First of all, I must mention the book "The ascent of money" by Prof. Niall Ferguson, which does a good job of telling the story of finance from the days of Medici (1400s). It tells about the events that led to the creation of the bond market, stock market and various booms and busts. Financial crises are not new to the modern economies.
Since financial crises are all over the news these days, I have been studying more about the history of banks in US. This is what I learned today.
First banks in US were established soon after the independence. Banks ran independently and relatively problem-free until the run of 1837 when due to a bubble in real-estate market, president Andrew Jackson decried that sale of land be done only in gold or silver. That caused the dollar to plummet. The real-estate bubble in turn was caused by the failure of "Second Bank". Andrew Jackson didnt renew its license because the bank was becoming "too big to fail" by that time. The failed bank's funds flushed smaller banks with lots of money, making capital available to many for buying land thereby causing a bubble.
The US underwent a period of depression for 6 years with hight levels of unemployment. The economy finally recovered in 1843.
Following this, until the civil war, many state-chartered banks came into being. Some banks assumed the role of a central bank informally by insuring deposits through private insurance. Lifespan of many banks was very small (almost 5 years on an average).
1867-1913: The civil war effort created a need for a larger nation-level bank and a national currency that banks from all states would accept. All national banks were backed up by treasury securities so as to increase liquidity and enlarge credit market for the war effort. Seasonal liquidity spikes due to farmers deposits and withdrawals led to bank runs often during this time. One of the worst such spikes occured in 1907 during a recession causing runs. Billionaire, JP Morgan stepped in to pledge his own money and convinced other rich men to do the same to shore up the banking system at that time. The 1907 crises led to a national debate among economists and legislators which resulted in the creation of the Federal Reserve bank.
1930s- Recessions are considered a normal part of business cycle that an economy goes through since supply and demand cant always be matched correctly. What blows a recession into a depression is a matter of debate among historians and economists even today. Anyway, WW1 ended and a sudden sense of optimism and a new wave of creation in arts and business started in 1920s. With wealth increase among americans, stock market investment reached a new high eventually leading to unsustainable levels and a crash in 1929. The stock market crash was precipitated by declining real-estate market that inflated during the period of excesses in 1920s.
3 main sets of theories attempt to explain why the recession in 1929 blew over to a depression - structural theories, the most important by Keynes, pointed to the breakdown of international trade, underconsumption and over-investment and corruption between industrialists and government officials. Once panic caused deflation, people believed they could make more money by keeping clear of the markets as prices dropped lower and a given amount of money bought ever more goods, exacerbating the drop in demand.
Monetarist theories blame significant policy mistakes by the Federal Reserve (which was still a relatively new entity) caused a shrinking of the money supply which greatly exacerbated the economic situation. Related to this explanation are those who point to debt debt-deflation causing those who borrow to owe ever more in real terms.
Lastly, heterodox theories argue that various labor market policies imposed at the start caused the length and severity of the Great Depression. The marxist critique of political economy emphasizes the tendency of capitalism to create unbalanced accumulations of wealth, leading to overaccumulations of capital and a repeating cycle of devaluations through economic crises. Marx saw recession and depression as unavoidable under free-market capitalism as there are no restrictions on accumulations of capital other than the market itself.
Recovery from depression is attributed by many to the "New Deal" by president Roosevelt that involved creation of unemployment benefits, more involvement of the government in the financial industry and heavy investment in the infrastructure by bloating the fiscal debt. Monetary policy complemented this by increasing money supply. To avoid bank runs, the government also created the Federal deposit insurance corporation (FDIC) under the Glass-Steagall act of 1933-34. Just as British government suspended convertibility of currency to gold during the Napoleonic wars and the US government during the US Civil War, US Government treated the depression as a war and suspended the gold-standard during the depression. With limited sources of tax revenue, the way to fund high levels of expenditure was to suspend convertibility of gold.
The book "Lords of Finance" by Liaquat Ahmed tells the story of the personality and predicaments of central bankers that led to the depression. Very good read.
1950s - Western economies didnt want to lose the lessons learned from the great depression so after the distraction of the WW2, the powerful economies came up with an idea for economic security—that a liberal international economic system would enhance the possibilities of postwar peace. The planners met at Brettonwoods to create IMF and World Bank. This also ushered in the era of higher government intervention. Finally, this is where the gold standard was replaced with US dollar as the reserve currency of the world for facilitating trade. Brettonwoods asked for all major currencies to be pegged with US dollar.
1970s - By the 1970s, the US economy started to slowing down leading to high inflation. This combined with Vietnam war expenses caused president Nixon to make dollar-gold convertibility more difficult, thereby ending the BrettonWoods agreement. Marshall Plan
1980s - Deregulation and S&L crisis
2008 - Collapse of Lehman Bros
2010 - Dodd/Frank Wall Street reform act