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But the economy started to slow a little in , depressing the prices of raw materials, including metals. With the prices of their stocks falling Heinze and Morse faced losses magnified by their huge leverage. To prop up the market, they began to tap funds from the banks they ran.

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This whipped up trouble for a host of smaller lenders, sparking a chain of losses that eventually embroiled a trust company, the Knickerbocker Trust. Its Corinthian columns stood out even alongside its neighbour, the Waldorf Astoria. The exterior marble was from Vermont; the interior marble was from Norway. It was a picture of wealth and solidity. Yet on the morning of October 22nd the Knickerbocker might as well have been a tin shack. When news emerged that it was caught up in the Heinze-Morse financial contagion, depositors lined the street demanding cash.

Some New Yorkers moved cash from one trust to another as they toppled. When it became clear that the financial system was unsafe, Americans began to hoard cash at home. For a while it looked as though the crisis could be nipped in the bud. After all, the economic slowdown had been small, with GDP still growing by 1. And although there were crooks like Heinze and Morse causing trouble, titans like John Pierpont Morgan sat on the other side of the ledger.

But it was not enough. Depositors across the country began runs on their banks. Sensing imminent collapse, states declared emergency holidays. Those that remained open limited withdrawals. Despite the robust economy, the crash in New York led to a nationwide shortage of money. With legal tender so scarce alternatives quickly sprang up. These included cheques and small-denomination IOUs written by banks. It did the trick, and by the American economy was growing again.

The earliest proposals for reform followed naturally from the cash shortage. But the emergency-money plan had a much longer-lasting impact. The NMC sat for four years, examining evidence from around the world on how best to reshape the system. It concluded that a proper lender of last resort was needed.


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Hamilton had belatedly got his way after all. Until the eve of the slump—the worst America has ever faced—things were rosy. Cars and construction thrived in the roaring s, and solid jobs in both industries helped lift wages and consumption. There were bumps along the way and saw slowdowns but momentum was strong. Banks looked good, too. With assets of such high quality the banks allowed the capital buffers that protected them from losses to dwindle. But as the s wore on the young Federal Reserve faced a conundrum: share prices and prices in the shops started to move in opposite directions.

Markets were booming, with the shares of firms exploiting new technologies—radios, aluminium and aeroplanes—particularly popular. But few of these new outfits had any record of dividend payments, and investors piled into their shares in the hope that they would continue to increase in value.


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At the same time established businesses were looking weaker as consumer prices fell. For a time the puzzle—whether to raise rates to slow markets, or cut them to help the economy—paralysed the Fed. In the end the market-watchers won and the central bank raised rates in It was a catastrophic error. The increase, from 3. Adding to the domestic woes came bad news from abroad. A sell-off was coming. Worse was to come. Bank failures came in waves.

The first, in , began with bank runs in agricultural states such as Arkansas, Illinois and Missouri. A total of 1, banks failed that year. Then a second wave hit Chicago, Cleveland and Philadelphia in April External pressure worsened the domestic worries.

As Britain dumped the Gold Standard its exchange rate dropped, putting pressure on American exporters. There were banking panics in Austria and Germany. As public confidence evaporated, Americans again began to hoard currency. A bond-buying campaign by the Federal Reserve brought only temporary respite, because the surviving banks were in such bad shape. This became clear in February A final panic, this time national, began to force more emergency bank holidays, with lenders in Nevada, Iowa, Louisiana and Michigan the first to shut their doors.

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Naturally the city bankers turned to their new backstop, the Federal Reserve. But the unthinkable happened. On March 4th the central bank did exactly what it had been set up to prevent. It refused to lend and shut its doors. In its mission to act as a source of funds in all emergencies, the Federal Reserve had failed. A week-long bank holiday was called across the nation. It was the blackest week in the darkest period of American finance.

What We Should Have Learned From the Financial Crisis

After this low, things started to improve. Unemployment, just 3. It took more than 25 years for the Dow to reclaim its peak in Reform was clearly needed. The first step was to de-risk the system. In the short term this was done through a massive injection of publicly supplied capital. Future risks were to be neutralised by new legislation, the Glass-Steagall rules that separated stockmarket operations from more mundane lending and gave the Fed new powers to regulate banks whose customers used credit for investment.

Limiting depositor losses would protect income, the money supply and buying power.

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And because depositors could trust the FDIC, they would not queue up at banks at the slightest financial wobble. In a way, it worked brilliantly. Banks quickly started advertising the fact that they were FDIC insured, and customers came to see deposits as risk-free. For 70 years, bank runs became a thing of the past.

Banks were able to reduce costly liquidity and equity buffers, which fell year on year. An inefficient system of self-insurance fell away, replaced by low-cost risk-sharing, with central banks and deposit insurance as the backstop. Yet this was not at all what Hamilton had hoped for. He wanted a financial system that made government more stable, and banks and markets that supported public debt to allow infrastructure and military spending at low rates of interest. By loading risk onto the taxpayer, the evolution of finance had created a distorting subsidy at the heart of capitalism.

The recent fate of the largest banks in America and Britain shows the true cost of these subsidies.

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Their capital buffers were tiny. The overall cost of the banking crisis is even greater—in the form of slower growth, higher debt and poorer employment prospects that may last decades in some countries. But the bail-outs were not a mistake: letting banks of this size fail would have been even more costly. The problem is not what the state does, but that its hand is forced. Knowing that governments must bail out banks means parts of finance have become a one-way bet. This makes debt cheap, and promotes leverage.

Again, this pins risk on the public purse. It is the same old pattern. To solve this problem means putting risk back into the private sector.


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  6. That will require tough choices. That's bad compared with the U. The government has responded to these reports with typical aplomb.