The Intended and Unintended Consequences of the Financial Crisis

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Mr. Bensel, Professor of Government, Cornell University, is the author of Yankee Leviathan: The Origins of Central State Authority in America, 1859-1877 (Cambridge University Press, 1991) and The Political Economy of American Industrialization, 1877-1900 (Cambridge University Press, 2008).

Just after the 2008 election, Newsweek ran a story comparing Barak Obama to Abraham Lincoln, a comparison that Obama in some ways has welcomed. Among other things, the two presidents both hailed from Illinois, shared a passion for rhetoric, recruited a cabinet containing one or more of their most serious opponents, and took the oath of office in the midst of a national crisis.  While Obama, of course, has not inherited a country on the brink of civil war, the new president does confront a financial crisis that at least matches in ferocity the one facing Lincoln in 1861.  Lincoln brilliantly solved the financial problems raised by an almost bankrupt Treasury and the financial policies enacted by the Lincoln administration almost 150 years ago might well hold lessons for his heir-apparent.

As southern states left the Union during the secession crisis in the winter of 1860-61, the major northern banks pondered whether or not to loan money to the federal government.  If they refused, the already thin and insubstantial ties between the American state and finance capital would have been irreparably severed. Although few people at the time thought war between the Union and the Confederacy would last more than a few months, the North would not have been able to fight at all without money.  And, for this reason, the terms offered New York financiers were generous.  Little did they know that this Faustian bargain would transform finance capital into a creature of national government policy, utterly dependent, in the first instance, on the success of Union arms and, for decades to come, upon the fiscal probity of the United States Treasury.

The Union solved the financial crisis brought on by the Civil War by integrating four major policies into an interlocking system that both worked very well in practice and, not coincidentally, won the confidence of finance capitalists throughout the North.  The first policy was not new, taking the form of a protectionist tariff that guaranteed a steady, secure, and efficiently-collected stream of revenue.  And, since those custom duties were to be collected in gold, the Union would have a source of specie even after abandoning the gold standard. The second policy was to create a new form of money, the greenback, making this paper currency a “legal tender” that could not be refused in commercial transactions.  Much of the war was paid for by printing paper currency and, thus, by way of inflation, widely distributing the fiscal burden throughout northern society.  Printing paper money was not novel but the legal tender provision was innovative.  And so was a corollary requirement that, in practice, abolished the paper currency that had hitherto been issued by state-chartered banks.  This corollary effectively and for the first time nationalized the monetary system of the United States.

The third policy was to issue millions upon millions of government bonds. These bonds sopped up many of the dollars that entered the economy, turning them into long-term government obligations.  Government bonds, of course, had been around for a long time.  What was novel about these bonds, however, was that their interest was to be paid in specie even though the government had abandoned the gold standard.  And that specie regularly came into the Treasury by way of customs duties, a source that finance capitalists and anyone else who invested in Union bonds could visibly monitor.  Although these policies were adopted at different times, they evolved into a tightly-interlocking and mutually-supporting triad.

The crowning achievement was the creation of the national bank system.  In order to establish a national bank, investors had to first purchase long-term government bonds and then deposit those bonds with the Treasury.  When the new bank was granted a charter, it could then issue what were called “national bank notes” for which those bonds served as security.  These notes were more or less identical to greenbacks except that, first, they were not legal tender and, second, they must be redeemed upon demand in gold or greenbacks by the issuing bank.  With the nation off the gold standard, almost all redemptions were in greenbacks. Investors supplying the initial capital for a national bank could not recover and then sell the bonds they had deposited with Treasury until they returned the notes the bank had issued to the government.  Other provisions restricted the kinds of loans the bank could make in such a way as to limit risk.  In practice, investments in national banks were very safe and returned a fairly generous profit. The bonds paid dividends in gold and the national bank notes were loaned out at interest in the private economy.  In terms of the triad described earlier, the national bank was connected to the tariff by way of the gold dividends paid on Union bonds, to greenbacks in that the banks held greenbacks as their reserves, and to Union bonds by way of the deposits held by the Treasury.  But the most important element in the national bank system was political: Because national bank investors had much of their capital tied up in Union bonds that they could not easily liquidate on the open market, many financiers became utterly dependent on the success of the Union war effort and, after the war ended, the fiscal success and soundness of the federal government.  These investors became a client group of the American state.

Over the short term, the financial system created by the North during the war worked brilliantly.  The payment of customs duties and bond dividends in gold kept, albeit in a somewhat compromised form, Union finance grounded in material representations of capital and wealth.  The fiscal health of the nation could be seen in the treasury statements by anyone who cared to look.  This visibility was extremely important for a government whose sovereignty and viability were challenged daily on the battlefield and in commercial markets. The nationalization of the currency created the opening for the national bank system and the ubiquitous use of greenbacks in commercial transactions.  The national bank system, along with the integration of tariff revenue and government bond dividends, created a secondary market for Union debt that also spawned a client group of wealthy financiers whose loyalty to the nation was beyond all question...because it was securely and almost inextricably grounded in their portfolios.

Over the long term, this financial system had several powerful and unintended effects upon the development of the American political economy.  Perhaps most importantly, this system created a powerful political interest centered on the national banks that became focused on return to and, later, defense of the gold standard.  Investors in national banks became one of the most organized, cohesive, and powerful interest groups in the country and their fiscal conservatism, exacerbated by their illiquid portfolios of government bonds, influenced many of the policies through which the United States encouraged rapid industrial expansion in the late nineteenth century.

One of the primary casualties of this fiscal conservatism was the half-hearted and prematurely aborted effort to reconstruct the southern political economy after the war ended.  When national sovereignty and fiscal health were no longer at risk, financiers defected from that part of the Republican coalition that otherwise would have fastened a new, proto-revolutionary political regime upon the South.  Although their defection did not immediately bring Reconstruction to an end, there were never enough Union troops in the former states of the Confederacy to suppress resurgent southern whites as they mounted increasingly violent attacks on freedmen and their allies.  In terms of the financial system itself, Union policies seriously exacerbated the periodic stock market “panics” associated with the harvest cycle.  Restrictions on the kinds of investments that national banks could make funneled their money into financial institutions in New York where, in turn, that money was lent to speculators in the stock market. Every fall when that money returned to the country at large in order to move the harvest to market, those loans were called back in New York, creating the annual monetary “stringency” that, among other things, was the proximate cause of the collapse in October, 1929.

How can we apply what we know about the Civil War financial system to the present crisis?  Although we don’t yet know the specifics, the Obama administration’s response to the financial crisis will apparently have three primary elements: reform and recapitalization of the banking system; fiscal stimulus of the national economy by way of increased federal spending and tax cuts; and direct subsidization of individual citizens and families who face mortgage foreclosure.  As a short-term solution to the financial crisis and the recession, these policies should be aligned with one another so that they avoid working at cross-purposes and, just as importantly, they reinforce one another in practice.  This alignment should focus primarily on tying the interests of finance capitalists to the success of the government program.  During the Civil War the central problem was confidence in the viability of the American state. That confidence, however, was not left up to the changing whim of public opinion or the success of Union arms.  It was, instead, tied down in the material interests of finance capitalists themselves and they were thus transformed from neutral spectators into cheerleaders for the Union cause.  Investor confidence in the present crisis is more diffuse but should be addressed in a similar fashion.

Another lesson to be learned from the Civil War is that financial mechanisms put into place should be transparent so that trust in the solution is not (at least not always) an act of faith.  For example, one of the most serious problems with the Obama administration’s program is the absence of any mechanism that will guarantee a market for the hundreds upon hundreds of billions of dollars in new government bonds that will fund this triad.  Without such a mechanism (and, despite Hillary Clinton's entreaties, it won’t be the Chinese this time), this program will probably collapse because uncertainty over the marketability of this debt (and thus the value of the dollar and the credit-worthiness of the United States) will become an ever more serious problem in credit markets which, in turn, are the primary focus of the program. The marketability for this new debt should not be left to the vagaries of public opinion but, instead, should be anchored in a transparent integration and alignment of the interests of the government and finance capitalists who, after all, command the wealth upon which the government will draw.

There are probably many ways we could align the interests of the government and finance capitalists but my feeling is that all of them, as was the case during the Civil War, will center on the national debt.  One possibility that has already been proposed would have the federal government trade long-term government bonds for so-called "toxic" mortgage-backed securities now held by the banks (including those which now include mortgages that the government intends to subsidize by directly aiding the borrowers).  If this were done, the banks should be required to hold the government bonds until they are able to redeem the mortgage securities.  Participating banks would thus be prohibited from selling those government bonds unless they redeemed mortgage-backed securities held by the government of the same value. That would guarantee placement for a large portion of the government bonds and tie the entry of these bonds into the open market to the reestablishment of an open market for the presently illiquid securities (the latter would be a precondition for liquidating the bonds because there would otherwise be no way of establishing an "equivalent value" for the securities).  Taking a capital stake in the banks themselves would, from this perspective, be counter-productive because it would liquidate the interests of finance capitalists in the survival of their banks (by making their own investments worthless).  The central pivot of the program should be to tie the long-term interests of shareholders to the success of government policy and, then, presuming that government policy succeeds, to craft a way of easing the banks out of the dependent relationship with the government.  If the government comes to own the banks themselves, it will be in the almost impossible position of creating a convincing investment climate for re-privatizing those institutions (which will, in any case, be radically transformed by the circumstances of their nationalization).

And there will be long-term consequences to all this.  Some of these we will think we can see already such as the consolidation of the banking system (the strong institutions swallowing the weak) and increased government control (not just regulation) of the financial system generally.  Others will remain unclear for some time to come such as the political consequences associated with direct subsidization of (what would otherwise be foreclosed) home mortgages.  In a very different arena, an intriguing possibility is a rapprochement between China and the United States as the interests of the world’s largest creditor and largest debtor become increasingly aligned.  But we cannot know what these long-term consequences will be; we can only know that they will be profound and, almost certainly, there will be some that we do not like.

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    More Comments:

    Steven Horwitz - 3/4/2009

    Sorry I don't measure up Jonathan. Of course you can go with your prejudgments or actually do what Bill says and read the article. The Southern Economic Journal is NOT, repeat NOT, any particular friend of libertarianism. It's a well-respected peer-reviewed economics journal. The article in question is rooted in real, actual historical research. Primary sources and everything. You might actually take a look. An open-minded scholar would.

    William J. Stepp - 3/4/2009

    People who can't tell the difference between the economy of 1929 and 1987, for example, don't make the cut.

    No one claims there were no substantial differences, but the qualitative differences that matter in explaining the various crashes were greater between 1907 and 1929 (only 22 years) than between 1929 and 1987 (58 years).
    As Casey Stengel would have said, you can look it up, except you evidently don't want to. Go ahead and teach a false theory of the great depression; the kids and the taxpayers won't know the difference.

    Jonathan Dresner - 3/4/2009

    The alternative is to wallow in ignorance

    No. The alternative is to pay attention to scholars in whose work I have more confidence.

    People who can't tell the difference between the economy of 1929 and 1987, for example, don't make the cut.

    William J. Stepp - 3/4/2009

    Well, if you bothered to actually read Steve Horwitz's paper rather than dismissing it out of hand, you might change your tune. Ditto for the work of other libertarian scholars, such as George Selgin (_The Theory of Free Banking: Money Supply Under Competitive Note Issue_; _Less Than Zero_) and Lawrence H. White (_Free Banking in Britain_; _The Theory of Monetary Institutions_), to name two.
    These are all good scholars, who have published in mainstream economics journals. Their work has been praised even by critics.
    The alternative is to wallow in ignorance, of which there is plenty on this board. See for example the screed on "A Nation of Tax Evaders," which absurdly claims the tax system is regressive, despite a mountain of stats which demonstrates otherwise.

    Why some of this garbage gets published on this website is beyond me.

    Jonathan Dresner - 3/3/2009

    I'm sorry, Mr. Stepp, but libertarian sources just don't carry a lot of weight with me, given their fundamental biases in this regard. Steven Horwitz? I'm sorry, but no.

    William J. Stepp - 3/3/2009

    A fine paper to read on this is Steve Horwitz, "Competitive Currencies, Legal Restrictions, and the Origins of the Fed: Some Evidence from the Panic of 1907" Southern Economic Journal 56(3), Jan. 1990, pp. 639-49.

    William J. Stepp - 3/3/2009

    Jonathan (and Rick),

    Before uncritically accepting his discussion of harvest-induced autumnal monetary stringeny as an explanation of the stock market crash of October 1929, I'd recommend having a look at some of the literature discussing that event. Although you'll find plenty of disagreement about what caused the crash (e.g., Friedman and Schwartz in their _Monetary History of the U.S._ claim it was a collapse in the money supply, whereas Peter Temin in his _Did Monetary Forces Cause the Great Depression?_ says it was a drop in the demand for money, which in turn caused a drop in its supply), what you won't find is the idea that the autumnal harvest caused it.
    You might recall the crash of 1987, and the fact that no one trotted out the fall harvest-leading-to-monetary stringency explanation.
    And for good reason. The fall harvest did lead to monetary stringency under the National Banking System, which was erected during the 1860s. State banking restrictions prevented the currency from being as elastic as it would have been under free banking, and this had severe repercussions, including some banking panics.
    The NBS was banished by the creation of the Fed in 1913, which started to operate in 1914. This made the currency more elastic during the fall, which was one of the rationales for creating it. Of course, the Fed imposed new problems, some of which have been manifested lately.
    None of this would have happened under a free market monetary system.

    HNN - 3/2/2009

    Hi Jonathan,

    That line also jumped out at me. And when I accepted the piece I noted that in an email to Professor Bensel!

    HNN editors think alike, I guess!


    Jonathan Dresner - 3/1/2009

    Every fall when that money returned to the country at large in order to move the harvest to market, those loans were called back in New York, creating the annual monetary “stringency” that, among other things, was the proximate cause of the collapse in October, 1929.

    This is fascinating. The whole thing is a very compact and lucid discussion, but this is the line that stands out for me. First, because it's going into my Great Depression lecture immediately. Second, though, because it highlights something which is at the center of our current difficulties: the failure of financial institutions to account for even the most forseeable strains.