The historical origins of financial crises teaches us about changing attitudes toward government intervention into private markets.
A lesson frequently taught by twentieth century economists was that government intervention in markets can be counterproductive. But the idea that government intervention in markets can backfire was voiced as an intuition long before, in 1857, during a financial crisis that prompted governments in the US and in Europe to consider bailing out banks. Two contemporaries, President James Buchanan and Karl Marx, objected: bank bailouts would do more harm than good.
By 1857, a financial crisis was not a new phenomenon. Major economies had suffered through several episodes of what at the time were called “revulsions.” In 1857, several years of brisk trade had tempted investors and lenders to overextend their commitments. Earlier that year, an unexpected interruption in settlements by some New York traders caused banks to rein in loan commitments and borrowers to hold back investments. That slowdown might have been temporary, if it weren’t for breaking news in August that a major institutional lender, the Ohio Life Insurance and Trust Company, had defaulted. From New York, a chain reaction rippled out across the country. Banks closed, factories shuttered, and workers were sent home. Ohio, the epicenter of the outbreak of the crisis, was a bright spot in this dismal picture. Working at speed and foregoing federal intervention, banks in Ohio created a mutual guarantee association, and Ohio became one of the first states to restore orderly markets.
President James Buchanan made the financial crisis the first agenda item of his State of the Union Address on 8th December 1857.
James Buchanan made three key points.
First, he showed empathy for the privations inflicted on the country: “In the midst of unsurpassed plenty in all the productions of agriculture and in all the elements of national wealth, we find our manufactures suspended, our public works retarded, our private enterprises of different kinds abandoned, and thousands of useful laborers thrown out of employment and reduced to want.” Second, however, he was adamant that the country could not look to the government to lighten “the suffering and distress prevailing among the people. With this the Government can not fail deeply to sympathize, though it may be without the power to extend relief.” Third, James Buchanan exposed the root cause of the financial crisis, namely “irresponsible banking institutions, which from the very law of their nature will consult the interest of their stockholders rather than the public welfare.”
James Buchanan must have been aware of the financial lifeboat that had helped Ohio sail out of the crisis. It would have been only too plausible a reaction to emulate this example at the federal level and set up a government-backed guarantor to support unsteady banks. This suggestion, however, Buchanan rejected – to let government intervene in financial markets, he argued, would give rise to misaligned incentives. To believe the United States could set up a central financial institution to defuse a financial crisis, he asserted, was illusory: that institution was destined to align its interests with those of the financial institutions it was meant to oversee.
“But a bank of the United States would not, if it could, restrain the issues and loans of the State banks, because its duty as a regulator of the currency must often be in direct conflict with the immediate interest of its stockholders. If we expect one agent to restrain or control another, their interests must, at least in some degree, be antagonistic. But the directors of a bank of the United States would feel the same interest and the same inclination with the directors of the State banks to expand the currency, to accommodate their favorites and friends with loans, and to declare large dividends. Such has been our experience in regard to the last bank.”
The 1857 crisis broke the mould.
Previous financial crises had been domestic, but in the meantime, advances in shipping and in telegraphy had connected markets across the Atlantic. Readers of the New York Daily Tribune on 30th November 1857 could read reports of how the financial crisis unfolded in Europe from their paper’s correspondent in London, Karl Marx: “The British commercial revulsion seems to have worn throughout its immense development the three distinct forms of a pressure on the money and produce markets of London and Liverpool, a bank panic in Scotland, and industrial breakdown in the manufacturing districts.” The effects of the crisis could not be contained in Britain and soon made themselves felt in continental Europe. In Hamburg, an autonomous city-state, the government decided to intervene and launched a tax-funded rescue operation. Reporting on unfolding developments, Karl Marx gave this assessment:
“The Senate proposed, and obtained leave from the freehold burgesses of the city, to issue securities bearing interest … To uphold prices, and thus ward off the active cause of the distress, the State must pay the prices ruling before the outbreak of the commercial panic, and realize the value of bills of exchange which had ceased to represent anything but foreign failures. In other words, the fortune of the whole community, which the Government represents, ought to make good for the losses of private capitalists. This sort of communism, where the mutuality is all on one side, seems rather attractive to the European capitalists.”
James Buchanan would have phrased it differently, but in substance, he would have had to agree with Karl Marx: bailing out distressed banks constituted a “sort of communism.”
Does it matter what James Buchanan and Karl Marx had to say in 1857 about a financial crisis? To answer that question we need to take stock of how attitudes have changed.
The bank bailouts of 2008 prompted Bernie Sanders to recycle a catchword: bailouts were socialism for the rich. That term – socialism for the rich – revived an accusation that made the rounds in American politics several decades ago, when it was voiced by Martin Luther King and Robert Kennedy. But in that era it was invoked in other contexts. The new element of the phrase coming from Sanders was that it applied to bailing out banks. Today, if a government would let a financial crisis run its course, the public would blame the fallout on government rather than on banks. In 1857, the opposite opinion prevailed. Across opposite ends of the political spectrum, from the Oval Office to a Soho garret, it was held that bank bailouts were a misuse of public funds. By 2008 that consensus had become anathema.
The turning point in attitudes towards government support for financial market stability came after the financial crisis of 1907 and the creation of the Federal Reserve Bank. As was thought at the time, a central authority with oversight of financial markets would put an end to financial crises, or at the very least make their impact less severe. But ever since, crises have gotten bigger, not smaller. And after each crisis, government expanded its powers to intervene in financial markets.
The 2008 crisis launched central bank remits into uncharted territory, tasking central banks not only with saving banks but also with buying bonds, equities, and funding government deficits. If the 1907 crisis made central banks lenders of last resort, the 2008 has made them investors of last resort.
James Buchanan and Karl Marx lacked an analytical toolkit about government failure, but they had the right intuitions. Analysis had to wait for George Stigler to unfold the economics of regulatory capture, showing that government intervention was not a panacea for curing market dysfunction and that incumbents can subvert government to serve their own ends.
The concept of regulatory capture was first applied to the analysis of monopolistic markets, such as utilities. Later, retail financial markets came into focus. In retail finance incumbents derive a benefit whenever regulators impose new rules for compliance – the higher their overheads, the higher the barriers keeping out new competitors. Arguably, however, regulatory capture in financial markets obtains not only in the retail sector. The post-2008 quantitative easing was billed as an emergency measure, but that emergency measure is still in place today. The toolkit of regulatory capture would explain why such would come as no surprise to James Buchanan, Karl Marx, and George Stigler.
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