Banking Panics In The Past—That Was The Government

Forbes

13-07-2025

Cortelyou shuffled that paper in a not-so-efficient way (Photo by Heritage Art/Heritage Images via ... More Getty Images)
We need the Federal Reserve because before we had it, the private banking system had panics all the time. Goodness gracious to we hear this justification for the Fed without surcease. We go over this theme in our new book, Free Money: Bitcoin and the American Monetary Tradition, because the government will not let us not do it. Federal websites to this very day—I'll spare you the URL's; they are in the book—say things like federal banking regulation pre and post the Fed strengthened and stabilized the American banking system, and by virtue of that, the economy.
In Free Money, we tested the proposition. We found it wanting in every case. Here's a paradigmatic one, to reinforce a column I wrote on this topic several months ago. There was a big bad banking panic in 1907. It was the one that resulted in the Fed. Everybody went so berserk over this panic that out came the Fed in 1913, and we have had this banking supervisor-in-chief ever since.
What was this panic and what caused it? In the fall of 1907, banks throughout the country depleted their reserves as brokers cashed on their accounts to ship the farm harvest—an annual ritual that had been going on for eons—and by October, banks were starting to not pay up to depositors and trim their hours and shut their doors and have managers throw themselves out the window. J.P. Morgan lent some people some money at a profit and the whole thing passed.
What caused the panic of 1907? Why capitalism, of course. Right. Wow has our historical consciousness been misled on this one. In Free Money, we followed the crack analysis of inestimable monetary scholar Richard Timberlake (perhaps Milton Friedman's greatest student) in his remarkable book of decades ago, Monetary Policy In the United States: An Intellectual and Institutional History.
Timberlake notes that at that time, the major banks in the United States were 'national banks,' so designated by the Federal government, and had to carry a high minimum of federal bonds in their reserves. Problem: the United States was generally running budget surpluses and otherwise shrinking the supply of federal debt instruments outstanding relative to the size of the economy, and therefore the natural size of the banking system. The United States had started the 'national bank' system in the civil war, because the union was issuing debt like crazy, nobody wanted to buy it, and the banks looked like a nice captive customer.
Whatever the merits before 1865, by 1907 it was ludicrous for an economy as surpassingly successful as that of the time to have a banking system that had to have a large reserve in federal bonds. There were not enough of them. Wise to this obviousness, Treasury secretary Leslie Shaw kept loosening the rules, shrewdly permitting national banks to have other useful media in addition to federal governments as their base reserves.
The man knew what he was doing! No panics through 1906. Then in a cloud of unclarity, Shaw was forced out in favor of gold-ole-boy George Cortelyou, a Knickerbocker buddy of the president TR's. This Mr. Amsterdam was no Leslie Shaw, a humble if canny Iowan. There were extra demands on the banking system because of insurance company losses against the San Francisco earthquake, and Cortelyou reinforced the requirement to base reserves in federal bonds. The harvest came, banks ran short, directors vaulted over the sills, and Morgan cleaned up.
Timberlake: 'Some imagination on [Cortelyou's] part might have adjusted the timing and operation of [Treasury's] ordinary housekeeping operation so that it would have complemented rather than conflicted with seasonal monetary policies.' Timberlake found that to Cortelyou, having the controlling hand in whether a general financial crisis develops was not to his taste. He thought the Treasury secretary should be more narrowly focused. Great—then he should have scrapped the relic national bank system that Congress put in place during the war to make a fake market for its bonds.
We got the Fed because of this comedy of errors. The whole problem was caused by the government. Design flaw #1: The national bank system requiring reserves in federal bonds was a leftover from the exigencies of 1862. There was no longer any need to encourage ownership of federal bonds because, um, the civil war had been over for two score years and some. Design flaw #2: the country had become ridiculously expert at producing wealth instruments of its own accord over the massive post-1865 industrial revolution, meaning that base reserve assets should have been diversified (as Shaw saw) as a nod to this reality. Design flaw #3: randos at the top of the Treasury (e.g., George Cortelyou) could ruin the whole thing if possessed of a bad idea.
What really stopped the panic, more than Morgan's intervention, was the issue on the part of private clearinghouse banks of scrip payable to other members of the banking associations. Banks could use this scrip to settrle their debts, and then could accept that scrip in good cash after the crisis lifted. This scrip was illegal by the national banking acts of the civil war era and should have been banned or taxed at 10 percent or both, by statute. Congress looked the other way. The government caused the crisis, and the private sector solved it—and we got the Fed!
How did the Fed do managing incipient crises? We got the worst ever—the Great Depression while the Fed was only a teenager, among other bad embarrassments. So we have the Fed, fine. The shame about it is that its extsitence and just-so history makes us get our heritage wrong. The private banking system performed beautifully back before the Fed. We continue to need the Fed to 'stabilize' our monetary system like we need a hole in the head.