The 1907 Panic

It is hard to feel confident about the prospects of global recovery when we do not really know what caused the 2009 world recession. Indeed we are little further ahead than intelligent financiers were a hundred years ago. In 1908, Frank A. Vanderlip, who was the Vice President of the National City Bank of New York, now Citibank, wrote an article about the panic of 1907 for "Lessons of the Financial Crisis", a work published by the Academy of Political and Social Science.

It is worth studying the 1907 panic. It was a global panic, though not the first panic to have a global character. The French Mississippi Bubble and the English South Sea Bubble both burst in 1720, and that was nearly two centuries before the panic of 1907. It was the last important financial crash to be stabilised by the actions of private bankers, in this case by J.P. Morgan himself. It led to the ratification in 1929 of the sixteenth amendment of the U.S. Constitution, which made a federal income tax constitutional. It also led to the creation of the Federal Reserve Board, therefore transferring the ultimate management of finance to the U.S. Government and to the Fed itself.

Mr. Vanderlip attributed the crash to the costs of wars and to the political vilification of the financial world by politicians and journalists. "We must run back to some of the roots to the terrific losses which the world's capital experienced as a result of the Boer War costing as it did one billion of dollars, the Japanese-Russian, which cost one and a quarter billions, and the losses of the San Francisco disaster (the earthquake) which footed another half billion. Here we have figures of nearly three billions of dollars directly lost to the world's capital."

Mr. Vanderlip also blamed the demand for capital which had resulted from the boom in American industry. "We have seen railroads and other corporations inexorably pushed to build new lines, to add to their equipment and to extend plant. But although the corporations were forced to make these expenditures by the demands which broadening industry and growing commerce made imperative, they became at last, owing to the exhaustion of the world's investment fund, unable to sell securities to provide money for their forced expenditures. They were unable to sell bonds, even though the security that was offered was wholly above criticism. The investment capital of the world became well nigh exhausted. That phase of the situation was by no means confined to America. It was international in its origin and world-wide in its effect."

Some of this we can easily recognise. Essentially it is a monetarist explanation, but seen from the point of view of the Gold Standard. There is a certain stock of money in the world, ultimately represented by gold coin or bullion, most of which is held in the banking system. The costs of war and earthquake have led to that stock being drawn down. Industrial demand has increased to the point at which there is a shortage of money relative to the demand for capital. This is not all that far from being an alternative way of describing what Irving Fisher called a process of "debt and deflation", or Joseph Schumpeter called "creative destruction". In both cases, money is seen as a real object. The world's limited monetary capital, seen as so many owners of gold, cannot simultaneously be spent on fighting the Russo-Japanese War and building an extension to an American railroad. Because money is limited by the quantity of gold, it imposes choices on Governments and on businessmen.

If one takes Irving Fisher's equation of exchange, in which mv = pt, one can see the choices that are actually available. m stands for money, and in a gold system it can only be increased by new mining or by melting down scrap. In practice gold convertibility makes the money supply a fixed factor.

v stands for velocity. This is the key variable now, and it was in 1907. The velocity of money depends on the level of confidence. When bankers believe that there are surplus available funds, the money markets run freely, and those businessmen who need funds can usually raise them without difficulty. When confidence is weak, velocity will be slow and funds will be scarce.

The other side of the equation is pt - prices and transactions. When money is in short supply, or velocity is slow, prices will be weak and transactions will be reduced in number.

We do not know how far practical bankers, like Mr. Vanderlip, thought in these monetarist terms, but clearly they had to assess the demand and supply of money. In seeking an explanation for 1907, Vanderlip recognises the psychological factor: "The financial crisis," he writes," has by no means been altogether a matter of money. It has, in large measure, been a matter of what was in men's minds."

In 2009, we have had similar experiences, in which real economic events interacted with human anxieties and expectations. All banking depends on confidence. So long as the expectation holds up, credit will be firm. Once expectation turns negative, then everyone becomes nervous of lending. In 1907, gold was the measure of confidence. I do not see what measure of confidence we can now rely on.

William Rees-Mogg
for The Daily Reckoning Austalia

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