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Title: Financial Panics: 1600 - 2000

1
Financial Panics 1600 - 2000

Peter Fortune
Ph.D. Harvard University
www.econseminars.com
Email pf_at_econseminars.com

Legendary Crises
in the
17th and 18th Centuries

3
The Dutch Tulip Mania Of
1636-37 A Famous Non-Event

References Garber, Peter. Famous First Bubbles
The Fundamentals of Early Manias, MIT Press,
Cambridge MA, 2000 (esp. pages 20-86)
4

? The Context
The Netherlands in the 1630s
? Bubonic Plague in the Netherlands
(1634-1637)\
? 17 of Amsterdam died
? The National Psyche Turned To The
Short Term
The Botony of Tulips
? Bulbs Were Planted in September, Bloomed in
May
? One Bulb Could Produce Several Bulbs via Buds
? Exotic Bulbs Always Rare A Known Commodity
? Common Bulbs Could Become Rare if Infected
by a Specific Virus, Making Them A Perfect
Speculative Commodity

? The Tulip Bulb Market
The Exotic Bulb Market
? Exotic Bulbs Traded in a Sophisticated Dealer
Market
? Exotic Bulbs Were Traded by the Bulb
? Exotic Bulbs Were Very Expensive Both Before
and After
the Tulip Mania
The Common Bulb Market
? Common Bulbs Were Traded in Bulk
? Common Bulbs Traded in Taverns (Colleges)
? Common Bulbs Traded in a Forward Market
Bulbs Were Bought in the Fall for Delivery in
May

? Characteristics Of Forward Contract
No Margin Required from Buyer
No Bulb Required of Seller (Naked Contracts)
All Contracts Were for Forward Delivery
Most Contracts Cash Settled Delivery of
Actual
Bulb Was Rare
Contracts Were Not Marked to Market (Limited
Lender Protection)
Contracts Traded in Taverns (Drinking Game)
Contract Trading And Prices Peaked at Height
Of The Plague (1636)

? Tulip Bulb Prices During The Bubble
Exotic Bulb Prices
? Prices Rose Steadily Throughout 1634-1636
? Prices Remained High After 1636
Common Bulb Prices
? Prices Remained Steady Until Sharp Spike in
November 1636
? Prices Fell Sharply After January 1637

? Effects on Dutch Economy
Government Suspended Tulip Contracts in
April 1637
No Evidence That Any Contracts Were
Enforced By Courts
No Indications of Bank Failures
The Tulip Mania Was A Non-Event

The French Mississippi Bubble
And
John Law
The First Financial Engineer
1716-1722
References
Garber, Peter. Famous First Bubbles The
Fundamentals of Early Manias, MIT Press,
Cambridge MA, 2000. (esp. pages 87-102)
Velde, Francis. 2004. Government Equity And
Money John Laws System In 1720 France. Federal
Reserve Bank of Chicago, mimeo.

10
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11

? John Law
A Brilliant Scottish Monetary Theorist
An Iveterate Gambler, Probable
Murderer, And
An International Black Sheep
Peripatetic, Chased Out of Many Cities,
Settled in
Paris in 1715
Became Financial Advisor to the Duke of
Orleans,
Regent for Louis XV After Convincing Him
That A
State Bank Would Improve The Public Credit

? The Historical Context
Louis XIV, The Sun King, Died in 1715
After Versailles, Profligate Spending, and
Numerous Wars, the French Government Was
Near Bankruptcy
The Economic Policies of Louiss Finance
Minister, Jean Claude Colbert, Left the
French
Economy Bound by Rigid Regulations and
Restrictive Trade Policies (Mercantilism)

13
The French Governments Budget Deficit Under
Louis XIV
14

? Key Elements of Laws Monetary Theory
Substitution of Fiat Money for Specie Will
Allow
Increased Credit Resulting in Increased
Trade
and Higher Tax Revenues
Privatizing the French National Debt Will
Strengthen the Public Credit and Prevent
Crowding Out of Private Investment
These Goals Can Be Achieved By Creating A
State Bank To Sell Shares to the Public, Use
the
Proceeds to Buy French Government Bonds (A
Debt for Equity Swap), And Increase the
Money
Supply by Lending and Issuing Bank Notes

? Formation of the Banque Generale (1716)
Functions of the Banque
? Deposit And Note Issue
? Took Specie Deposits Convertible Into
Bank Notes
? Made Private Loans Issuing Bank Notes
In Exchange
? Investments And Asset Management
? Purchased French Government Debt at
Par, Paying
In New Bank Notes
? Held Tax Farming Rights And Foreign
Trading Rights
Protection Of Deposits And Notes
? Initially Held High (50) Reserves in
Specie
? Value of Notes Protected Against
Devaluation of
Coinage
? By 1720 the Government Prohibited Large
Payments in
Specie And Made Bank Notes the Sole Legal

? The Banques Equity Structure
Issued Shares to the Well Connected
? The King Was the Largest Investor
? Society Subscribed Heavily
Shares Viewed As A Slam-DunkA Free Call Option
? Shares were sold via Call Option with 5,000L
Strike
Price20 Up Front, Remainder in 5 Months,
with
Right to Cancel
? Payment for Shares was 25 Specie and 75
Government Bonds at Par (Market Price was
60 of Par)
? Investors could borrow from the Banque to
Pay for Shares (Margin Debt)

? The Market For Banque Shares
A High Share Price Was Essential To Banque
Viability
? Shareholders Received Value Increase
If Price-Earnings
Ratio on Stock Exceeded The
Price-Dividend Ratio On
Government Debt That Was Tendered
For Shares
? Three Sources Of High Stock Price
? Strong And Increasing Revenues
From Government
Bonds Held, Tax Farming Rights,
Foreign Trading
Rights, And Return On Loan
Portfolio
? High Confidence In Convertibility
Of Notes Into
SpecieA Run On Specie Would
Deplete Reserves,
Force Sale Of Assets, And Reduce
Capital
? The Banques Stock Repurchase
Program

? Laws Share Price Support Plan
If Share Prices Fell Below A Threshold,
The Banque
Would Engage In Stock Repurchases
? Print Notes And Buy Shares To
Maintain Required Price
The Inherent Contradiction
? Effect Of Share Support Would Be
Increased Note
Issue
? As Notes Outstanding Grew
Relative To Specie,
Noteholders Would Convert
Notes To Specie
? A Run On The Banque Might
Result
? The Note Issuance Would Create
Inflation
? Foreign Noteholders Would
Convert Notes To
Specie And Repatriate The
Specie
? Credit Would Tighten In France
And A Credit
Crunch Would Emerge

? The Banques Middle Stage (1717 1718)
In 1716 to 1717 The Banks Was Wildly Successful
? Shareholders Received A 64 Annual Dividend
? The Business Model Was Confirmed
In 1717 Law Formed the Compagnie dOccident
? Purchased the Louisiana Company and the Canada
Company
with All Development Rights in Canada and
Mississippi
? IPO Was at 500L Per Share, Payable Entirely in
Government
Bonds
? IPO Was Executed Via Call Option Sale, As In
General Bank
In 1718 The Government Nationalized The Banque
? The King Bought All Existing Shares
? Provided the King With a Printing Press

? The Compagnie dOccidente Buys The Government
In 1718 The Company of the West Undertook
a Series
of Major Acquisitions
? Bought the Rights to All Tax Farming
in France
? Acquired Other Trading Companies
(Senegal, West
Indies, Africa)
? Was Granted the Right to Run the Royal Mint
and
Receive All Seignorage (10-20 Premium)
The Company Was Renamed the Compagnie des
Indes
? Shares Sold For 500L At IPO
? Subscribers Coud Delay Payment And Had
Right To Cancel
The Company Acquired the Royal Bank in
Feb 1720

? The Status Of Laws System By Early 1720
Law Had Completed an LBO of the Government
? Taken Over All Aspects of Frances Finances
? Taken over All Government Foreign Trading
Rights
? Become the Sole Issuer of Bank Notes--Which
Had
Become Frances Sole Legal Tender Except for
Company
Use of Specie in Foreign Transactions
Use Of Banque Notes To Finance LBO Created
Excessive Note Issuance And Major Economic
Problems
? Significant Inflation Began As Money Supply
Exploded
? The French Livre Began To Decline Relative To
Specie,
Reducing Confidence In Note Convertibility
Into Specie
? The French Currency Depreciated Relative To
Foreign
Currencies, Creating More Inflation And
Specie Outflows

? The Late Stage (1720-1721)
In May 1720 The Baque Experienced Runs As
Noteholders Converted To Specie
? Surge In Notes Outstanding Relative To
Specie Reserves
Created Loss Of Confidence In Paper
Money
? The Banque Lost Specie Reserves
? The Loss In Reserves Led To Further
Conversions
? The Banque Was Forced To Sell
Assets
? Asset Prices Declined, Reducing
Bank Capital
? Government Delared Notes To Be The Sole
Legal
Tender
? Goal Was To Prevent Conversion Of
Notes To Specie

? In May 1720 The Companys Stock Price Collapsed
? Initial Causes
? Profit-Taking Share Price Had Risen
To 10,000L
? Banques Capital Was Eroding
? Paltry Revenues From Foreign Trading
Rights
? Law Implemented Stock Repurchases
? The Company Set A Repurchase Price
Of 9,000L
? Stock Repurchases Added To Note
Issue And
Additional Banque Problems

24
Banque Notes in Circulation Peaked in May 1720
25
The Specie-Value of Banque Notes Began
Rapid Depreciation in May 1720
26
The Companys Stock Price Collapsed After May 1720
27

? What Went Wrong?
Key Weaknesses
? Laws Business Model Flawed
? Subscribers To Company Shares Could Pay
Modest
Amount Down, Remainder Later, With
Right To Cancel
? Viability Required a High Share Price
But Stock
Repurchase Program Exacerbated The
Economic Problems
? After Initial Success, Company Revenues
Failed To Meet
Expectaions
? Banque Had Seriously Overpaid For
Government Bonds
? Laws Monetary Theory Was Wrong
? Substitution Of Fiat Money For Specie
Resulted In Inflation,
Not Greater Trade

? The Aftermath
Several Attempts to Save the Company by
Converting
Banque Notes to Banque Bonds Failed
Law Fled France in 1720, Died in 1729
The Government Reversed the System,
Converting
Banque Notes and Bonds to Government
Bonds
The Indies Company Was Given Additional
Monopolies and It Survived
The Clean-Up Was Completed in April 1722
France Prohibited the Creation of
Organizations
Named Banque, Substituting the words
Credit or
Societe, as in Credit Agricole or
Societe Generale

Did Laws System Create Additional Trade?
No, Its Primary Effect was on Inflation

30
? Answer An Emphatic NO To All Of The
Following Did Laws System Strengthen the
Governments Credit? Did The System Create
Financial Stability? Did The System Create
More Production And Trade? Did The System
Develop the Mississippi Area? ? No
Significant Investments Were Made in Louisiana ?
The Spanish Were Unwilling to Let France Take
Away Its Trade Routes in the Americas
31

? Lessons From The Mississippi Bubble
Monetary Expansion Affects Prices More
Than Trade
The Risk of Low Bank Cash Reserves The
Banques
High Ratio of Notes Outstanding to
Reserves
Exposed It To Runs
The Risk of Reputational Put Options
The
Companys Efforts to Set a Floor on Its
Stock Price
via Buy-Backs Contributed to Its
Weakness
The Risk of High Leverage The Company
Had High
Indebtedness And Its Capital Was Easily
Threatened By
Declines In Asset Prices
All Of These Have Re-Emerged In Later Financial
Crises!

The English South Seas Bubble
Lawss System Redux
Reference
Garber, Peter. Famous First Bubbles The
Fundamentals of Early Manias, MIT Press,
Cambridge MA, 2000.

? The Background
1711 - The South Seas Company Is Formed to
Develop Trade With The East Coast of South
America
? Gold and Silver in Spanish Americas Mexico,
Peru, Chile
? Spain was Expected to Allow English Trade
Presence In
The South Seas
? Spain Allowed Only One Vessel Per Year,
Demanding
25 of Profits and a Tax of 5 On
Remainder of
Profits
? First Vessel Not Sent Until 1717 But
Spain Allowed
No More
? Even So, The Companys Shares Remained Strong

? The Government Captures The South Seas Company
In 1717 the King, Impressed by The Apparent
Success
Of Laws Scheme, Proposed Refunding the
Public Debt
? South Seas Company and Bank of England Both
Invited to
Propose Plans to Sell Shares and Buy
Government Debt,
Then Renegotiate Debt With Government
? The Company Embarked on Extensive Bribery
of
Parliament to Obtain Favorable Terms
? After Lengthy Debates, the South Sea
Company Won
the Contract
? The First Act Allowing Refunding Passed
Parliament in
March 1720
? Investors Could Covert Government Bonds
to South
Seas Shares, Bonds, and Cash at
ParAbout Twice
The Market Value Of Government Bonds

A Surge in Speculation on South Seas Shares
Began

? The End
The Speculation Resulted in Formation of
Numerous Bubble Companies, Many of Them
Scams
? Parliament Passed Bubble Act In June
1720 to
Prevent Competition With The Company
? Shares of Bubble Companies Fell,
Forcing Margin
Calls and Sales of Shares in Good
Companies
? A Liquidity Crisis Emerged In Which The
South Seas
Companys Shares Were Dragged Down

The U.S. Monetary System 1870 1936
Essential Background Information
Reference
Friedman Milton. Money Mischief Episodes in
Monetary History, Harcourt Brace Co., New York,
1994. (esp. pages 51-79)

? Bimetallism Before 1870
Until 1873 Most Of The World Was
On A
Bimetallic Monetary Standard
? Both Gold and Silver Were Legal
Tender
? The Mint Would Buy or Sell Silver at a
Silver-Gold
Ratio of 16 Ounces of Silver to 1 Ounce
of Gold
? The U.S. was Effectively on a Silver
Standard
Before the 1870s Because the Silver-Gold
Market
Price Ratio Exceeded the Mint Parity of
161
The Problem Of Bimetallism
? When Gold-Silver Market Price
Deviated From
161, One Metal Would Be Hoarded, The
Other
Used For Payments
? Greshams Law Bad Money Drives Out Good
Money

? The Rise Of The Gold Standard
Prior To 1870 Bimetallism Prevailed
? Every Country Set A Mint Ratio
(Usually 161)
? Mint Would Exchange 1 oz. of Gold
For 16 oz. of Silver
? 1 oz. Gold 20.64 gt 1 oz.
Silver
The Start of The Gold Standard
? Germany Won The Franco-Prussian in 1871
? Germany Levied Reparations on France
Payable in Gold
? Germany Then Went on a Gold Standard
? In 1873 The U.S. Went On The Gold Standard
? By 1900 All Western Countries Had
Demonetized Silver
And Adopted a Gold Standard
? China and Other Asian Countries Adhered to a
Silver
Standard

? The U.S. Goes To Gold
Fourth Coinage Act of 1873 (The Crime Of
73)
? Ended Purchases of Silver by U.S.
Mint
? Created A Gold-Based Currency and U.S.
Adherence to an
International Gold Standard at 1 oz.
20.64
? Resulted in a Decline in Silver Prices and
Economic Difficulties
in the Western U.S.
? Called The Crime of 73 by Western
Silverites
? Shaped the Political Debate for 30 Years,
for example, Bryans
Cross of Gold Speech in 1896
? Had U.S. Stayed on a Silver Standard, the
Depression of the
1890s Might Have Been Mitigated
? Dollar Would Have Depreciated Relative
To Gold Area
? Periodic Gold Outflows That Troubled
The Economy Would
Not Have Occurred

41
The Gold Standard after 1873
42

? The Pros And Cons Of The Gold Standard
Positive Aspects Of Fixed Exchange
Rates
? No Exchange Rate Risk
? Easy to Compute Prices of
Foreign Goods
? International Lending Less
Risky
? Encourages Globalization of
Trade and Finance
? Reduces Possibility of Prolonged
Inflation
Cons
? Limits Control Over Domestic Money
Supply
? Links International Economies
TogetherBooms
and Busts Quickly Transmitted
Abroad
? Can Promote Economic Instability
When Policies in
Different Countries Arent
Synchronized

43
The U.S. Monetary Framework Under the
Gold Standard
44
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45
19th and Early 20th Century Monetary Crises
The
Panic of 1893 The Panic
of 1907
46
The Panic of 1893
References
47

? The Ecnonomic Context
Railroad and Steel Consolidations
? Declining Rail Tariffs led to Increased
Competition,
Especially For Short Haul Routes
? JP Morgan Led a Railroad Consolidation Movement
? Morgan Formed U.S. Steel, A Consolidation of
Carnegie-
Related Steel Companies
Declining Commodity Prices
? Western Farmers Under Pressure As Ag Prices
Fell
? Silver Prices Declined in Utah and Nevada
? Coalition of Western Senators Pushed for
Increased
Credit From Eastern Banks and Return to
Bimetallism

? The Monetary Context
Supply of Bank Notes Was Linked to Gold
Reserves at Banks And The U.S. Treasury
(High-Powered Money)
Predictable Credit Cycle Associated with Crop
Harvests
? Bank Notes And Gold Moved Westward as Farmers
Borrowed In The Fall Planting Season
? Gold Imports Rose as Eastern Banks Borrowed
Abroad in The Fall To Finance Farm Credit
? A Regular Credit Crunch in FallInterest Rates
Would Rise As Credit Demands Rose

? The Triggers
Sherman Silver Purchase Act of 1890
? Required U.S. Treasury to Buy 4.5M
Ounces of Silver
Monthly Using Silver Certificates (Bank
Notes
Convertible Into Silver)
? Created Foreign Fears That U.S. Would Abandon
the Gold
StandardLending to U.S. Fell Sharply and
Gold Flowed Out
of Country
? Reduction in Treasurys Gold Reserves Created
Incentives to
Convert Gold Certificates into Gold for
Non-Monetary Uses
? Treasury Suspended Convertibility of Gold
Certificates
? Result Was A Severe Credit Crunch as Bank
Lending Fell
? The Sherman Act Was Suspended in 1893

? The Economy In The Early 1890s
Continued Decline of Agricultural Prices
?Bumper Crops in U.S.
? Farm Loans Defaulted in Midst of
Prosperity
? Farmers Reduced Purchases
Important Industrial Company Failures
? Philadelphia and Reading Railroad
? National Cordage Company
? Many Banks (Mostly Western)
Labor Strikes

? The Economy After 1893
The 1890s Had Several Money-Related Episodes
Unemployment Remained High Throughout the
Decade
The 1896 Campaign Was Between the Easy-Money
Silverites, Led by Bryan, and the
Hard-Money
Gold Standard Advocates led by McKinley
The Debate Over The Gold Standard Continued For

52
The Economy After 1893
53
Interest Rates In 1890-1910
54
The Panic Of 1907ReferencesBruner,
Robert and Sean Carr. The Panic of 1907 Lessons
Learned from the Perfect Storm, John Wiley
Sons, Hoboken NJ, 2007.Tallman, Ellis and John
Moen. Lessons From The Panic of 1907, Economic
Revew, Federal Reserve Bank of Atlanta, 1990.
55

? The Players
Commercial Banks
? National Banks in Money
Centers Could Hold Treasury
Deposits
? Rural Banks Held 25 of Deposits in
Reserves40
Cash And 60 In Deposits at
Reserve City Banks
? Reserve City Banks Held 25 of Deposits in
Reserves
50 Cash and 50 in Deposits At Major Money
Center
Banks
? Money Center Banks Provided Services to
Lesser
BanksCheck Clearing, Currency and Coin
? Money Center Banks Provided Security Credit
to
Brokerage Companies Which Made Margin Loans
to
Stock Investors

? The Players
The Trust Companies
? Tended Toward More Aggressive Investments
Than Banks
? More Lightly Regulated Than Banks
? Provided Deposits Like Banks
? No Reserve Requirements Before 1906
? 15 Reserve Requirements Imposed in 1907
33 In Cash

? The Players
The New York Clearing House (NYCH)
? Cleared Checks for Money Center, Reserve
City, and
Rural Banks
? Made Net Payments at End of Day
? Provided Loans if a Banks Balances at
NYCH Were
Insufficient
? Served as the Lender of Last Resort
The New York Stock Exchange (NYSE)
? Member Firms Traded Stocks
? NYSE Responsible For Clearing (Settlement)
? Member Firms Borrowed from Money Center
Banks to Make
Margin Loans to Customers
? NYSE Provided Loans To Members With
Insufficient
Balances to Meet Net Payments

? The Economic Context
A Deteriorating Economy
? Stock Prices Down 8 Sept 06 to Feb 07
? Stock Decline Accelerated in March 07
Gold Outflows After Britain Prohibited
Finance Bills
? Finance Bills Were Loans to U.S. to Speculate
Against the
PoundBorrow Sterling, Buy Dollars
? Gold Outflows Reduced Bank Reserves and Bank
Lending
? Interest Rates Increased
Tight Money Was Compounded by Annual Fall
Credit
Demand Associated With Agricultural Harvests

? The Triggers
Stock Manipulation A Short Squeeze on United
Copper Company Shares
? Otto Heinze (Heinze Co. Broker), F. Augustus
Henize
(President, Mercantile Bank), and Charles
Morse (Chairman,
Mercantile Bank) Believed that There was a
Large Short
Position in UCC Shares
? Hatched Plan for a Short SqueezeBuy UCC Shares
on
Margin, When Short Sellers Try to Cover The
Heinze-Morse
Group Would Profit From Price Spike
? Problem UCC Price Increase Was Not Due to
Short Positions
But To Copper Supply Restrictions By a UCC
Competitor
? Heinze Tried to Force Shorts to Cover by
Requiring Return of
Groups Shares That Had Been Loaned to Short
Sellers
? Instead, UCC Price Fell When Competitor
Returned to Normal
Copper Production
? Heinz Bros. Faced Margin Calls When UCC Price
Weakened

? The Triggers
Consequences of the Failed Short Squeeze
? In Mid-October, 1907 UCC Shares Plunged as
UCC
Owners Sold HeavilyLiquidity Disappeared
? Heinze Bros. Defaulted on Margin Loans,
Forcing
Brokers Into Default on Bank Loans from
Mercantile Bank
? Heinze Co. Was Suspended by NYSE
Mercantile Bank Fired
Augustus Heinze
? A Run on Mercantile Bank Began Its Cash Was
Drained and
It Was Unable to Repay Loans or Redeem
Checks
? NYCH Concluded that Mercantile was Solvent
and Decided to
Lend to It To Restore Payments
? A General Banking Panic Was Averted by NYCH
Intervention
and by Redeposit of Mercantile Withdrawals
at other NYC
Banks

? Development of A General Panic
The Early Stages
? Knickerbocker Trust Fires its President,
Perhaps Guilt by
Association with Heinze-Morse
Confidence in Knickerbocker
Weakens
? National Bank of Commerce Refuses to Clear
Checks for
Knickerbocker
? A Run on Knickerbocker Begins, both Retail and
Wholesale
? Call Money Rates Rise Sharply, Forcing Stock
Sales and Margin
Loan Defaults
? Bank Runs Begin at Other Trust Companies
? As Money Center Banks Weaken, Reserve City and
Rural Banks
Experience Runs
? J. P. Morgan Determines that Knickerbocker Can
Not Be Saved

? Development of A General Panic
J. P. Morgan Personally Intervenes
? Doubts About NYC Credit As European
Investors
Withdraw and Uncertainty Rises About
Safety of NYC
Deposits at Banks
? Morgan Calls Meeting of Financial Leaders
Benjamin
Strong, JPMs Assistant George Perkins,
JPMs Partner
James Stillman,National City Bank George
Baker, National
City Bank Other Bank and Trust Company
Presidents
? Group Organizes Pool to Make Loans to Trust
Companies
(JD Rockefeller Pledges 50M)
? Pool Temporarily Helps, But Stock Market
Begins to Tank
? NYCH Issues Clearing-House
CertificatesIOUs That Banks
Can Use in Clearing Checks
? Morgan Invests Heavily in NYC Bonds to
Prevent Collapse

? Continuation Of The General Panic
Problems Continue into November
? Trust Companies Still Under Pressure
? On Nov 2 Morgan Calls Trust Company
Presidents to His
Office and Locks Them In Until They Agree
to a Self-
Support Fund
? Trust Companies Subscribe to a 25M Pool to
be Used
for Loans to Weaker Trust Companies
? A Major Brokerage Company in Near-Bankruptcy
for
Cash-Flow Reasons is Rescued By Morgan,
who
Arranges via Henry Frick for US Steel to
Buy Its
Holdings of a Coal Company
? With This, the Worst Was Over!

? Lessons from the 1907 Panic
Weaknesses of the Financial System
? The US Financial System Had No Lender of
Last
Resort-Reliance on People Like Morgan
To
Organize Support Was a Weak Reed to Lean
On
? The Currency in the U.S. was InelasticGold
Outflows and The Harvest-Related Demand
for
Credit Had Demonstrated the Need for an
Elastic
Currency
? The Banking Systems Connection to the
Stock
Market Via Margin Loans to Brokers was a
Weak Point
Led To The Federal Reserve Act Of 1913

? The Federal Reserve Act Of 1913
Major Features Of The Act
? Created a Lender of Last Resort Provided
Loans to Banks
by Discounting Commercial Bills at the
Discount Rate
? Supervised Banks to Ensure Adequate
Capital and Asset
Quality
? Limited Currency to Federal Reserve Notes
No More than
4 Times Gold Stock at Fed
? Held Bank Reserves as Deposits at Fed
? Established and Monitored Required Reserve
Ratios
? Established 12 Regional Banks Following
the Reserve City
Classification as Model
? Centralized Authority in the Board of
Governors in DC
? Act Was Amended 1934 to Set Margin
Requirements

66
Financial Collapses In The
Great Depression 1929-1933
67

The 1929 Stock Market Crash
Reference
Galbraith, Kenneth. The Great Depression,

? The Context
Significant Rise in Stock Prices IN 1920s
? The Bubble Was Largely In New
Technology Stocks (Radio,
Electric Utilities, Automobiles)
? Widespread Public Participation
? Easy Broker-Dealer Margin Credit
(101 debt/equity reported 41 more
realistic)
The Triggers
? Federal Reserve Concern About Margin
Loans
? Warning Letter to Banks in Late
1928
? Discount Rate Increase from 1.5
to 5 During
Jan-July 1929
? GNP Peaked in September 1929
? Stock Market Peaked On September 3 DJIA
381.17

69
The 1929 Stock Market Crash

? The Crash
The Sequence
? From September 3 To Friday October
25 The DJIA Fell
By 21
? On Monday, October 28, And Tuesday,
October 28, The
DJIA Fell By An Additional 23.6
? The DJIA Did Not Reach Its October
25, 1929 Level
During the Decade
Why The Sharp Selloff?
? Forced Liquidation Due To Margin
Calls By Brokers And
Loan Calls By Banks
? Anticipation Of Defaults On
Non-Security Bank Loans
? General Fear And Panic

70
The 1929 Stock Market Crash
71

? Did The Crash Cause the Great Depression?
The Yes Vote
? The Crash Destroyed Confidence
? The Crash Reduced Consumers Wealth,
Hence
Discouraging Spending On Consumers
Goods, Particularly
Durables
? The Crash Discouraged Business
Investment
? By Raising The Cost Of Equity
Capital
? By Reducing Consumer Spending
The No Vote
? A Serious Recession Was Already In
The Works
? The 1920s Consumer Spending Boom
Was At An End
? The Auto And Utility Boom Was At
An End
? The Stock Market Is Forward-Looking And
The Crash
Reflected Anticipations Of A Serious
Recession
? The Depth and Length Of The Depression
Was Due To Bank
Failures, Bad Policies, And Non-Stock
Market Factors

72
Overview OfThe Great DepressionReference
73
Overview Of The 1930s The Real Picture
74
Overview Of The 1930s The Financial Picture
75
Overview Of The 1930s The Stock Market
76
The Banking Panics Of 1930-1931ReferencesFried
man, Milton and Anna Schwartz. A Monetary History
of the United States, Princeton University Press,
Princeton NJ, 1962. (esp. pages 308-332)
77

? The Context
Economic Environment
? Stock Market Crash (Oct 1929)
? Smoot-Hawley Tarriff (June 1930)
? Real Interest Rates Rose Very
Sharply, by at least 10
? During 1930 GNP and Prices Dropped
by 10 and 2.5,
Respectively
Borrowers Experienced Difficulty Paying
Principal and
Interest on Bank Loans, Especially in
Midwest
? Non-Paying Loans at Banks Increase
Sharply in November
? Capital at Banks Was Seriously
Impaired, Forcing Reduction
New Loans Loans
? Internal Drains from Bank Reserves
to Gold Outside Banks
And Interior Banks
? Shift Assets Toward Cash To Build
Liquidity
? Bank Loans Contract Sharply

? The Unfolding Of The 1930-31 Banking Panics
The First 1931 Banking Panic
? A Major Credit Crunch Occurred (Oct
1930 - Feb 1931)
? Bank Asset Values, Capital, And New
Loans Fell Sharply
? The Real Short Term Interest Rate Rose
Sharply
? The First 1931 Banking Panic Eased By
February 1931
The Second 1931 Banking Panic
? Bank Failures in Austria and Germany
In May, 1931
? Led To Shift Into Dollars And Gold
Inflows to the U.S.
? Gold Inflows To The U.S. Initially
Helped U.S. Banks
? Deposits At Foreign Banks Were Frozen
? Foreign Bank Failures Led to
Sympathetic Runs on
Domestic Bank Deposits
? Internal Gold Drains Forced Banks
To Sell Assets And
Impaired Bank Capital

? The Third 1931 Banking Panic
Britain Faces Large Gold Flows to the
France and
Leaves The Gold Standard in September,
1931
? A Speculative Attack On U.S. Gold
Reserves Begins
? U.S. Gold Outflows Led to Further
Declines in High-
Powered Money and Additional
Pressure on Bank Credit
? U.S. Bank Failures Rose Sharply

? The Economy In 1931
Financial Markets
? A Flight To Quality Reduces Treasury
Bond Rates And
Increases Rates On Corporate Bonds
? The Rise in Interest Rates Combined With
Continuing Falls
in the Price Level Kept Real Interest
Rates High
? Reduced Bank Credit and High Real
Interest Rates
Contributed to Further Economic Malaise
The Economy
? The Price Level Fell by 9 From
1930 To 1931
? Real GNP Declined by 15
? Employment Declined by 9

? Federal Reserve Actions in 1931
Actions To Increase Bank Reserves
? Loaned Heavily to Banks Through the
Discount Window
? Did Not Engage In Open-Market
Operations
? Did Not Restrictions on Bank
Withdrawals, so Bank Runs
Were Not Contained by
Inconvertibility
? Efforts Were Insufficient To Increase
Money And Credit
Why Minimal Fed Action?
? Did Not Yet Understand the Impact and
Effectiveness
Of Fed Purchases of Securities (Death
of Benjamin
Strong in 1929)
? Thought That Its Primary Tool Was The
Discount Rate,
Which Was Very Low
? Did Not Understand That It Is Real
Interest Rates That
Determine Spending, Not Nominal
Interest Rates

? Policy Actions During 1932
Major Financial Legislation
? Formed The Reconstruction Finance
Corporation (RFC) to
Make Treasury Loans to Banks
Eventually RFC Bought
Preferred Stock Of Troubled Banks
? Formed The Federal Home Loan Bank to
Make Loans to
Mortgage Lenders on First-Mortgage
Collateral
Federal Reserve Actions
? First Open-Market Purchases Begin in
July, 1932
? Thereafter, Discounting and the
Discount Rate
Began to Fade in Use
The Economy Began to Strengthen and Real
Interest
Rates Fell

83
The Banking Panic Of 1933
84

? The Context
In Late 1932 A Wave of Bank Failures in
the West and
Midwest Led To Another Period of Bank Runs
? The New Government Institutions
(RFC, FHLB) Were
Insufficient To Maintain Confidence
? Federal Reserve Discounting and
Open-Market Operations
Did Not Provide Sufficient
Liquidity
Pressures on Interior Banks Created
Internal Drains In The
Form Of Losses of Gold (Reserves) At
Reserve City Banks
A Wave of Bank Holidays Began
? Bank Holidays Were Initiated By
States
? Bank Holidays In One State Led to
Runs In Other States.
? By March, 1933 About Half Of The
States Had Initiated
Bank Holidays

? External Drains Add To Banking Collapse
Fears That The U.S. Would Be Forced To
Devalue As Gold
Reserves Were Drained From Banks Led To
Foreign Runs
On U.S. Banks
? The Fed Followed The Classic
Central Bank Rule Of
Protecting The Gold Standard It
Raised The Discount Rate
To Increase U.S. Interest Rates
? No Open-Market Purchases Occurred
New Yorks Governor Lehman (déjà vu)
Declared A Bank
Holiday After Reserves at New York Banks
Fell Below
Legal Limits
Unemployment Rate Peaks At 25

86
Government Actions Under FDR

? Securities Legislation
Securities Exchange Act Of 1933
? Required Registration Of Investment
Advisors
Securities Exchange Act Of 1934
? Required Full Disclosure Of Material
Facts
? Required Registration Of New Security
Issues
? Established the Securities Exchange
Commission (SEC)
Investment Company Act Of 1940
? Regulated Investment Companies
(Mutual Funds)

87
Government Actions Under FDR

? Banking Legislation
Bank Act Of 1933 (Glass-Steagall Act)
? Separated Investment Banking,
Insurance, and
Commercial Banking
? Established The FDIC To Insure Bank
Deposits And
Prevent Bank Runs

88
Government Actions Under FDR

? Industrial And Labor Legislation
National Industrial Recovery Act
(June, 1933)
? Gave President Broad Authority To
Regulate Businesses
? Created National Recovery
Administration (NRA)
? Established Floors On Wages
And Prices By Industry
? Established Detailed
Regulations On Businesses
? Guaranteed Right To Collective
Bargaining (Title 1)
? Created National Labor
Relations Board
? Prohibited Unfair Labor
Practices
? Established Rules For
Collective Bargaining

89
Government Actions Under FDR

? Legacy Of The NIRA
Contributed To Depth Of Depression
? Excessive Bureaucracy--Detailed
Regulations Added To
Business Costs
? Wage-Price Fixing Added To Depth Of
Depression
? Employment Dropped 25 In First Six
Months
Title 1 Of NIRA Found Unconstitutional
In May, 1935

90
Government Actions Under FDR

? National Labor Relations Act Of 1935 (Wagner
Act)
Affirmed Labor Relations Features Of NIRA
? Right To Collective Bargaining
? Renewed The National Labor
Relations Board
? Established Criteria For Union
Formation
? Established Procedures For Union
Elections

91
Government Actions Under FDR

? FDR Ends The U.S. Gold Standard In 1936
Gold Outflows Since 1931 Had Impeded
Recovery
Prohibited Sales Of Gold To Foreign
Entities
Ended Internal Convertibility Of Gold
(Privatized Gold)
Negated Gold Clauses In Contracts)

Modern Financial Crises
The 1987 Stock Market Crash
The SL And Junk Bond Episode
The Enron Debacle

93
The Stock Market Crash Of
1987ReferenceLowenstein, Roger. The Origins
of the Crash The Great Bubble and its Undoing,
Penguin Press, New York, 2004.
94

? The Context
Several Years of Above-Average Stock
Price Increases
? Started After The Reagan-Volcker
Recession in 1982
? Further Encouraged By Oil Price
Collapse In Mid-1980s
Possible (But Unlikely) Triggers
? No Specific Macroeconomic,
Financial, Or Foreign Events
? Rising Interest Rates Begin To
Bite30 Year Treasuries
Reached the Magic 10
? Dow-Jones Industrial Average Had
Peaked on August 17
? Legislation Limiting Tax Advantages
Of Mergers
? Market Poised To Crash--Between Peak
on August 17 And
October 15 The DJIA Had Fallen 500
Points
On October 16 The DJIA Fell By 23 (500
Points)

95
The Event The 1987 Stock Market Crash
96

? What Happened? Financial Innovation
Development of Index Futures, Stock
Options and
Synthetic Options
? Examples
? Portfolio Insurance Strategies
? Index Arbitrage Through
Cash-Futures Transactions
? Problems
? Created Illusion of Hedges
Against Risk of Complex
Instruments
? Incomplete Hedges Induce High
Volume Of Transactions
Development of Computerized Trading (DOT)
? Instantaneous Order Transmission When
The Cash-Futures
Relationship Is Out Of Line (Index
Arbitrage)
? Triggered Massive Order Volume

? What Happened Problems On The Trading Floor
Specialists On The NYSE Took a Walk
Information Overload
? Overwhelmlng Volume Of Orders
? Long Delays In Printing
Confirmations-Customers
Didnt Know If Orders Had Been
Executed
? Led To Multiple Sell Orders
? Stale Prices
? Long Delays In Reporting Trade
PricesCustomers
Had Out-Of-Date Price
Information
? Created Inverted Futures-Cash
Price Relationship,
Inducing Cash Market Sales

98
? What Happened Disconnects Across Related
Markets Cash vs. Futures Relationship
? Cash Markets Closed But Options And
Futures Markets Remained Open
? The Panic Depressed Futures Prices But
Cash Prices Were Stale
? Result Was Strong Phantom Sell Signal In
Cash Markets
99

? Lessons Learned
In A Panic, Everyone Tries To Exit At
Once
? Offers To Sell Surge, Bids Dry Up
? Prices Free Fall
Markets Are Highly Interconnected
? The Futures Market Rapidly Transmitted
The Effects of
Bad Information And Exacerbated Sell
Orders In The
Cash Market
Technology Is A Double-Edged Sword
? Electronic Trading (DOT) Transmitted
Problems Quickly
? Mixed Technology (Old Paper Trading On
NYSE, New
Electronic Trading In Futures) Can
Add To Problems
? New Instruments (Derivatives Like
Stock Index
Futures) and New Methods (Portfolio
Insurance) Can
Compound Problems

100
The Savings Loan
And Junk Bond Crises
1989ReferencesBruck, Connie. The
Predators Ball The Inside Story of Drexel
Burnham and the Rise of the Junk Bond Raiders,
Simon Schuster, New York, 1988.
101

? The Context
SL Institutions Had Limited Financial
Opportunities They
Borrowed Short-Term (Deposits) And Made
Long-Term
Loans (Mortgages)
In The 1970s and 1980s Interest Rates
Rose, With Short
Rates Rising Faster Than Long Rates
The Rise In Short Rates Led To A Loss In
Deposits
And Forced Sales of Mortgages (Regulation
Q)
The Rise In Long Rates Led To Declines In
Asset Values
And Deterioration Of Capital
As SL Balance Sheets Deteriorated, And
Liquidity

102
? The Advent Of Junk Bonds
Milken Sees That Below-Investment-Grade Bonds
Earn More Than High-Rated Bonds After
Adjusting For Defaults Drexel,
Burnham, Lambert Creates A Market For Junk
Bonds ? Junk Bonds Allowed Smaller
Companies To Get Access To
Long-Term Financing ? SLs Bought
Junk Bonds On A Large Scale As A
Way To Diversify Beyond Mortgages and Get High
Returns
103