Lecture 10: The Financial System

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Lecture 10The Financial System
Econ 311 University of Maryland Fall 2006
Ethan Ilzetzki
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The Financial System

• We have discussed a number of causes for growth
  in 19th century U.S.
• The legal system and the release of energy
• Specialization and the division of labor
• We discussed the importance of transportation in
  this context.
• Like transportation, a well functioning financial
  system helps oil the wheels of commerce and
  allow for specialization based on comparative
  advantage.
• In this lecture we will
• Understand the role of banks.
• Discuss the 19th century debate on the role of
  banks.
• Discuss the financial crises of the 1830s.

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The Role of Banks I Commerce

• One of the two main functions of banks prior to
  the 20th century was providing short term
  financing for commerce.
• The main tool used for this purpose was the Bill
  of Exchange.

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Bills of Exchange Introduction

• Bills of exchange were used to finance long
  distance exchange.
• It was (is) used very much like a check is used
  today.
• This financial instrument was invented by Dutch
  banks in the 17th century.
• When discussing the role of bills of exchange,
  keep in mind that the only form of cash before
  the Civil War were precious metals (gold).

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Bills of Exchange Example (I)

• Suppose a piano store in Ohio wants to buy a 500
  piano from a New York piano maker.
• Without a financial system, the transaction would
  look like this

Step 1 Gold
Piano maker
Customer
Step 2 Piano
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Bills of Exchange Example (II)

• With a bill of exchange the transaction becomes
  more simple
• The piano maker receives a bill of exchange for
  500 from the buyers agent in return for the
  piano.
• The bill of exchange is issued by a bank.
• It is redeemable (typically within 90 days) in
  cash (gold) upon presentation to the buyer.
• In theory, the piano maker could send the bill to
  his agent in Ohio, who can receive the gold and
  send it back to the planter.
• The piano maker can sell the bill of exchange to
  a bank or to a merchant in return for gold.
• A merchant could use the bill to buy 500 of
  goods from Ohio (or elsewhere where New York
  bills of exchange are used).
• For example, the merchant could send the bill of
  exchange to Ohio in return for wheat. The wheat
  grower trades 500 of wheat for the bill of
  exchange and redeems the bill at the piano
  stores bank in return for gold.
• The bank could hold the bill as a financial asset.

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Bills of Exchange Example (III)

• Notice how this simplifies matters
• Only goods and paper have to travel not gold.
• Only the trade balance between regions needs to
  be settled.
• This is netted between banks.
• Only banks need to be trusted.
• But banks are chartered corporations. If they
  dont respect their contracts, they will lose
  their charter.

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Bills of Exchange and Regional Specialization

• Bills of exchange (and the banks that issue
  them), like transportation networks reduce
  transactions costs.
• They also reduce informational barriers to trade.
• They therefore facilitate trade, regional
  specialization and growth.
• This is why the Calendar article discusses
  government investment in transportation networks
  and banks.
• Where the free market did not invest in banks on
  its own (such as Louisiana and Mississippi),
  governments intervened to invest in them.

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The Role of Banks II Money

• The only cash was gold.
• But conducting large transactions in gold is
  costly and risky.
• Banks provided a service by printing notes (paper
  money) redeemable in gold.
• The public benefits because it can use these
  notes (rather than gold) as a medium of exchange.
• The bank benefits, because it gets the right to
  print money (quite literally).
• And it might hold less gold reserves than in has
  notes in circulation.

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How Do Notes Work? Example

• A bank might have an initial stock of 1 million
  in gold.
• Its charter gives it the right to print notes
  (money!).
• It might choose to issue 3 million in notes.
• Thus its reserve ratio is said to be 1/3.
• As long as no more than 1 million of its notes
  are redeemed at any one time, the bank has made
  2 million.
• But the public also benefits it has a money
  supply that is 3 times larger due to the bank.
• This facilitates economic activity (the problem
  of the double coincidence of needs)
• Problem What if more than 1 million is redeemed
  at once.
• This is a run on the bank.
• The bank will have to go bankrupt.
• This might be motivation enough for the bank to
  hold enough reserves A run would force it to
  exit from a very lucrative business.

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The Role of Banks III Deposits

• Nowadays, banks arent allowed to print money
• The government has a monopoly on printing paper
  money.
• Paper money is no longer redeemable in gold.
• Redeemable in taxes.
• But deposits play the same money creation role
  that notes did.
• Deposits did not play as big a role in the 19th
  century as they do today.

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The Role of Banks IV Intermediation

• Nowadays, one of banks main roles is to
  intermediate between savings and investments.
• Savers might not want their deposits or savings
  accounts to be directly linked to a specific
  investment.
• Banks pool deposits and take a number of risks
  that the depositors themselves would not have
  been willing (or able to make).
• We will not focus on this role of banks at all.
• Trade finance was their biggest role in the 19th
  century.
• Trade finance is still a major role of banks
  today.

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Theory The Role of a Central Bank

• We saw how private banks could print and create
  money.
• Each bank is printing money to maximize its own
  profits.
• But the total supply of money might not be
  socially optimal.
• The total supply of money might be too high and
  create inflation.
• When there is uncertainty in the economy, banks
  might hold more reserves and decrease the supply
  of money, which could cause a recession.
• A large bank either private (such as was the Bank
  of England) or public (such as the Federal
  Reserve Board) could coordinate the supply of
  money.
• A central bank also serves as a lender of last
  resort to banks that have a temporary shortage of
  reserves.

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The U.S. Currency

• At the time of the revolution, it was commonplace
  to use precious metals (specie) as currency
  (cash).
• Some countries selected gold (Britain) others
  silver (China, Mexico).
• Banks could also issue notes backed by cash.
• But prices were denominated in units of local
  currency (20 pesos, 30 pounds) rather than in
  gold weights.
• After the revolution it was decided that the U.S.
  currency would be the dollar.
• It was difficult to decide which precious metal
  to use.
• It was decided to use both gold and silver and
  that their relative values be fixed at 151.

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Theory Greshams Law

• Bad money eventually drives out good.
• The government decided to fix the price of silver
  to gold at 151 (later 161)
• But what if the market value of gold to silver
  drops?
• For example, after gold is discovered in
  California.
• As an example, lets say the market price becomes
  101
• The domestic price remains as determined by the
  government
• The government continues to promise 15 ounces of
  silver for one ounce of gold.
• But the government cant control the
  international price
• People begin using the currency that is
  undervalued by the government price for
  international transactions.
• People can buy 15 ounces of silver at the U.S.
  mint for 1 ounce of gold.
• And then turn around and buy 1.5 ounces of gold
  on the international market!
• Eventually one form of money disappears.
• This is how gold came to be the main form of cash
  in the U.S.

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Theory The Gold Standard (I)

• Money was convertible into specie in most
  countries in the world, just like in the U.S.
• However, prices were denominated in local
  currency, such as dollars or pounds.
• The international financial system prevailing
  until WWI was known as the Gold Standard.
• Under the Gold Standard, each government
  committed to fix the price of its local currency
  to a certain amount of gold.

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The Gold Standard (II)

• The Gold Standard self regulates monetary policy
  and automatically controls inflation and trade
  balances.
• Lets say the U.S. is experiencing inflation (in
  the prices of goods).
• This might be because the U.S. experiences an
  increase in its money supply.
• Maybe because the U.S. has trade surpluses.
• Since dollars and pounds are both fixed to gold,
  the increase in prices will make U.S. goods less
  attractive.
• Thus, the U.S. will export less and import more.
• This will cause an outflow of specie from the
  U.S. to the world.
• Prices in the U.S. will decline (or rise less
  rapidly), due to the drop in the supply of money.
• And prices in the rest of the world will rise.
• This continues until prices equalize.
• Thus countries export and import inflation from
  each other.
• More precisely, inflationary conditions are a
  worldwide phenomenon, affected most strongly by
  the largest country.

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Banks in Early America

• Despite some suspicions, (such as Jeffersons)
  banks proliferated in the U.S. like nowhere else.
• In the 19th century there were more banks in New
  England than in all of Europe combined!
• States were chartering, and in some cases even
  investing in, banks.
• There was a debate as to the constitutionality
  and desirability of chartering a national bank by
  the federal government.

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The Bank Wars (I)

• We studied the debate between Jefferson and
  Hamilton on the Bank of the U.S.
• As we saw, Hamilton won
• The BUS was founded in 1781 as a private bank.
• In 1791 it was chartered as a national bank.
• The BUS functioned somewhat like a central bank,
  although it had no obligation to do so.
• Lender of last resort.
• Regulated other banks.
• The BUSs charter expired in 1811.
• President Madison does not renew the banks
  charter.
• He was a Jeffersonian.
• Republicans (Jeffersons followers) control the
  political system for over 2 decades.

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The Bank Wars (II)

• In 1812 Madison declares war on England.
• But there is no main bank for the government to
  borrow from.
• This causes high inflation and many bank
  failures.
• Madison learns the lesson He Charters the Second
  Bank of the U.S. in 1816, again for 20 years.
• 35 million of initial assets
• 4/5 privately owned, 1/5 government owned
• Reflected the banks board as well.
• Other Republicans change their views radically
  and become strong proponents of the national bank
  and of federal investment in infrastructure.
• Their main leader in the House of Representatives
  is Henry Clay.
• At this stage they call themselves National
  Republicans.
• The other faction is the Democratic Republicans.

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The Bank Wars (III)

• Elections of 1824Very contentious
• Jackson, Adams, Crawford, Clay.
• Jackson forms the Democratic party.
• Its ideology is very Jeffersonian.
• And the personal rule of Jackson.
• Wins the elections of 1828, running on an
  anti-bank platform.
• Nicholas Biddle appointed as president of the
  SBUS.
• Strengthened the banks role as a central bank
• Lender of last resort and regulator of banks.
• Established a policy of presenting notes of state
  banks for redemption in specie on a regular
  basis.
• Was the main player in foreign exchange and
  domestic exchange.

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The Bank Wars (IV)

• Biddle attempts to gain Jacksons support for the
  Bank, but is unsuccessful.
• Important issue bank needs to be re-chartered
  before 1836
• Within Jacksons second term.
• Clay passes the bank re-charter through congress.
• Hopes to make it a central issue in the 1832
  campaign.
• Overall, the bank was very popular.
• But Jackson vetoes re-charter of the bank
• And wins the election of 1832.
• The personal popularity of Jackson enormous
• Creates an interesting alliance between
  mid-western farmers (suspicious of banks) and
  Wall Street (want to erode Philadelphias
  financial power).
• In the 1840s, U.S. states move to free banking.
• Any bank can receive a charter if it acts
  appropriately.
• This happens just as general incorporation
  spreads.
• Follows the crisis of 1839 and the failure of
  many state banks.

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Financial Volatility in the 1830s

• The economy of the 1830s was one of the most
  volatile ones the country has ever known.
• 1820s prices were stable or in mild deflation
  (does not mean a recession).
• 1830s Inflation
• With intense inflation 1833-36
• Ends with a minor financial crisis in 1937
• 30s end with a huge crash (1839)
• 1839-1841 intense deflation (and one of the worst
  recessions in history)

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Financial Volatility in the 1830s Causes

• Historians have debated the causes of the
  financial crises of the 1830s for years.
• The conventional wisdom was that Jacksons
  policies were to blame.
• Revoking the charter of the SBUS
• May have caused the intense inflation of the
  mid-30s.
• Perhaps even a financial bubble
• What comes up must come down Crash.
• The Specie Circular of 1836
• Increased the demand for cash (gold)
• Decreased the supply of money.
• Caused the recession of 1837?
• Others blamed Biddle
• Clear evidence that he was increasing the banks
  reserves.
• To decrease the supply of money, cause a
  recession and punish Jackson?
• Or simply because the new SBUS (chartered only in
  Pennsylvania) needed to be more prudent?
• Some evidence that this really did cause a minor
  recession in 1834.

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Rockoff (1971)

• Rockoff looks at the actual data on the money
  supply and its components to see if the
  conventional wisdom holds.
• Finds that the standard story cant be true.
• Posits that international factors were to blame.

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Rockoff (1971)

• Rockoff assumes the following (simplified)
  equation for the supply of money
• M Money Supply
• C Cash held by the public
• R Bank reserves
• S Stock of Gold
• C/M Proportion of money public wants to hold in
  cash (determined by public)
• R/D Reserve ratio (determined by banks)

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Did Jackson Cause the Volatility?
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Wildcat Banks and Intense Inflation (I)

• Standard story
• Jackson revokes charter of SBUS and moves
  deposits to less prudent (wildcat) banks in the
  west.
• They hold much less reserves, which increases the
  money supply and causes inflation.
• Also, the SBUS regulated western banks by its
  policy of redeeming their notes in large amounts.
• Rockoff
• If inflation caused by standard story, drop in
  R/D should be the main cause for inflation.
• But Rockoff finds that reserve ratio barely
  affected supply of money in this period.
• Instead, it is S (the supply of gold) that
  increases!

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Wildcat Banks and Intense Inflation (II)

• Moreover, northwestern banks were actually more
  prudent that in other regions!
• This is a blow for the standard theory

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Did Wildcat Banks Exist?

• Rockoff claims banks were self regulating in this
  period.
• Ohio notes could be redeemed in Maryland, but
  Maryland banks might only redeem them at less
  than their face value.
• Unless the Maryland bank knows and trusts the
  Ohio bank.
• So the Ohio bank has the incentive to hold more
  reserves so that it can be trusted by banks
  elsewhere, and so that the public would be
  willing to use its notes.
• Rockoff also claims that the SBUS may have
  continued its regulatory role even without its
  national charter.

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The Specie Circular and the Financial Crash

• Standard story
• Jacksons Specie Circular forces all land sales
  to be conducted in gold.
• This would tend to increase the demand for cash,
  increasing the C/M ratio and decreasing the
  supply of money.
• This would have the effect of contractionary
  monetary policy and may have caused the crash of
  1837 or of 1839.
• Rockoff
• If deflation caused by standard story, drop in
  C/M should be the main cause for deflation.
• Instead, the effects of the increase in the
  reserve ratio on the supply of money are 5 times
  larger!

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International Capital Flows and Inflation

• Inflation caused by an increase in the supply of
  specie.
• International flows of specie must be the cause
  of changes in the supply of specie in the U.S.
• Unless new gold is discovered, as was the case in
  the 1850s and later.
• Rockoff claims that the increase in the supply of
  specie (and therefore the inflation) was caused
  by a combination of
• An increase in silver inflows from Mexico
• A decrease in silver outflows to China
• English investment in the U.S. is very strong

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Mexico

• The 1830s are an uncertain period in Mexico.
• Wealthy Mexicans seeking safe haven for their
  investmentsU.S. natural candidate.
• Mexico moves to a bimetal standard
• Copper introduced in addition to silver
• Greshams Law Bad money drives out the good.

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China

• Great demand for Chinese goods in the West
• Tea, ceramics.
• Before 1830s, Chinese have no interest in
  inferior western goods.
• So until the 30s, China has a large trade surplus
  with the west, causing an outflow of silver from
  the west (including the U.S.)
• Opium wars
• Britain forces Chinese to legalize opium and
  exports opium from India and Afghanistan.
• Now China has more balanced trade with the west.
• U.S. can now buy Chinese goods with English bills
  of exchange.
• Which the Chinese can use to buy Opium from the
  British Empire.
• Less need for actual silver outflows to finance
  this trade.

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Britain

• We have seen that there are higher inflows and
  lower outflows of specie due to Mexico and China.
• This increases the supply of money in the U.S.
  and would tend to cause inflation.
• But without understanding Britains role, our
  story is incomplete.
• The gold standard implies that if inflation in
  the U.S. were higher than in London (which is the
  financial center), gold would flow from the U.S.
  to Britain until the inflation is exported to
  Britain or wiped out.
• This doesnt happen because of another offsetting
  factor High flows of British investment to the
  U.S.
• Remember all the loans for transportation
  improvements in the 1830s in Calendar?

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The Crash of 1839

• We have seen that the Specie Circular could not
  have caused it.
• Newer evidence points to the idea that
  international flows are the culprit here too.
• In 1839, specie outflows from Britain begin to
  concern the Bank of England.
• In response the Bank of England increases
  interest rates.
• This decreases specie outflows from Britain.
• Including investments in the U.S.
• This is a Sudden Stop in capital flows to the
  U.S.
• Since this is caused by an event in Britain, it
  takes people in the U.S. by surprise
• Many state government default on their debts
• Many banks fail
• The banks that remain in business in the U.S need
  to hold more reserves than usual to secure
  themselves against a run on the banks.

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Sudden Stops Today

• Many economists believe that bad policies in
  emerging market countries do not fully explain
  why they are so vulnerable to financial crises.
• They believe that there is a financial center
  and a financial periphery and that changes in
  monetary policy in the center can precipitate
  crises in the periphery.
• In a way, the U.S. in the 1830s was an emerging
  market. The Bank of England was playing the
  role that the Federal Reserve plays today.
• Policy question Should the Fed take
  international conditions into account when
  setting monetary policy in the U.S.?