08 June 2010

The Crisis of 1893 (3)

(Part 1 ξ Part 2; 1893, India, and the USA)

There are a couple of issues that remain from my study of the 1893 Crisis.

Default, Pseudo-Money, and the Industrial Depression

My understanding of this is pretty much taken from Oliver M.W. Sprague (1910, p.171, pp.181-186, ξ pp.195-203), and what follows is a summary of his views.  For others wondering why I'm so impressed with Prof. Sprague's report for the National Monetary Commission, the answer is that he examined the actual financial composition of US banking assets in such detail that it's the closest I can (conveniently) get to a primary source. Also, the report is extraordinarily well-conceived: Prof. Sprague is intimately familiar with each controversy among bankers regarding the major events of his epoch, and avoided all the easy pitfalls.1 

In State I of the Crisis (10 June--12 July), there were two waves of bank failures that culminated in the loss or suspension of over 5% of the total banking institutions (by number) in the country.  This catastrophe caused a massive hemorrhage of reserves from the central reserve city banks.2 As a result, by the middle of July when the Crisis had dramatically returned, the banks had reduced their loan portfolios immensely  from the beginning of the year but were nevertheless draining reserve deposits to affiliated country banks.

During Stage II (12 July--2 September 1893) the banking clearinghouses responded to a shortage of currency by resorting to clearinghouse loan certificates (CLCs), or "bridge loans" for banks awaiting delivery of gold/gold certificates. The CLCs looked like checks, with the one exception that they actually were in fixed denominations and were liabilities of the banks.

The first point that Prof. Sprague's report makes about the institution of CLCs was that it was pre-emptive:
Never since the establishment of the national banking system had they been confronted with a like situation—widespread distrust of the solvency of their banks among the people in entire sections of the country. The ability of the New York banks to maintain payments was not as yet in question. But though no bank in the city was in difficulty and there was still a surplus reserve on June 17 of $8,700,000, the machinery for the issue of clearing-house loan certificates was set up on the 15th of June. (p.170)
The next is that it was not expected to lead to actual suspension of payments in cash by the banks (but was was during the later, 1907, crisis) (p.171).  Prof. Sprague believes the issuance was logically or ethically defensible at first:
Never since the establishment of the national banking system had they been confronted with a like situation—widespread distrust of the solvency of their banks among the people in entire sections of the country. The ability of the New York banks to maintain payments was not as yet in question. But though no bank in the city was in difficulty and there was still a surplus reserve on June 17 of $8,700,000, the machinery for the issue of clearing-house loan certificates was set up on the 15th of June. (p.175)
The Chicago banks waited until 26 July before issuing CLCs, their first ever. Prof. Sprague, at this point, starts to question the judgment of the banking authorities

Two reasons may be advanced for this action. It may have been thought that a further depletion in the reserve might cause general loss of confidence in the New York banks, but this is a superficial reason at best. There is no evidence that depositors had become distrustful of the banks, and had this been feared the banks might have adopted the expedient resorted to in 1873—the discontinuance of the publication of the bank statement altogether. The real reason for suspension was that which was pointed out in the report of the clearing-house committee of 1873. The drain had not fallen equally upon the banks. We have no means of knowing the exact position of the few large banks which held the bulk of bankers' deposits at this time, but there can be no doubt that they must have suffered a far more serious loss of reserve than that of the banks taken as a whole.
Suspension was at no time complete, and in explaining its extent bankers gave indirect but convincing evidence that the deficiency in the reserves of particular banks rather than a small total reserve was the cause of the restriction of cash payments.  (pp.181-182, emphasis added)
Naturally, as soon as use of CLCs to settle debts started to spread to other banks, it became impossible for banks who had not been using CLCs to avoid doing so. Prof. Sprague argues from this that the banks could have avoided a general suspension by equalizing (i.e., pooling) reserves according to some system.  This would probably have permitted the banks to avoid suspension, but required some mode for coordinating action--like the federal funds system of the Federal Reserve System.

The consequences of the suspension were dire, and probably eclipsed (at the very least) the effects of the Sherman Silver Purchase Act, which was repealed in early August, and pre-empted by large foreign shipments of gold to several reserve centers of the USA.  One reason the suspension was such a catastrophe was it triggered a lasting collapse of the the system of credit[s] and payments, leading to a massive in the amount of cash required for any given amount of transactions.

Was 1893 a Balance Sheet Recession?

Click for larger image--original presentation
A "balance sheet recession" is a term coined  by Richard Koo, head of research for Nomura Securities, to describe a condition in which economies are stagnant because the firms are determined to clear debt from their balance sheets.  The classic example of a balance sheet recession is Japan between 1990 and 2007.  During this time, interest rates were very low but Japanese banks were reluctant to lend and Japanese firms were reluctant to borrow.

In Koo's presentation of the concept, he describes a dichotomy of the economic universe between yin and yang economies.  Yang economies adhere to classical economic postulates.3

In a yin economy, the private sector ceases to be profit-maximizing and becomes focused on shrinking its debt.  Koo observes that this is a fallacy of composition (although he would probably concede that even business managers who know it's a fallacy of composition are compelled to the same behavior). In a yin economy, everyone wants to reduce debt relative to income, which means doing everything possible to cut expenses. If a stable percentage of households/businesses are trying to do this (and they self-select rationally), it's fine: debt loads will probably stay at manageable levels overall, and the part of the economy not engaged in debt reduction will take up the slack.  But if everyone does so at the same time, then there's less income with which to pay off debt.

This post is not about Koo's theory, and if I tried to elaborate on it (and the differences between Koo and Irving Fisher's debt-deflation theory--see Fisher, 1933), readers would probably find a lot of mistakes.  The real question is, does Oliver Sprague believe that the 1893 Crisis had elements of debt-deflation/balance sheet recession avant la lettre?

In the run-up to the Crisis (4th quarter, 1892), Prof. Sprague notes that lending was both moderate and Minskyian:
There was therefore only a moderate increase in the loans of the New York banks during the year, although the rates for call loans were abnormally low. Activity on the stock exchange was largely in connection with speculation in industrial companies and the financing of various combinations. Finally it may be noted that the increase in loans, taking the country as a whole, was not greater than at many other periods of active business in our history and that the change in the proportion of reserves was not such as to weaken the banks very materially. In May, 1891, the proportion of cash reserves to deposit liabilities was 16.6 per cent, in 1892 it was 18.4 per cent, and in 1893 it was 16.9 per cent. The statistical position of the banks was, therefore, reasonably satisfactory.  (pp.160-161)
One might surmise that, minus the speculative-phase lending for MξA activity, the real economy was slipping into post-recovery mode--note the world economy had "recovered" from the Barings Crisis.4
During 1892 the low rates for loans were a clear indication that the banks would have been glad to lend more than the demand of borrowers made possible. The situation was in marked contrast to the months preceding other crises when every available credit resource at the money centers has been stretched to the extreme limits of safety and beyond.

It sounds like Prof. Sprague, ever extremely attentive and perceptive, detected this with the record of bank assets from the Comptroller of the Currency.  His analysis was at odds with the economics field at the time (and today), and with "real bills" doctrine then prevalent in the banking field.  A dogma of economics during this epoch was that, any serious economic crisis had to have some monetary explanation at the back of it, mainly taking the form of some explanation for a withdrawal of the circulating medium.   Either this indicted direct constriction (like Andrew Jackson's Specie Circular), or else it indicted excessively loose money policy--something allegedly caused by pro-silver policy during the Gilded Age, by reducing confidence in the likelihood of repayment in gold.  His analysis suggests the fault lay in the institutions managing private credit.

  1. A downside is that his book is that he (and Conant) use vague generalizations when passing over the skullduggery of the financial system. Some of the investments are "ill-advised."  Gilded Age corruption was exceptionally pervasive and egregious. There have been many side-investigations I made in my study of the 1893 Crisis, involving specific firms (e.g., National Cordage, the Dwiggins System of "banks"), and all of them involved profound turpitude and, more amazing still, utter disregard for the immediate future. 

  2. For bank failures and suspensions in 1893, see the  Annual Report - Comptroller of the Currency, Vol. I (Dec 1893). p.14.

  3. Actually, judging by the diagram, I'd say Koo is paying a subliminal tribute to Minsky, 1992 in his description of a yang economy. Notice the economy does not tend toward a virtuous equilibrium in Koo's analysis (nor in real life).  See Minsky, 1992.

  4. Regarding the Barings Crisis of 1890, see Gerardo della Paolera ξ Alan M. Taylor, Straining at the Anchor: the Argentine Currency Board and the Search for Macroeconomic Stability, 1880-1935, University of Chicago Press (2001); Chapter 3,  "A Monetary and Financial Wreck: The Baring Crisis, 1890-91" (PDF), is hosted at the NBER website.  The effects in the United States are described in Sprague, p.124ff, and Conant (1909), p.518ff.

Sources and Additional Reading:

Mark Carlson, "Causes of Bank Suspensions in the Panic of 1893" (PDF),  Federal Reserve Board working paper (2002) 

Charles Conant, A History of Modern Banks of Issue, G.P. Putnam's Sons (1896)

Irving Fisher, Debt-Deflation Theory of Great Depression (PDF), Econometrica, 1 (4): 337-57 (1933)

Richard Koo, "The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005" (PDF), Nomura Research Institute, Tokyo (March 2009)

Hyman Minsky, "The Financial Instability Hypothesis," Jerome Levy Economics Institute Working Paper No. 74 (May 1992).

O.M.W. Sprague, History of crises under the national banking system, Volume 5624, United States. National Monetary Commission (1910).

Annual Report - Comptroller of the Currency, Vol. I, Government Printing Office (December 1899)

Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year ended 1897U.S. Government Printing Office (1897)

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