It also saddled the economy with debt, a property bubble and wasteful projects throughout the country. As part of a strategy to help the companies unwind the debts they had taken on in that push, policy makers encouraged stock investing.
"Chinese Government Struggles in Attempt to Stem Distress in Stock Market", Lingling Wei, Wall Street Journal Online, July 8, 2015 9:42 a.m. ET
When you cut through a lot of the mumbo jumbo, and if you ignore the body of laws and regulations that have grown up since 1860 that affect banks and other financial institutions, the business of being a banker is not very difficult. You as a banker have a stock of money that comes from two sources – the capital provided by the owners of the bank, and the deposits that come from people who have given you their money for safekeeping. The world is filled with people who want to use your money, and you lend it them for a fee.
If you are careful about who you lend to, most of the people who borrow from you will pay you back, but a few will not. Taking this into account, you set the fee for the use of your money so that it will cover the costs of your doing business (including your salary and the interest you have promised to pay your depositors), reimburse you for the losses you will suffer from those who don't pay you back, and provide a profit so that you can pay a dividend to the owners who provided the capital.
When we think about banking in the United States before the Civil War, we need to keep in mind the fact that two types of money (as currency) were in use. One type was specie – gold and silver coins minted by the government. The other type was banknotes – pieces of paper issued by commercial banks that represented the issuing bank's promise to pay the bearer a specified amount of money in the form of gold and silver coins.
The law required the banks to keep in their vaults an amount of specie – the "reserves" – that represented a percentage of their banknotes that were in circulation. Of course, because the reserves represented only a portion of the banknotes in circulation, it would not be sufficient to repay all the notes if the holders sought to redeem them all at once. But since a paper banknote is redeemable at will for an equivalent amount of coin, most of the time an individual will be indifferent as to whether he holds a banknote or coin.
So, if you are a banker looking at the balance sheet for you bank, you have certain assets, including the cash (specie) in your vaults and the money you have loaned and that you expect to receive back from your borrowers, and you have certain liabilities, including the amounts that your depositors have given you for safekeeping and the banknotes you have issued that represent their right to demand from you the payment in specie.
If you are an experienced banker who has learned the business of banking from other experienced bankers you will understand that your business goes through seasonal cycles. The amount of loans, deposits, banknotes in circulation, and reserves of coin in the vault will rise and fall, but so long as they remain within the rough relationship to one another that they have maintained over time, all should go smoothly and profitably.
In 1857 New York City possessed the largest concentration of banks in the United States making it the financial capital of the nation. For the convenience of their respective business, the banks had formed a clearinghouse organization in which representatives of all the banks met at the end of each business day and settled their accounts. It not only promoted the efficiency of their business, but provided the members with insight into each other's financial condition. The advantage to you as a banker is that you knew not only the condition of your own balance sheets but also the condition of the balance sheet of every other major bank in the city.
In late summer of 1857, a substantial number of the bankers in New York City woke up to the realization that they were operating outside of their comfort zone. Summer was a peak lending time. The aggregate amount of loans outstanding for the New York banks was nearly a third larger than it had been in any of the recent years, and the combined amount of banknotes in circulation and deposits at the banks – both representing claims against the banks' reserves – also was substantially larger than in prior years. At the same time, the aggregate amount of reserves had declined.
The banks reacted by demanding repayment of loans then due – a portion of the loans were "demand" loans that permitted to lender to require repayment at any time – and by refusing to renew existing loans or make new loans. Needless to say, these actions caused substantial distress as people who needed money to operate their businesses and ventures could not get it. People who had borrowed money to buy securities and other assets were forced to sell, and the flood of selling pushed prices down. Business that could not pay their bills failed. The telegraph and newspapers spread the story – and the panic – across the nation. The failure of a major financial institution in Ohio increased the alarm. Depositors and holders of banknotes sought to redeem their claims for specie, but the banks, acting as a group, refused to honor their requests.
What does all this have to do, as we used to say, with the price of tea in China? What is the relevance of the Panic of 1857 to the conditions in the United States in the twenty-first century?
To sort this out, let's look at what has changed and what has not. First, the money is different. Banknotes and specie are a thing of the past. Starting with the introduction of greenbacks during the Civil War and culminating with the birth and grown of the Federal Reserve System, the United States now has a national currency that is not directly dependent upon the financial health of any one bank. Second, many bank deposits are insured, which has made bank runs as scarce of hens' teeth. In fact, the only exposure to a bank run that most people have nowadays consists of a few scenes in the 1946 Frank Capra movie "It's a Wonderful Life" starring James Stewart and Donna Reed. Bank failures still occur, but the collateral damage is reduced when individual banks implode. Third, we have the Federal Reserve System that oversees the money supply and acts as a lender of last resort. In 1791 and again in 1816 the United States gathered the political will to establish the Bank of the United States, which acted as the fiscal agent for the national government and imposed some discipline upon the banking industry, much to the displeasure of the industry. The first Bank of the United States was permitted to expire, and President Andrew Jackson killed the second one. Fourth, the amount of regulation and regulatory apparatus has grown from virtually nothing into multiple state and federal institutions with broad mandates, broad powers and overlapping jurisdictions.
In spite of all that has changed, major financial dislocations still occur and are likely to occur in the future. No one fact causes a major financial dislocation, and while specific underlying facts differ from one event to another, the general causal trends seem to be a growing consensus that the debt load in some part of the economy or the world is larger than can be readily repaid because of the amount of the debt, changing economic conditions or worries that the assets purchased using credit – like stocks in 1929 or houses in 2008 – might be substantially overvalued.
Let's look at how the aggregate debt load might become excessive. The marketplace has thousands of potential lenders, all of whom are in the business of renting money to people who believe they can use the money to turn a profit. If you are a loan officer, you have a choice between making the incremental loan and earning your bonus or failing to make the loan and getting fired. If you are the bank president, you look at the balance sheet of your institution and the financial conditions generally, and then you decide whether it is prudent for your institution to take on the additional risk of the incremental loan. Even if the bank president is considering the aggregate amount of similar loans being made by all the lenders in the marketplace, his inclination will be to keep lending because failing to do so means foregoing the incremental profit.
But at some point the bank president becomes worried. He reads the economic statistics; he sees some leading indicators weaken; he recalls that he has authorized the consummation of some slightly aggressive loans (compensated, of course, by a correspondingly higher rate of interest); and he begins to wonder how his bank's loan portfolio might fare if conditions go south. And, of course, there is always some Cassandra predicting that the next crash or recession is just around the corner – from time to time one of them will be right.
If one bank president has cause to become worried, perhaps a dozen come to the same conclusion, and without coordinate action among them, but reacting to the same general indicators, their previous optimism becomes clouded over by prudence, and they scale back their incremental lending and stop rolling over their more worrisome credits. The fact that they are doing so inevitably becomes known, and the fact becomes an additional – and additionally persuasive – factor that other bank presidents and other market participants will weigh in the mix.
The foregoing discussion has spoken about "loans", but it could easily have focused on other assets. If one became persuaded that the stock market was exhibiting "irrational exuberance", one might be prudent to reduce one stock portfolio before the market tanked. If one became persuaded that housing prices were overstated, one might unload one's portfolio of collateralized mortgage obligations before the default rate spiked and exceed the rate assumed when the instruments were originally sold. In either case, the selling itself becomes an economic fact of which others will take note and contribute to the tipping of greed into fear.
Greed and fear are, of course, the primary economic motivators. They are selfish motivators that focus primarily upon one's own profit and one's own safety. There is nothing intrinsically wrong with this since we expect our commercial institutions to be profitable and we expect them to behave rationally to that end. There are always unintended or collateral consequences. Although Adam Smith's "invisible hand" may produce a greater overall benefit in many cases and under ordinary circumstances, it does not do so in every case and certainly not in emergency situations. When conditions start to go bad, those who act first to protect themselves are most likely to suffer the least injury, although their precipitous actions may result in injury to others.
In a perfect world we would be able to eliminate panics and market disturbances by preventing the aggregate debt in any part of the national or the world economy from becoming excessive, by curbing "irrational exuberance" before it becomes irrational or exuberant and by preventing supply and demand from pushing the market price of assets in excess of their "real" value – whatever that may be. Based upon what we know, what we believe and what we reasonably can foresee, nothing like this is ever going to happen.
Since we have not been able to achieve the impossible, we have tried alternative approaches. One such is to require institutions to become more robust and therefore capable of withstanding the consequences of the market's folly by restricting the institution from certain lines of business that are considered too risky and imposing requirements and limitations on how its business operates. The judgment is that of a governmental regulator and not of the institution's manager so the limits will not be tailored to the needs of the institution's business and will probably be contrary to the institution's profit interest. Moreover, insofar as making the institution sufficiently robust to withstand the next economic crisis, the institution's vulnerability to the effects of that crisis will depend upon the nature of the crisis. If the institution's portfolio is not heavily exposed to the assets that are being hammered in the crisis, it is less likely to be at risk. I don't see where a regulator has a better chance of making that call correctly than does a manager.
In 1857 the traditions and ideas about the duties of government left regulation of banks to the states, and even there the hand of government rested lightly. Government has grown to be more intrusive, but that does not mean that it has become more effective, and I am fearful – when I hear government officials speak about institutions that are too big to fail and too big to jail – that much of the actions taken by the government are window dressings, intended largely to persuade the public that it has the problem is well in hand.
If you are careful about who you lend to, most of the people who borrow from you will pay you back, but a few will not. Taking this into account, you set the fee for the use of your money so that it will cover the costs of your doing business (including your salary and the interest you have promised to pay your depositors), reimburse you for the losses you will suffer from those who don't pay you back, and provide a profit so that you can pay a dividend to the owners who provided the capital.
When we think about banking in the United States before the Civil War, we need to keep in mind the fact that two types of money (as currency) were in use. One type was specie – gold and silver coins minted by the government. The other type was banknotes – pieces of paper issued by commercial banks that represented the issuing bank's promise to pay the bearer a specified amount of money in the form of gold and silver coins.
The law required the banks to keep in their vaults an amount of specie – the "reserves" – that represented a percentage of their banknotes that were in circulation. Of course, because the reserves represented only a portion of the banknotes in circulation, it would not be sufficient to repay all the notes if the holders sought to redeem them all at once. But since a paper banknote is redeemable at will for an equivalent amount of coin, most of the time an individual will be indifferent as to whether he holds a banknote or coin.
So, if you are a banker looking at the balance sheet for you bank, you have certain assets, including the cash (specie) in your vaults and the money you have loaned and that you expect to receive back from your borrowers, and you have certain liabilities, including the amounts that your depositors have given you for safekeeping and the banknotes you have issued that represent their right to demand from you the payment in specie.
If you are an experienced banker who has learned the business of banking from other experienced bankers you will understand that your business goes through seasonal cycles. The amount of loans, deposits, banknotes in circulation, and reserves of coin in the vault will rise and fall, but so long as they remain within the rough relationship to one another that they have maintained over time, all should go smoothly and profitably.
In 1857 New York City possessed the largest concentration of banks in the United States making it the financial capital of the nation. For the convenience of their respective business, the banks had formed a clearinghouse organization in which representatives of all the banks met at the end of each business day and settled their accounts. It not only promoted the efficiency of their business, but provided the members with insight into each other's financial condition. The advantage to you as a banker is that you knew not only the condition of your own balance sheets but also the condition of the balance sheet of every other major bank in the city.
In late summer of 1857, a substantial number of the bankers in New York City woke up to the realization that they were operating outside of their comfort zone. Summer was a peak lending time. The aggregate amount of loans outstanding for the New York banks was nearly a third larger than it had been in any of the recent years, and the combined amount of banknotes in circulation and deposits at the banks – both representing claims against the banks' reserves – also was substantially larger than in prior years. At the same time, the aggregate amount of reserves had declined.
The banks reacted by demanding repayment of loans then due – a portion of the loans were "demand" loans that permitted to lender to require repayment at any time – and by refusing to renew existing loans or make new loans. Needless to say, these actions caused substantial distress as people who needed money to operate their businesses and ventures could not get it. People who had borrowed money to buy securities and other assets were forced to sell, and the flood of selling pushed prices down. Business that could not pay their bills failed. The telegraph and newspapers spread the story – and the panic – across the nation. The failure of a major financial institution in Ohio increased the alarm. Depositors and holders of banknotes sought to redeem their claims for specie, but the banks, acting as a group, refused to honor their requests.
What does all this have to do, as we used to say, with the price of tea in China? What is the relevance of the Panic of 1857 to the conditions in the United States in the twenty-first century?
To sort this out, let's look at what has changed and what has not. First, the money is different. Banknotes and specie are a thing of the past. Starting with the introduction of greenbacks during the Civil War and culminating with the birth and grown of the Federal Reserve System, the United States now has a national currency that is not directly dependent upon the financial health of any one bank. Second, many bank deposits are insured, which has made bank runs as scarce of hens' teeth. In fact, the only exposure to a bank run that most people have nowadays consists of a few scenes in the 1946 Frank Capra movie "It's a Wonderful Life" starring James Stewart and Donna Reed. Bank failures still occur, but the collateral damage is reduced when individual banks implode. Third, we have the Federal Reserve System that oversees the money supply and acts as a lender of last resort. In 1791 and again in 1816 the United States gathered the political will to establish the Bank of the United States, which acted as the fiscal agent for the national government and imposed some discipline upon the banking industry, much to the displeasure of the industry. The first Bank of the United States was permitted to expire, and President Andrew Jackson killed the second one. Fourth, the amount of regulation and regulatory apparatus has grown from virtually nothing into multiple state and federal institutions with broad mandates, broad powers and overlapping jurisdictions.
In spite of all that has changed, major financial dislocations still occur and are likely to occur in the future. No one fact causes a major financial dislocation, and while specific underlying facts differ from one event to another, the general causal trends seem to be a growing consensus that the debt load in some part of the economy or the world is larger than can be readily repaid because of the amount of the debt, changing economic conditions or worries that the assets purchased using credit – like stocks in 1929 or houses in 2008 – might be substantially overvalued.
Let's look at how the aggregate debt load might become excessive. The marketplace has thousands of potential lenders, all of whom are in the business of renting money to people who believe they can use the money to turn a profit. If you are a loan officer, you have a choice between making the incremental loan and earning your bonus or failing to make the loan and getting fired. If you are the bank president, you look at the balance sheet of your institution and the financial conditions generally, and then you decide whether it is prudent for your institution to take on the additional risk of the incremental loan. Even if the bank president is considering the aggregate amount of similar loans being made by all the lenders in the marketplace, his inclination will be to keep lending because failing to do so means foregoing the incremental profit.
But at some point the bank president becomes worried. He reads the economic statistics; he sees some leading indicators weaken; he recalls that he has authorized the consummation of some slightly aggressive loans (compensated, of course, by a correspondingly higher rate of interest); and he begins to wonder how his bank's loan portfolio might fare if conditions go south. And, of course, there is always some Cassandra predicting that the next crash or recession is just around the corner – from time to time one of them will be right.
If one bank president has cause to become worried, perhaps a dozen come to the same conclusion, and without coordinate action among them, but reacting to the same general indicators, their previous optimism becomes clouded over by prudence, and they scale back their incremental lending and stop rolling over their more worrisome credits. The fact that they are doing so inevitably becomes known, and the fact becomes an additional – and additionally persuasive – factor that other bank presidents and other market participants will weigh in the mix.
The foregoing discussion has spoken about "loans", but it could easily have focused on other assets. If one became persuaded that the stock market was exhibiting "irrational exuberance", one might be prudent to reduce one stock portfolio before the market tanked. If one became persuaded that housing prices were overstated, one might unload one's portfolio of collateralized mortgage obligations before the default rate spiked and exceed the rate assumed when the instruments were originally sold. In either case, the selling itself becomes an economic fact of which others will take note and contribute to the tipping of greed into fear.
Greed and fear are, of course, the primary economic motivators. They are selfish motivators that focus primarily upon one's own profit and one's own safety. There is nothing intrinsically wrong with this since we expect our commercial institutions to be profitable and we expect them to behave rationally to that end. There are always unintended or collateral consequences. Although Adam Smith's "invisible hand" may produce a greater overall benefit in many cases and under ordinary circumstances, it does not do so in every case and certainly not in emergency situations. When conditions start to go bad, those who act first to protect themselves are most likely to suffer the least injury, although their precipitous actions may result in injury to others.
In a perfect world we would be able to eliminate panics and market disturbances by preventing the aggregate debt in any part of the national or the world economy from becoming excessive, by curbing "irrational exuberance" before it becomes irrational or exuberant and by preventing supply and demand from pushing the market price of assets in excess of their "real" value – whatever that may be. Based upon what we know, what we believe and what we reasonably can foresee, nothing like this is ever going to happen.
Since we have not been able to achieve the impossible, we have tried alternative approaches. One such is to require institutions to become more robust and therefore capable of withstanding the consequences of the market's folly by restricting the institution from certain lines of business that are considered too risky and imposing requirements and limitations on how its business operates. The judgment is that of a governmental regulator and not of the institution's manager so the limits will not be tailored to the needs of the institution's business and will probably be contrary to the institution's profit interest. Moreover, insofar as making the institution sufficiently robust to withstand the next economic crisis, the institution's vulnerability to the effects of that crisis will depend upon the nature of the crisis. If the institution's portfolio is not heavily exposed to the assets that are being hammered in the crisis, it is less likely to be at risk. I don't see where a regulator has a better chance of making that call correctly than does a manager.
In 1857 the traditions and ideas about the duties of government left regulation of banks to the states, and even there the hand of government rested lightly. Government has grown to be more intrusive, but that does not mean that it has become more effective, and I am fearful – when I hear government officials speak about institutions that are too big to fail and too big to jail – that much of the actions taken by the government are window dressings, intended largely to persuade the public that it has the problem is well in hand.
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