The Panic of 1907 was a financial crisis similar to the Panic of 1893 but resulted in a legislative framework that far exceeded that of the 1893 and earlier crises. Because of the length and severity of the crisis, as well as the outsized role that J.P. Morgan played, there was considerable pressure for legislative reform of the banking system. To address the problems raised by the Panic of 1907, Congress passed the Aldrich-Vreeland Act in 1908 and the Federal Reserve Act in 1913.
The Panic of 1907 was precipitated by several events. First, there was stress on the American money supply due to reconstruction aid to San Francisco after the April 1906 earthquake and to the Bank of England’s rising interest rates due to British insurance companies paying out so much to American policyholders. Second, the Hepburn Act, which gave the Interstate Commerce Commission the power to set maximum railroad rates, became law in July 1906 and resulted in the depreciation of value of railroad securities. These events led to a slide of almost 18% in the New York Stock market between September 1906 and March 1907, which became known as the “Rich Man’s Panic.”
The economy remained volatile throughout the summer of 1907 with a continual drop in the value of stocks. A series of events contributed to this decline: the failure of the New York City’s bond offering, the collapse of the copper market, and the $29 million fine against the Standard Oil Company for antitrust violations. Abroad, there were several runs on the banks in Egypt, Japan, Hamburg, and Chile. By September, the value of stocks had dropped by 24.4%. On October 22, 1907, the Knickerbocker Trust, the second-largest trust company in the United States, was forced to suspend, triggering fear throughout the country and massive cash withdrawals from New York City banks.
The Treasury Department intervened with a $25 million deposit in New York banks, and J.P. Morgan organized a pool of $10 million, but these efforts were insufficient to stop the spread of panic. Public confidence needed to be restored as Morgan, the other banks, and even the U.S. Treasury were low on funds. The bankers consequently talked to the press to persuade them that the worst had passed; and, on Monday, October 26, the New York Clearing House issued $100 million in loan certificates to be traded among banks to settle balances while allowing them to retain cash reserves for depositors. These actions led to a return of stability on Wall Street, although specie payments did not fully resume until January 1908 after considerable imports of gold.
In November, a new set of crises emerged with J.P. Morgan playing a critical role in each of them once again. By purchasing $30 million of bonds, Morgan precluded New York City from declaring bankruptcy; by organizing a $25 million loan to the Trust Company of America and other weak financial institutions, Morgan stopped another potential run on the banks; and by persuading anti-trust busting President Roosevelt to allow U.S. Steel to acquire the Tennessee Coal, Iron and Railroad Company, Morgan was able to prevent another stock market crash. By the end of the year, the Panic of 1907 had ended with Morgan preventing a collapse of the entire financial and economic system of the United States.
In the aftermath of the Panic, there was a lengthy economic contraction from May 1907 to June 1908. According to economists Christine Romer, Nathan S. Balke and Robert Gordon, the stock of money fell 6.8% from the second quarter of 1907 to the first quarter of 1908 with estimates of real GNP falling from 4.3-5.6% from 1907 to 1908. Industrial production dropped further than any previous bank run and 1907 saw the second-highest volume of bankruptcies to that date. Production fell by 11%, imports by 26%, and unemployment rose from under 3% to 8%. The frequency and severity of the 1907 Panic, in addition to the outsized but critical role that Morgan played, created considerable pressure for reform of the financial system. This reform was directed at the banking system rather than the monetary standard, as the gold standard seemed to be in good working order when the crisis began.
In May 1908 Congress passed the Aldrich-Vreeland Act that permitted groups of banks acting in concert during emergencies to issue non-redeemable currency and withdraw them once the emergency had passed. Simply put, according to The Cambridge Economic History of the United States, Volume 2, the Act legalized and regulated what had happened under Morgan’s leadership during the Panic of 1907. More importantly, the Act also established the National Monetary Commission to investigate the Panic and to propose legislation to regulate banking. The Commission issued 23 studies by leading scholars of money and banking with a final volume of recommendations. The common theme in the reports was the need for the United States to have a lender-of-last-resort. The Commission submitted its final report in 1912; and on December 23, 1913, Congress passed the Federal Reserve Act very much consistent with the Commission’s recommendations.
The Federal Reserve Act created a new form of currency, the Federal Reserve Note, which could be issued rapidly to meet a sudden demand for cash in banking crises. The U.S. government would create and loan these Notes to banks secured by various forms of bank assets. The Notes also could be used to acquire gold, as the law required that they be backed by 40% by gold. To be the lender-of-last-resort, the Federal Reserve would have to have a sufficiently large reserve of gold and rely upon its ability to attract additional gold during a crisis. The Act therefore took for granted the continuation of the gold standard which was viewed favorably by the public.
The Federal Reserve Act also established a banker’s bank, although it was prohibited from making loans to business or private individuals. As the banker’s bank, the Federal Reserve was given supervisory power to ensure that banks were in compliance with reserve requirements and other regulations. However, the organization of the Federal Reserve made this task difficult as it was organized into twelve federal districts with a board of governors exercising overall supervision. Member banks were to hold their reserves in their district banks. The result of this arrangement was a struggle between the board of governors and the district banks, particularly the Federal Reserve Bank of New York, over issues of independence, authority, and supervision.
By being committed to the gold standard, the United States had to reduce its money supply when economic expansion produced balance-of-payment deficits. However, economic expansions also increased the demand for credit and therefore required an increase in the money supply. As the lender-of-last-resort, the Federal Reserve had to expand the money supply while, at the same time, deplete its gold reserves. As long as the gold standard was maintained, this policy was sustainable. World War I and its aftermath made adherence to the gold standard impossible and put the Federal Reserve into new territory for which it was not prepared.
Monetary History Highlights
The Rueffian Synthesis