What if Bernanke had been a Student of the Panic of 1907 Rather than the Great Depression?
By Marc D. Weidenmier
Is the "Great Recession" another Great Depression? Federal Reserve Chairmen Ben Bernanke and Christina Romer, President Obama's Head of the Council of Economic Advisors, seem to think so. The two policymakers have been implementing Great Depression style programs over the past year to counteract the current economic downturn. Following the lead of Milton Friedman and Anna Schwartz, Bernanke and his policy advisors have increased the monetary base by more than one trillion dollars in an attempt to prevent a repeat of the Great Depression where the money supply dramatically declined in the early 1930s. The Fed has also taken unprecedented actions by bailing out financial firms on Wall Street involved in the current sub-prime mortgage crisis. Some of these actions are reminiscent of the Reconstruction Finance Corporation that extended loans and injected preferred stock into banks during the 1930s. Romer, on the other hand, has spearheaded a large fiscal stimulus that John Maynard Keynes argued should have been employed during the 1930s to jumpstart the US economy out of the Great Depression.
Much of the policymaking in Washington appears to have made the assumption that only lessons from the Great Depression are relevant for dealing with the current recession. While "Great Depression" remedies may be appropriate now, the Panic of 1907 probably offers more insight into policymaking during the early stages of a financial crisis. Crisis management at the onset of a meltdown is particularly relevant in the collapse of Lehman Brothers. This is so because the current crisis, like the Panic of 1907, was centered in New York City, where in both cases several large intermediaries were forced to close. During the Great Depression banks in the interior of the country failed in large numbers; the New York banks were much less affected than in 1907.
In both 1907 and today, authorities had to decide which intermediaries would be offered financial aid, but several differences emerge. The Panic of 1907 started in earnest on October 22 with a massive run on deposits on the Knickerbocker Trust Company following some bad publicity about the trust and its president. J.P. Morgan had Benjamin Strong, one of his deputies and later Governor of the Federal Reserve Bank of New York, examine the balance sheets of Knickerbocker for solvency to help him decide whether emergency loans would be made to the stricken trust, a move similar to the "stress tests" applied to modern institutions seeking TARP funding. Strong could not evaluate Knickerbocker's situation in the short time available to him. Morgan thus decided that no funding would be made available. Knickerbocker suspended business. The next day the panic spread to another large trust company, The Trust Company of America, even though there had been no bad news about the trust. This time Morgan stepped in and quickly arranged emergency funding for TCA. Runs on deposits at TCA subsided over the next two weeks. Morgan and his associates continued to raise funds to aid other intermediaries, the New York Stock Exchange, and New York City over the course of the next month.
In the current crisis, Bear Stearns was aided in March, 2008 and soon taken over by JP Morgan and Co. By September 2008 several other large intermediaries were in trouble. Merrill Lynch was taken over by Bank of America, while AIG was bailed out. Most troublesome, however, was the bankruptcy and collapse of Lehman Brothers. No aid was forthcoming from Bernanke's Federal Reserve or Paulson's Treasury. Overnight lending between banks froze up in response, and financial markets were on the edge of collapse. Lack of aid was criticized by many as being the worst policy move of the current crisis, although others have argued that a major collapse was unavoidable. Unlike in 1907 and Trust Company of America, there may have been plenty of time to diagnose Lehman's financial condition, attempt to recapitalize it, and prevent its collapse while its share price remained strong in the summer of 2008.
The lesson of this comparison is to show that quick action like that in 1907 is important to mitigate a financial panic and its subsequent real effects. New York credit markets had recovered from the Panic of 1907 by the end of December. Although the 1907 Panic was accompanied by a severe recession, it was also one of the shorter recessions in American history. We can only speculate as to what would have happened in 2008 if Bernanke had been a student of the Panic of 1907 rather than the Great Depression.
Marc D. Weidenmier is the William F. Podlich Associate Professor of Economics and George R. Roberts Fellow at Claremont McKenna College. He also is the Director of CMC's Lowe Institute of Political Economy and a research associate for the National Bureau of Economic Research. Jon Moen is an associate professor of economics and chair of the department of economics at the University of Mississippi.
