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The Anatomy of Crisis
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great economists of the twentieth century, offered an alternative
theory. The Keynesian revolution not only captured the economics
profession, but also provided both an appealing justification and a
prescription for extensive government intervention.
The shift in opinion of both the public and the economics pro-
fession resulted from a misunderstanding of what had actually
happened. We now know, as a few knew then, that the depression
was not produced by a failure of private enterprise, but rather by
a failure of government in an area in which the government had
from the first been assigned responsibility—"To coin money, regu-
late the Value thereof, and of foreign Coin," in the words of Sec-
tion
8,
Article 1, of the U.S. Constitution. Unfortunately, as we
shall see in Chapter
9,
government failure in managing money is
not merely a historical curiosity but continues to be a present-day
reality.
THE ORIGIN OF THE FEDERAL RESERVE SYSTEM
On Monday, October 21, 1907, some five months after the start
of an economic recession, the Knickerbocker Trust Company, the
third largest trust company in New York City, began to experience
financial difficulties. The next day a "run" on the bank forced it
to close (temporarily, as it turned out; it resumed business in
March 1908). The closing of the Knickerbocker Trust precipi-
tated runs on other trust companies in New York and then in
other parts of the country—a banking "panic" was under way of
a kind that had occurred every now and then during the nine-
teenth century.
Within a week, banks throughout the country reacted to the
"panic" by "restriction of payments," i.e., they announced that
they would no longer pay out currency on demand to depositors
who wanted to withdraw their deposits. In some states the gov-
ernor or attorney general took measures that gave legal sanction
to the restriction of payments; in the remaining states the practice
was simply tolerated and banks were permitted to stay open even
though they were technically violating the state banking laws.
The restriction of payments cut short bank failures and ended
the runs. But it imposed serious inconvenience on business. It led
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to a shortage of coin and currency, as well as to the private cir-
culation of wooden nickels and other temporary substitutes for
legal money. At the height of the shortage of currency, it took
$104 of deposits to buy $100 of currency. Together, the panic and
the restriction, both directly, through their effects on confidence
and on the possibility of conducting business efficiently, and in-
directly, by forcing a decline in the quantity of money, turned the
recession into one of the most severe that the United States had
experienced up to that time.
However, the severe phase of the recession was short-lived.
Banks resumed payments in early 1908. A few months later,
economic recovery began. The recession lasted only thirteen
months in all, and its severe phase only about half that long.
This dramatic episode was largely responsible for the enact-
ment of the Federal Reserve Act in 1913. It made some action
in the monetary and banking area politically essential. During
Theodore Roosevelt's Republican administration a National Mon-
etary Commission was established that was headed by a prominent
Republican senator, Nelson W. Aldrich. During Woodrow Wil-
son
'
s Democratic administration, a prominent Democratic con-
gressman, later senator, Carter Glass, rewrote and repackaged the
commission's recommendations. The resulting Federal Reserve
System has served as the key monetary authority of the country
ever since.
What do the terms "run" and "panic" and "restriction of pay-
ments" really mean? Why did they have the far-reaching effects
we have attributed to them? And how did the authors of the
Federal Reserve Act propose to prevent similar episodes?
A run on a bank is an attempt by many of its depositors to
"withdraw" their deposits in cash, all at the same time. The run
arises from rumors or facts that lead depositors to fear that the
bank is insolvent and will be unable to live up to its obligations.
It represents an attempt by everyone to get "his" money out
before it is all gone.
It is easy to see why a run would cause an insolvent bank to
fail sooner than it otherwise might. But why should a run cause
a responsible and solvent bank trouble? The answer
is
linked to
one of the most misleading words in the English language—the
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