private banks in Edinburgh. This is largely because of a well-developed clearinghouse mechanism that the large Scottish banks employed. They accepted each others’ notes and returned those notes to the issuing bank. Suspicious of the Ayr Bank’s issue, other banks made a practice of quickly returning Ayr’s notes to it. When the collapse came, they were not affected. Nevertheless, to insure public confidence (and get their own notes into wider circulation) the two largest banks, the Royal Bank and the Bank of Scotland, announced that they would accept the bankrupt bank’s notes. This was not as mad as it may appear. The collapse had few rippling effects because of Scotland’s extraordinary practice of unlimited liability on the part of the bank’s shareholders. So Ayr’s loss was borne completely by the 241 shareholders, who paid all creditors in full.

A helluva a lot different than the recent crisis where taxpayers instead of Goldman Sachs shareholders JPMorgan shareholders paid the losses. But this 1772 crisis is the model, resolved by private parties and limited in damage, that Roubini is suggesting is more damaging than the model used to deal with current crises that get every one to pay for the recklessness of a few.

The 1792 crisis was a direct result of the First Bank of the United States. The bank was founded by Congress in 1791 at the insistence of Alexander Hamilton. In other words it was a central bank. As Ron Paul reports:

The bank immediately fulfilled its inflationary potential by issuing millions of dollars in paper money and demand deposits pyramiding on top of $2 million in specie.

David Cowen backs up Ron Paul’s account and explains how the halt in the central bank money printing resulted in the crash, the way all such manipulations always do:

The Bank had an enormous impact on the economy within two months of opening its doors for business by flooding the market with its discounts (loans) and banknotes and then sharply reversing course and calling in many of the loans. Although the added liquidity initially helped push a rising securities market higher, the subsequent drain caused the very first U.S. securities market crash by forcing speculators to sell their stocks. The largest speculator caught in the financial crisis was William Duer. When he went insolvent in March 1792, the markets were temporarily paralyzed. This so-called "Panic of 1792" was short lived as again Secretary Hamilton (as in the previous year during the script bubble) injected funds by buying securities directly and on behalf of the sinking fund. Yet incidents like the Panic of 1792 and the script bubble would be remembered for many years by opponents of the Bank who were still in steadfast opposition to the Hamilton inspired institution.

Thus, we see that Roubini’s throwing out dates of financial crashes completely distorts the picture. The first date Roubini cites was a small crisis that hurt mostly the shareholders of the bank involved. The second crisis had nothing to do with the private sector, it was the result of a central bank.

But Roubini is only getting warmed up, he then claims that current crises, during the watch of the Federal Reserve, were not caused by the Fed:

Great Depression caused by voodoo laissez faire de-reg. Fed not easing after crash, no fiscal stimulus & letting disorderly bank collapses.

Read Murray Rothbard’s America’s Great Depression and Robert Murphy’s The Politically Correct Guide to the Great Depression and the New Deal for the Fed’s key role in the Great Depression. The short explanation is that the crisis was mostly caused by Fed printing in the 1920s and contraction that started in 1929, coupled with heavy regulation in the 1930s that extended the crisis, not laissez faire policies.

Read the rest of the article

2011 Economic Policy Journal

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