Lessons from the Panic of 1907

Few remember that the Federal Reserve was created in 1913 because of the panic of 1907. This panic was caused by the failure of several banks that were overly indebted and had made a lot of bad loans. If this sounds familiar to you, you’re not alone.

The lessons of 1907 were that when a banking panic occurs, the smart bankers of the world need to get together, examine the books of questionable banks, draw a line in the sand on which banks are solvent and should be supported, and let the rest go into bankruptcy to be sold off piecemeal to solvent institutions and investors.

Back in 1907, the leader of the smart bankers was J.P. Morgan. Although vilified for the power he displayed in this role, Morgan managed to save the economy from complete collapse because he understood banking better than most and had the knowledge, experience, and iron will to make things happen.

The Federal Reserve was originally created to serve this purpose (so that some would-be J.P. Morgan would not have so much power), but its mandate has drifted significantly. Instead of drawing a line in the sand between solvent and insolvent bankers, it now tries to set monetary policy to provide full employment and manage inflation at reasonable levels.

Note how markets have reacted to the Federal Reserve’s policies over the last 2 years. At first, markets were assured (early 2007 to mid 2008). Now, markets are tanking because of the Fed’s actions. If you believe markets are tanking because of conditions beyond our control, you’re not alone, but I don’t think you’re right. Markets are tanking in reaction to inept policy, not because of economic circumstances, per se.

Instead of allowing bad banks to go under and supporting good banks, the Fed is doing the opposite. Its supporting the bad banks, thus punishing good banks for their prudence. Markets are tanking for good reason.

Letting bad banks go under would hammer the bond and equity holders of such institutions, but their customers need not suffer. In almost every bail-out so far, banking customers were safe. What was threatened were the bond and equity holders, including the stupid banks who had invested in such bonds and equities.

Bailing out the ineffectual at the expense of the effective is a recipe for disaster, and markets will continue to tank as long as such a policy is followed.

In the long run, the truth will out. The bad banks will go under anyway, and the day of reckoning will merely be delayed at great expense, pain and frustration.

If, instead, the government would draw a line in the sand and let the insolvent go under by effecting an orderly liquidation while supporting the solvent, the impact would be painful but over quickly.

Regardless of how the Fed and U.S. government try to solve this problem, the hardworking people of this country will provide the bailout. That bailout will come in the form of hardworking entrepreneurs, prudent businessmen, diligent workers, and rational consumers.

Inept policy will only delay recovery, it will not prevent it.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.