October 29, 1929 Haunts U.S. Economic Policy To This Day
The economic history of the United States outwardly appears in the mainstream to have started on October 29, 1929, with almost all scholarly inquiry attached the events that came immediately thereafter. So powerful was that stage that not only is the monetary policy toolkit designed expressly from it, but also the very arrangement of the financial system itself. It is quite remarkable that the period immediately before the great crash is left so undiscovered, as if there is nothing useful in examining how it all got to the point of unfolding so wrong - and then again right where it was supposed to be impossible.
Because of that blindspot, we are too often left with vague impressions and shortened conventions. As it was, the 1907 panic is well-known to be instrumental in carrying out the third US attempt at a central bank, with JP Morgan simultaneously playing the roles of villain and hero. It was his gallantry that supposedly saved the country from worse economic fate, with the "lost decade" of 1890's and the 1893 panic still fresh in vivid memory, and then that same graciousness that reminded and motivated a shaken political environment of just how dangerous such a "private" bottleneck could be.
Not to be left to the apparently impure whims of the banker class on Wall Street, we were first dignified with the Aldrich-Vreeland Act and then the National Monetary Commission, both of which crafted and carved by men whose mistrust of the people was only slightly less than that of the bankers (who were themselves undeterred in influencing these outcomes). From that point, the leap to the Federal Reserve was rather small, and almost logical as of necessity.
But a full survey of events surrounding 1907's irregularities is far, far less assured, which suggests the motive for it being left to the whims of historical notions driven by the desire to fit the conventions for the current age. For one, JP Morgan may have had himself a very great hand in the panic. When speaking about Morgan, it must be made plain that you are referring to all of the man as an individual, the man as a tangled financier and the very large, heavy apparatus to which was attached. His "interests" were far reaching, to say the least.
Over the years, here and there, scholarly articles have appeared no more than suggesting that there was a deficiency in the conventions surrounding Knickerbocker Trust. It was Knickerbocker that continues on as the central focus in turning more limited bank runs into a systemic panic. Immediately one should notice the legal structure which is designated in the name of the financial firm itself, as it was a trust not a bank.
Trust companies as a legal class were relatively new at that time and had arisen as such innovations always do, to get around regulations. The free mind of any free market will seek to stretch any and all limitations, so it should always be kept in mind, especially in finance and banking, that the shelf life of any regulation is also its issuance date. The trust structure had clear advantages over especially banks in the National Banking era, and so trusts were able to grow quite quickly out of the 1890's that had hampered and restricted especially national-chartered banks.
By the mid-1900's (the decade of the oughts, not the 1950's), trusts were becoming more than a nuisance to traditional banking. The domestic structure of the banking system itself, absent any central bank, had never really been as lonely as is presented mostly whenever someone gets around to poking about pre-1929 banking in America. The fact that there was no Federal Reserve was not a fatal distinction, though it is so often made out that way. In fact, through the whole industrial development of the nation there have been numerous private associations that performed the job not only admirably but quite ably. The Suffolk System in Boston in the early decades of the 1800's is perhaps the largest and most well-known, but the clearinghouse association was nothing new by 1900.
The rise of any clearinghouse is of natural necessity to any economy that wishes to gain more than a local foothold. Trade of goods beyond the horizon requires, and even demands, the ability to do more than barter at the point of transaction. In earliest years of the trade movement that was done strictly with actual money; gold and silver coin. Currency was rare because there was no sure means by which to settle it against money. A banknote drawn on a Boston bank would lose "value" (get discounted) the further from Boston you traveled. The Suffolk's System's genius was to incorporate regional banks within a single payment system network to "make the world smaller."
These clearinghouses were self-regulated not by diktat or arbitrary rules so much as true survivable discipline. Banks within the network had a very good interest in making sure they would not get stiffed by any other banks within the network, so banking was almost open book. What happened was that individual banks would hold correspondent balances within the system, usually a founding member bank or firm, based upon the system's perceptions of creditworthiness. That had the practical effect of some insulation against an individual bank's potential recklessness in issuing too much currency, bank notes, but also gave that bank very good incentive to carefully manage their reputation - larger correspondent balances were very expensive in terms of idle resources.
What is interesting as trusts came up and into the upper echelons of national banking at the end of the 19th century, is how different they were treated in the two primary money centers: Chicago and New York. As this article from 1995 published by the Federal Reserve Bank of Atlanta details quite well, for various reasons Chicago's clearinghouse incorporated trust companies while New York City's did not.
"The fact that New York trust companies were not members of the New York Clearinghouse, whereas the larger Chicago trusts were members of the Chicago Clearinghouse, greatly influenced how the private sector in each city was able to cope with the panic. In Chicago, the clearinghouse had timely information on the condition of most intermediaries in the city, including the trusts, and therefore was able to react quickly to any potential threats to the payments mechanism. The circumstance in New York was notably different. The apparent isolation of trusts from the New York Clearinghouse left the clearinghouse with inadequate knowledge of their condition and hindered prompt action when panic withdrawals first struck those intermediaries."
It had not always been the case, however, as trust companies had been welcomed into the clearinghouse earlier, perhaps as a matter of emergency lingering after the 1893 panic. But for whatever reason, they were effectively handed an unwelcome sign on June 1, 1904; in a bid against what the NYC banks termed "unfair advantage" with regard to being free of specie reserves in commercial banking activities, the New York clearinghouse association implemented a rule that trusts must hold a cash reserve of up to 15% of deposits. That was far greater than the 5% convention that had been operable until then.
The New York trusts, including Knickerbocker, promptly withdrew from the clearinghouse. The effect of that was a much more indirect line into the systemic liquidity function provided by the network. Not only were clearinghouses attentive toward reconciling and managing payment flows and balances, they could also provide quasi-currency when the need arose - acting out the call for "currency elasticity" that pro-Fed proponents claim did not exist until the Fed did.
If there were deposit problems leading to a liquidity shortage for a clearinghouse member, the clearinghouse would issue, upon its own very close reassurance (read: line by line intrusive audit) of member activities, loan certificates that could be used against payment liabilities. Thus members could be freed of reserve balance constraints with which to meet any large deposit withdrawals. In other words, it was a primitive but quite well-formed interbank methodology.
The clearinghouse could also order suspension of convertibility, one of the most powerful anti-panic tools available (and the central point of Milton Friedman's 1963 A Monetary History about the Great Depression; that the Fed didn't do it early in the panic when they clearly could and should have, according to him and co-author Anna Schwartz). The only matters missing from the clearinghouse system was, as of trusts in NYC, universal membership and universal, national currency.
But that did not mean the payment system in the United States was stunted, not at all. While regional clearinghouses served regional interests, the banking system itself had formed an organic network for taking and maintaining the national payment systems. Local banks, colloquially referred to as country banks, would hold correspondent balances with reserve city banks, which held correspondent balances with central reserve city banks, mostly the money centers of New York and Chicago. In that sense, there was a national clearing system and function without the designated formality; and minus the liquidity matters that were embedded in the local arrangements.
The central drawback of that schematic is the idle correspondent balances that banks had to maintain just to participate. It was a high but necessary cost of doing business, but only for the institutions further down the trough. Banks in the money centers had options, mostly "call money." The call market was the means by which banks in primarily NYC and Chicago (but also Philadelphia, Boston and St Louis) could "invest" these otherwise inefficient deposit balances somewhere. Because they needed to be highly liquid, the only place that made "sense" was in the stock market. As name "call" itself implies, the nature of the investment was intended for only the most short term basis and the money center bank making the investment had to be reasonably sure of its sound collateral and liquidity.
In some respects, that idea runs afoul of modern sensibilities about stocks, as our perceptions have been highly (too highly) influenced by what stock investing has become, the bubble aspects that weren't always around. In fact, stock investing used to be extremely boring, and if one wanted to take on huge risks and gamble with high degrees of speculation and "action" that was what the bond market was for. For banks using the "call market" to place correspondent deposits (indirectly, of course, the asset, the call loan, was owned by the money center bank balanced by its correspondent deposit liability) it was for the most part safely collateralized thus by stocks, with "appropriate" haircuts.
The net effect of this arrangement is as obvious as it sounds (if you can get past the arcane setup), namely that the domestic payments system was directly tied to the domestic stock market; so bank panics and stock markets crashes were really and truly synonymous. But that said more of the entanglement of correspondent network nodes and the payment system than how "risky" stocks were.
The effect of moving trusts out of the New York clearinghouse network in 1904 was to leave them precariously positioned in the existing interbank liquidity assembly. A trust would have to maintain a deposit account with a clearing member bank, but was then subject to the particular idiosyncrasies of that bank as a point of entry or egress, monetarily speaking. It also had the practical effect of tying that bank to the trust, for good or ill.
While there are several indications that the dismissal of the trusts from NYC clearing network was as innocent as it sounds, as a matter of "fairness", there are perhaps just as many that suggest far more nefarious intent. Trusts had become not just alternate financial structures but a real threat to banking interests. In the article I quoted above from the Atlanta Fed the authors quote non-contemporary sources recounting how banks at the time had openly declared "a trust company problem." Some sources have speculated that the NYC banks even went so far as to instigate the panic in 1907 as a means to eliminate the competition.
These are not the fever swamps of conspiracy enthusiasts, as in addition to the Atlanta Fed's article there is a favorable 1989 review of the history of Montana copper magnate F. Augustus Heinze published in a Minneapolis Fed magazine that also mentions the determination of New York banks to set an example of some trust. Heinze had made a fortune in copper mining and by 1906 had moved to New York, purchased a bank and several trust interests which placed him on their boards (which was important at that time, as opposed to now those that ran firms also held large equity positions, thus entangling personal fortunes with financial firms; a bank's or trust's reputation could therefore be enhanced by whomever was in charge).
It is here that the panic gets so very murky, because one side tells it as Heinze as who was primarily the responsible party in his attempt to corner the copper market through the stock of United Copper Company. The "other side" more favorable to Heinze says that it was agents of Morgan wishing to end the trust threat by weakening the liquidity position of some trusts connected to Heinze, exploiting that indirect manner in which trusts accessed the clearinghouse. Among those that were hit with "silent runs", as they were called, was one outfit particularly entangled with Heinze's various interests, Knickerbocker Trust.
Before Knickerbocker failed, however, the United Copper fiasco had opened a window into Heinze's personal financial interests, which were then used (appropriately or not) as justification for recriminations against some of his other financial interests. Mercantile National Bank, for one, was hit with a determined bank run as one of the more prominent Heinze-connected financials, to which the New York clearinghouse determined it solvent and savable with but one caveat - that Heinze resign from the board and relinquish all control.
There was no such courtesy for Knickerbocker, however, as it was not a clearinghouse member and one of its interbank "conduits", The National Bank of Commerce, declared that it would no longer clear Knickerbocker liabilities. It is here that JP Morgan enters our story; as either savior or instigator will forever be unknown. Morgan had been trying to gather together resources to engineer a relief of Knickerbocker and some other of Heinze's interests, but was that as benevolence to the wider banking and, more importantly, payments system or as the brilliant but dangerous end of what amounted to a hostile takeover?
The accusations were contemporary, as even JP Morgan's son-in-law, HL Satterlee, was noted to have proclaimed no bank would dare bring a run on another, trust or not, for direct fear of bringing itself down in the wave. It's a sound argument, but risk is (in the long run) closely tied to reward.
I have no earthly idea which version is "correct" and there may just as well be enough of both to make any distinctions not worth the time it takes to think about them. What did occur was exactly what the trusts feared most, that the panic would galvanize the people enough in a backlash against them that would see re-domination by the banks. And that is what happened with one important addition - the addition of the central bank itself as an "answer" to this "unanswerable" mystery. There was enough suspicion that brought the central bank idea over the hump, and thus secured support that had been noticeably absent prior to that point.
The Federal Reserve came into existence in 1913 and the convention is that we all rode into the sunset with both thanks and admonition for the Wall Street banking syndicates, including Morgan's. The problem with that narrative is that it doesn't account for both the full measure of 1907 nor what occurred in 1929. The Fed system had addressed the clearinghouse "deficiencies", as it saw them, with both universal (almost) membership nationally and of course the Federal Reserve Note and national currency. In 1907, Chicago's financial standing, though much smaller than New York, survived the panic intact as, again, their clearinghouse system admitted trusts; no liquidity distinctions were made due to their own close, but isolated, experience with trust failures in the years just prior to 1907. Why didn't the Fed then perform like the Chicago version in 1929?
The conventional lessons taken are those of Friedman, added further from Bernanke and others that say the Fed didn't print, essentially, enough currency to satisfy liquidity needs of banks; thus the management of the Fed at the time comes under withering suspicion of modern historians and economists of not adhering closely enough to "currency elasticity", especially of the Chicago type. That view is highly debatable itself (but beyond the argument here) but it still doesn't answer why the setback was so devastating in the first place.
The only response to that charge has been Irving Fisher's supposed "paradox"; that high degrees of prior indebtedness work against the initial deflation that comes with depression. Fisher assumed that lower prices mean a greater burden for borrowers, and thus in the actual economy paying off debts only leads to further deflationary pressures which reinforces all the badness, and so on. While I have little doubt that was a factor, it still doesn't comprehensively answer the devastation, instead only yields this continued obsession with credit and debt as the only means to expression.
Actual observation of the 1920's shows several problems with all these interpretations. Primary among those is the call market. The amount of correspondent balances that were ending up in the call market, and thus driving stock prices, was simply staggering as convertibility expanded almost exponentially; there is no way to express it in our own terms as the numbers were absolutely mind-boggling. But these interbank balances were not just driven by the correspondent system, they were also very much a function of central banks around the world doing whatever they could to remove any and all gold standard restrictions. That included immense (for that age) currency swaps and the holdings of various foreign "reserve" balances on deposit in money center banks in New York, London and Paris.
This was never supposed to happen under a true gold standard as exchange was supposed to be self-extinguishing. These "reserves" and swap arrangements had the effect of increasing liabilities balances at the various global bank network connections (as the eurodollar standard has done since the 1960's in today's replacement regime for Bretton Woods) which, in NYC, were not to be left idle and thus found their way into the call market and the roaring stock bubble of the late 1920's.
The real problem of that was this intimate arrangement whereby the national (and international) payments system was inextricably linked to stock prices (if only as collateral at first, but that was a huge problem in setting the stage for systemic illiquidity). As it all began to reverse, the correspondent system imploded on itself, amplified to no end by the removal of those foreign "reserve" balances in the earliest stages. The effect of that was to hinder the entire national payment system from the top on down.
Currency, despite the national nature of the Federal Reserve system, was no longer quite negotiable because there was no honest trade among the correspondents. Worse, and where the Great Depression really came from, was the fact that Americans not only lost jobs and incomes they lost the ability to transact for even the basics of their modern existence. The shortage in the payment system not only led to bank failures, it exploded the means by which currency could flow where it needed to flow - no matter how much the Fed used its "printing press." This should all sound very familiar to anyone observing the deficiencies of the 2008 panic and the age of QE.
Deflation wasn't borrowers paying themselves down into oblivion, it was the very real inability of actual monetary flow to foster beneficial economic transactions; to the very real point that far too many people had to sell their own possessions to raise their own personal "liquidity" just to survive. Making that a money "supply" problem alone misses a great deal of the decline, in my view.
What happened after 1907 was that the national system under the Fed only tied the payment and financial systems that much closer together, and thus set up the very pathology of panic, crash and depression that hit in 1929. Similarly, in 2008 under the various QE's and especially TARP the Fed has done it again, a fact made all the more curious since the panic itself was of wholesale and global finance, having nothing to do with the modern payment system itself. It is the system of personal deposits, the foundation of economic payments, that has been used to give overemphasis to the financial system when there is no earthly reason for that; which, in view of what occurred, means the world's central banks hold much higher priority for the credit capacity of the financial system than even actual payments since they used the latter to bail out the former. If that doesn't address just how upside down and how out of hand this credit-driven obsession has become over the decades then nothing will. If anything, the lessons of history strongly suggest compartmentalization and prioritization of payments over credit (and it should not even be close), not the least of which is the vast tendency for that entanglement to present numerous and dangerous vulnerabilities and bottlenecks; intentional or not.
