[This past week marked the publication of the second edition of The Panic of 1907: Heralding a New Era of Finance, Capitalism, and Democracy, by Sean Carr and myself. This new edition is almost 40% longer than the first and has been revised substantially throughout.
In preparing the book for publication, friends and colleagues offered recurrent questions. Why should one care about an event that happened more than a century ago? Aren’t financial panics just about big economic forces—leadership doesn’t matter does it? What’s new here? Why issue a revised and updated second edition—history doesn’t change, does it? Answers to these and other questions are addressed in the following excerpt from the introduction to our book.
The timing of this second edition has caught the interest of some: the first edition came out in 2007, just as the global economy was sliding into the crisis of 2008. Now, this second edition comes forth in the midst of financial troubles: the collapse of crypto companies, the slump in tech sector stocks, and the collapse of financial intermediaries that served such sectors (Silvergate Bank, Silicon Valley Bank). As Mark Twain allegedly said, “History doesn’t repeat itself; it rhymes.” However, for the sake of innocent people, Carr and I hope that this is not a rhyming moment.]
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The past is never dead. It’s not even past.
—William Faulkner[i]
The Panic of 1907 stands out among history’s financial and economic disturbances. Over a century later, this crisis seems so small—its epicenter was short and intense—but it rippled nationally and internationally for years. Economic damage of the Panic was “extremely severe,” according to economists Milton Friedman and Anna Schwartz.[ii] It strained the fabric of societies, producing distress, dislocation, and even revolution. Its political impact was massive, triggering and accelerating the final push to establish the U.S. Federal Reserve System, after years of ineffectual debate. It fundamentally changed public attitudes about government intervention into markets and economic affairs. It highlighted the role of human agency in the turn of events. The wrangling of powerful personalities such as J. Pierpont Morgan, Elbert Gary, Henry Frick, Theodore Roosevelt, Woodrow Wilson, and William Jennings Bryan exposed the diversity of ideologies and motivations that would roil the U.S. political economy throughout the twentieth century. Ranked among pivotal events of the age, the Panic of 1907 ushered out an old guard and its orthodoxy, to be replaced by a new generation of leaders who held new notions.
However, memories are short. Eclipsed by two world wars, the Great Depression, the halting emergence of a new global economic order, and a string of crises in the early twenty-first century, the events of 1907–1913 have faded from mind. Also, each rising generation tends to believe that its own crises are without precedent and that harnessing lessons from further past is pointless.
The aim of this book is to counterargue: forgetting the past is dangerous; it contains valuable lessons for the present and future. While a deep dive into one important crisis will not foretell the future, it will expose insights into crisis dynamics that can forearm the reader. To study past crises is to learn the paths that adversaries of human welfare—panic and market breakdown—might take.
The onset of the Panic of 1907 and the efforts to quell it form a valuable lens through which to examine the fragility of economic and financial systems, the contagion of fear, the challenges of mobilizing collective action, and the relevance of human agency in the context of powerful forces. Modern theories—and public policies—about financial crises must start from some concept of what a crisis is. The Panic of 1907 is an excellent point of reference.
The Progression of Financial Crisis
A financial crisis is a breakdown of normal financial market activities to such an extent that capital flees, resources are misallocated, institutions are destabilized, and disorder spills into the real economy, causing job loss, bankruptcies, recession, and social distress and political ferment.
Scholars have tended to view crises narrowly. For instance, economists Hyman Minsky and Charles Kindleberger viewed a crisis as the moment when market euphoria turns to revulsion. Unfortunately, this narrow view tends to disregard important events and forces that stage and summon the crisis, as well as the shocks and spillovers that ensue. We argue that to understand financial crises, one must follow the entire progression of crisis, from early benign conditions that sowed the crisis, through to the ultimate recovery in the economy, polity, and society that frames a new orthodoxy in thinking. The word “progression” implies that each new phase acts upon the preceding one and sets the stage for the next one, for instance, boom -> shock -> climax -> collapse -> reaction -> recovery. Thus, the idea of progression requires you to take a longer view.
In the account of the Panic of 1907 that follows, the narrative spans 1897 to 1913. The progression of crisis occurred in four acts. First, an economic recovery of the U.S. economy gathered momentum into one of the largest growth spurts in the country’s history: business optimism rose, as did leverage and strains on the financial system. The good times peaked in early 1906, when it seemed that nothing could go wrong.
Second, shocks battered the system. As in Greek tragedies, nemesis follows hubris. To destabilize a financial system, a shock must be real (not cosmetic), large and costly, unambiguous, and surprising—the San Francisco earthquake of April 1906 surely qualifies. To that event we add discussion of some other surprises that shocked the system.
Third, trouble broke out among the less prepared and more vulnerable financial institutions, what in modern parlance would be the “shadow financial system.” A system is only as strong as its most vulnerable link. Financial institutions on the periphery (out of sight and out of mind to the rest of the industry) have tended to be the vulnerable links. Then trouble traveled to other parts of the system through relations among institutions and markets. The initial responses to the crisis were initially halting because financial systems are complex and opaque, and it was difficult for people to know what was going on. This bred fear. Contagion spread, at first locally, then nationally, and was reflected in declining security prices and the hoarding of financial assets. Then the crisis, initially confined to the financial sector of the economy, reverberated through the real economy, causing widespread distress and dislocation.
Fourth, the crisis began to ebb as confidence recovered—but the ripple effects of the crisis set the stage for the establishment of a “new order” of public sentiment, political power, and regulation. The institutional changes that ensued from the Panic of 1907 were as much a part of the entire progression of crisis as the shocks, instability, and spillovers.
Causes and Dynamics
As the following chapters show, the speed and fury of day-to-day events left little time for reflection and understanding. Yet any plan of action must proceed from some theory about the origin and progress of crises. With what theory could J.P. Morgan or anyone else have seen the Panic coming?
One line of thought attributes crises to a hodgepodge of period-specific factors. For instance, the contemporary Wall Street observer, Henry Clews, cited nine causes for the panic of 1907.[iii] Charles Kindleberger, ascribed 13 origins of the Panic of 1873.[iv] With enough detail (and imagination) an analyst could summon a long list of possible causes for financial crises. The problem with that approach is its idiosyncrasy: If there is a different explanation for each crisis, then what can we say about crises in general?
Other approaches rest on one big idea: a sole cause large enough to cover a multitude of sins. A favorite big idea among some economists, for example, is that financial crises are caused by a lack of liquidity in the financial system. The economist Milton Friedman blamed the government’s failure to manage well the money supply as a leading contributor to such events. Likewise, Roger Lowenstein, writing about the stock market bubble and collapse of 1997 to 2001, blamed the credo of shareholder value.[v] A related “silver bullet” explanation is greed. Radical and progressive critics blamed financial crises on the wealthy, the profit motive, and class exploitation. Unfortunately, the silver bullet explanation produces generic remedies that poorly treat the disease. One wants a Goldilocks explanation for crises that is neither too much nor too little; neither too idiosyncratic nor too simplistic.
By drawing on a detailed history of the Panic of 1907 and on research about financial crises in general, we offer an alternative view: crises are cascades of shocks and information problems to which bank runs, market crashes, rumors, hoarding, fear, and panic are predictable responses. Scholars such as Charles Calomiris, Gary Gorton, and others have documented the informational aspects of crises. To our knowledge, this is the first book-length study of a single financial crisis to apply this view. And we extend this view to consider institutional changes that ensue.
Information problems are central to an understanding of financial crises. Over time, innovation in financial institutions, markets, instruments, and processes breed growing complexity in the financial system. Complexity makes it difficult for decision makers to know what is going on. The resulting information asymmetries spawn problematic behavior, arising from adverse selection[1] and moral hazard.[2] Information problems contribute to the overoptimism associated with buoyant business expansion and the tendency of debtors to overlever and of lenders to ignore prudent credit standards.
The architecture of a financial system links institutions to one another in a way that enables contagion of the crisis to spread. Trouble can travel. Safety buffers (such as cash reserves and capital) may prove inadequate to the coming crisis. Then, one or more shocks hit the economy and financial system, causing a sudden reversal in the outlook of investors and depositors. Confusion reigns. Public sentiment changes from optimism to pessimism that creates a self-reinforcing downward spiral. In the vicious cycle, more bad news prompts more behavior that generates bad news. Collective action proves extraordinarily difficult to muster until the severity of the crisis and the insight and information held by a few actors prompts mutual response.
Information matters, as our narrative of the Panic of 1907 shows. Key figures relied on information networks to assess conditions, identify trouble spots, set priorities, allocate rescue funds, and make other changes to restore the confidence of depositors and investors. The intense round of meetings, dinners, breakfasts, telegrams, and phone calls essentially aimed to resolve information asymmetries in order to make better decisions.
A Question of Leadership
Do times make the leaders? Or do leaders make the times? Modern historians have dismissed Thomas Carlyle’s “great person theory” in which brilliant and talented individuals bend the arc of history. Instead, a modern vogue inclines some historians toward determinist theories in which the clash of large forces changes history and incidentally renders some individuals rich, powerful, and famous and others out of luck. The events surrounding the Panic of 1907 afford an interesting debate between the two theories.
Technological change (the Second Industrial Revolution), demographic change (waves of immigration), social change (urbanization), political change (progressivism, populism, socialism), and economic change (industrialization, growth and growing inequality) loomed over the first decade of the twentieth century. Against such powerful tides, it is easy to view the strivings of individuals as incidental to larger events.
Yet it is also true that the central figures of the episode brought to bear unusual attributes of character, intelligence, and talent. Theodore Roosevelt arguably changed politics and the presidency more than they changed him. And by virtue of his reputation, intelligence, resources, and social network, J. Pierpont Morgan mobilized a fractious financial community into collective action. One of Morgan’s strengths was an ability to size up people and their problems quickly—maybe hastily. These and other big personalities brought unique attributes to the Panic as it brewed, erupted, and subsided. Perhaps their good (or bad) luck figured in their role in the unfolding events. Certainly, the choices they made reveal underlying attributes of character that also affected the course of events. Thus, this narrative commences with a sketch of the times and the financial leaders who shaped it.
What’s New Here?
More breadth and depth. The first edition of this book was published in 2007, on the verge of the most serious financial crisis since the Great Depression. The Global Financial Crisis sparked new interest in its ancestor of a century earlier. Again in 2020, the global financial and economic crisis associated with the COVID-19 pandemic tested conventional theories and policies. These eruptions sparked new interest in its ancestor of a century earlier. Researchers in the academy, government, and business turned to the Panic of 1907 as a laboratory in which to test ideas. This version of the book adds the findings from more than four dozen relevant research papers and books published since the original edition in addition to other older sources that came to our attention. Throughout this edition, we provide more graphs and visual figures to help the reader grasp the significance of economic developments.
This new edition extends coverage of the crisis to communities across the United States and addresses international spillovers. And it illuminates the buoyant economic expansion over the decade before the crisis, along with the growth of debt financing in the economy.
Furthermore, this edition treats the civic reaction of 1908–1913 in more detail to illuminate the deep institutional changes that occurred. We examined contemporary analyses, newspaper accounts, and government archives about the civic reaction. The hearings of the Stanley Committee (1911–1912) and Pujo Committee (1912–1913), reports of Treasury Secretary Cortelyou as well as memoirs of Paul Warburg, Carter Glass, and Robert Owen yield insights into the motives of individuals who sought to shape the new regime of state intervention into financial markets and institutions.
Finally, in selected chapters we have added original findings that enrich or challenge the interpretations of researchers. In Chapter 2 we test the statistical significance of the plunge in the Bank of England’s gold reserves to explain the motive behind the BoE’s sharply restrictive monetary policy in October 1907. Our analysis of call loan interest rates in Chapter 14 affirms that the spike in volatility vastly exceeded the historical “noise level” and persisted much longer than implied in other accounts. In Chapter 16, we depict the declines in trust company deposits by firm size that shows the asymmetry in experience among firms. Chapter 19 gives evidence of hysteresis, a lingering slowdown in economic growth following the Panic. In Chapter 21, we analyze the panel of witnesses called to testify at the Pujo Committee hearings to illustrate the focus of the investigation. Our statistical analysis of the runs on trust companies in the technical appendix (after Chapter 24) illuminates the diversity among those firms, associated with variations in business model and the extent of affiliation with notorious figures. And various chapters show that the extensive impact of the Panic lasted well beyond the October–November 1907 period that figure in conventional discussions.
Motivating One’s Attention to History
As William Faulkner argued, the past is not dead; it is always with us. Just as victims of crime and veterans of combat must endure the indelible imprint of their experience, so societies must deal with the lingering effects of financial crises. To learn from the experience of a financial crisis requires one to process events and their causes, assess consequences, acknowledge agency, and derive meaning. There are no shortcuts to insights: begin at the beginning and trace events to the end. In this volume, we offer the long view. It is insufficient to study only the climax of a panic; one must also study the precursors and the long consequences to frame a deep understanding of these events.
Notes
[1] Adverse selection arises if a better-informed party in a transaction can exploit information to the disadvantage of the less well-informed party. Think of buying a used car (the seller knows more about the condition of the car, possibly a “lemon”) or selling health insurance (the buyer knows more about his or her health outlook). Concern about adverse selection may drive parties out of the market, thus diminishing liquidity and the ability of the market to clear. Also, adverse selection might drive quality goods out of the market because sellers of high-quality goods cannot obtain the prices they deserve. In finance, “Gresham’s Law” (i.e., bad money drives out good money) is an example of adverse selection.
[2] In the case of moral hazard, a party to an agreement fails to act in good faith and shifts risk onto counterparties. For instance, debtors who believe that the government will always bail them out in a crisis may simply borrow more, ultimately shifting risk onto taxpayers.
[i]. William Faulkner, Requiem for a Nun (New York: Random House, 1951, reprinted 1994), p. 73.
[ii]. Friedman and Schwartz (1963), pp. 156, 157.
[iii]. Clews wrote, “The real causes of all the trouble can be summed up as follows: (1) the high finance manipulation in advancing stocks to a 3.5 to 4 percent basis, while the money was loaning at 6 percent and above, on six and twelve months, time on the best of collaterals; (2) capital all over the nation having gone largely into real estate and other fixed forms, thereby losing its liquid quality; (3) the making of injudicious loans by the Knickerbocker Trust Co., hence suspension; (4) the unloading by certain big operators of $800,000,000 of securities, following which were the immense sales of new securities by the railroads; (5) the California earthquake, with losses amounting to $350,000,000; (6) the investigation of the life insurance companies; (7) the Metropolitan Street Railroad investigation; (8) the absurd fine by Judge Landis of $29,400,000 against a corporation with a capital of $1,000,000; (9) the Interstate Commerce Commission’s examination into the Chicago & Alton deal and the results thereof” (Clews 1973, p. 799).
[iv]. Kindleberger (1990), p. 71.
[v]. Lowenstein (2004), pp. 218–219.