How Banking Panics Worked Before the Fed
By Bryan Caplan
Princeton has re-released Friedman and Schwartz’s The Great Contraction. Ben Bernanke’s speech in honor of Friedman’s 90th birthday is now the book’s epilogue. The highlight, for me, is Bernanke explaining how banks dealt with panics before the Fed existed:
Before the creation of the Federal Reserve, Friedman and Schwartz noted, bank panics were typically handled by banks themselves–for example, through urban consortiums of private banks called clearinghouses. If a run on one or more banks in a city began, the clearinghouse might declare a suspension of payments, meaning that, temporarily, deposits would not be convertible into cash. Larger, stronger banks would then take the lead, first, in determining that the banks under attack were in fact fundamentally solvent, and second, in lending cash to those banks that needed to meet withdrawals. Though not an entirely satisfactory solution–the suspension of payments for several weeks was a significant hardship for the public–the system of suspension of payments usually prevented local banking panics from spreading or persisting…
The Fed was created, of course, to improve upon this system. But after pushing aside the market’s traditional response to financial crisis, the Fed proved unable to equal it:
It was in large part to improve the management of banking panics that the Federal Reserve was created in 1913. However, as Friedman and Schwartz discuss in some detail, in the early 1930s the Federal Reserve did not serve that function… At the same time, the large banks–which would have intervened before the founding of the Fed–felt that protecting their smaller brethren was no longer their responsibility. Indeed, since the large banks felt confident that the Fed would protect them if necessary, the weeding out of small competitors was a positive good, from their point of view.
Just to be clear, Bernanke isn’t just explaining the Friedman-Schwartz view; he’s endorsing it with a few caveats.
One point I wish Bernanke made: The U.S. banking system’s “not entirely satisfactory” approach to crisis operated under a major handicap: The branch banking laws. Until then 1990s, an array of state and local regulations prevented banks from geographically diversifying. As a result, the U.S. banking system was unusually vulnerable to regional economic shocks. Thus, even without the benefit of hindsight, the creation of the Fed was poorly conceived. If Americans wanted to increase the stability of their banking system, they could simply have abolished the laws that made it so unstable.