Don’t say it can’t happen again
When the New York commercial and investment banks couldn’t arrive at a deal, and they and the government let Lehman Brothers go into Chapter 11, we understood the decision and agreed with it. Companies have to try to make prudent decisions, and the government shouldn’t be in the business of bailing out every large bank under the TBTF rubric. But then the shorts (how many of them, if any, are actual adversaries of the US in the oil-exporting and and other surplus countries?) went after AIG, and then Morgan and Goldman.
It is hard to overstate the absurdity of this situation. We know both investment banking institutions fairly well, and indeed worked at one of them a long time ago. Their capital ratios are sound, their managements are excellent; yet Morgan Stanley in particular is in the crosshairs of people who would destroy it to make a buck — and maybe of some whose motives are more nefarious. We have little doubt that if either one of these large institutions were allowed to fail, that we would have America’s second Great Depression as a result of the other failures that would multiply from the ripple effect of that failure. But it wouldn’t have to be an institution the size of a Morgan or a Goldman to have such an impact. Indeed, the last time that bank failures cascaded from a modest beginning was in 1930, in the case of a relatively small New York bank with the grand name of Bank of the United States. We should take a moment to remember what happened there and try to take a lesson for today.
We knew a man who was present as a child at one of the precipitating events of the Great Depression, the failure of New York’s Bank of the United States in December 1930. His grandfather, who lost his savings in that bank, took him to witness the scene as depositors thronged to bank doors that were locked during normal business hours. The panic from bank failures in New York and elsewhere spread around the country — there was no deposit insurance — driving banks to maximize liquidity, sell assets, foreclose loans, and create the Mother of All Credit Crunches, which became known as the Great Depression. Here’s how the NYT described the scene in its December 12, 1930 city edition:
Perhaps you have been taught that the stock market crash of 1929 caused the Great Depression. That is not exactly the case. The crash both reflected and amplified the recession that the US economy was entering in 1929; however, it was the problems of the banking system and of monetary policy that cascaded recession into depression. We will quote from Friedman and Schwartz’s Monetary History of the United States (from pp. 309-313):
The stock market crash…left no mark on currency held by the public. Its direct financial effect was confined to the stock market and did not arouse any distrust of banks by their depositors.
The stock market crash coincided with a stepping up of the rate of economic decline. During the two months from the cyclical peak in August 1929 to the crash, production, wholesale prices, and personal income fell at annual rates of 20%, 7.5%, and 5%, respectively. In the next twelve months, all three series fell at appreciably higher rates…Even if the contraction had come to an end in late 1930 or early 1931, as it might have done in the absence of the monetary collapse that was to ensue, it would have ranked as one of the more severe contractions on record….
In October 1930, the monetary character of the contraction changed dramatically…A crop of bank failures, particularly in Indiana, Illinois, Iowa, Arkansas, and North Carolina, led to widespread attempts to convert demand and time deposits into currency…A contagion of fear spread among depositors…such contagion knows no geographical limits. The failure of 256 banks with $180 million in deposits in November 1930 was followed by the failure of 352 with over $370 million of deposits in December…the most dramatic being the failure on December 11 of the Bank of the United States with over $200 million of deposits.
That failure was of especial importance. The Bank of the United States was the largest commercial bank, as measured by volume of deposits, ever to have failed up to that time in US history. Moreover, though an ordinary commercial bank, its name had led many at home and abroad to regard it as somehow an official bank, hence its failure constituted more of a blow to confidence than would have been administered by the fall of a bank with a less distinctive name.
In addition it was a member of the Federal Reserve System. The withdrawal of support by the Clearing House banks from the concerted measures sponsored by the Federal Reserve Bank of New York to save the bank — measures of a kind the banking community had often taken in similar circumstances in the past — was a serious blow to the System’s prestige…
Friedman implies that the reason that the Clearing House banks failed to bail out the Bank of the United States, despite often intervening in other, similar cases, is that the BoUS’s customer base and board were Jewish. This contention seems to be supported by statements from the NY State Banking Commissioner of that time, Joseph A. Broderick (p. 310). Let’s take a look at how the New York Times reported the attendees of the meeting the day before the Clearing House pulled the plug on the Bank of the United States:
We have no way of knowing if Milton Friedman’s contention is true or not, though it appears likely to us that, unlike Herbert H. Lehman, the “small, able” Mr. Isidor J. Kresel was probably not a member of Our Crowd. TIME Magazine summed up the banking community’s view of the Bank of the United States in its December 22, 1930 issue on that fateful meeting:
Another late arrival was lanky Owen D. Young who came about 11 p.m. in full dress, accompanied by Thomas William Lamont of J. P. Morgan & Co. Looking taller than usual in his full dress, Mr. Young paused to peer down at and converse with small, able Isidor Kresel, counsel for Bank of United States…Conservative Manhattan bankers last week were angry at Bernard K. Marcus, dark-haired, heavily-built president of Bank of United States. His aim was perhaps much too high. Only last year he stated: “Often we’ve put two or three days work into one. We have gone ahead two or three times as fast as we would have had we been working only one day at a time.” To bankers, a day’s work is a day’s work, to be done well, thoroughly.
The tall and lanky in full dress versus the small, able, dark-haired, overreaching, and heavily-built. We get the picture. Thanks, TIME. We see once again that great events can turn on small episodes of human weakness, prejudice and folly. And who knew at the time that a crowd gathered at a bank on a cold December day would become anything other than the “local” event that the head of the NY Clearing House opined that it would be?
We should not believe that we can’t make mistakes of similar magnitude or wrongheadedness again. The stagflation of the 1970’s was caused by foolish economics policies of three presidents in a row — Nixon, Ford, and Carter — that weren’t reversed for a decade until Ronald Reagan and Paul Volcker had the wisdom and courage to take the harsh steps required to kill inflation.
Today we face new and dangerous challenges that are in part a result of the staggering size of unregulated international commitments of financial institutions. How we got here is not the point for today; rather, the important thing is how we respond. There are many who say that the government should stay out of the way and let imprudent institutions pass from our midst. In general, we agree with that, but there comes a point where such orthodoxy can produce grave results. It is, in our view, a proper duty of government to do what it can to prevent the loss of public confidence in large financial institutions with complex and international commitments that are leveraged 10 or 15:1. Probably Lehman Brothers wasn’t this generation’s Bank of the United States. But a similar challenge seems quite likely to occur in the current environment.