Text | Shao Yu Chen Dafei
The original article will be published in the Journal of Finance and Economics, and this article is one of the columns in the "Fed Prequel" series
Related Article: Prequel to the Federal Reserve: A History of Politically Dominated Banking Transaction Games and Institutional Change
Since the outbreak of military clashes between Russia and Ukraine at the end of last month, global commodity markets have been volatile. WTI crude oil futures broke through $100/b without resistance and soared all the way to $130. On March 7, nickel futures rose more than 88% overnight, reaching a record high of $55,000/mt. On March 8, Lun Nickel once soared by more than 110% during the day, breaking through $100,000 / ton. The London Metal Exchange (LME) urgently suspended nickel trading, and before the suspension, it rose 59% during the day to 80,000 US dollars / ton.
Due to the high volatility of commodity prices, related companies generally use financial derivatives for hedging. It is reported that the sharp rise in nickel prices stems from the "short-selling" (also known as "short-squeezing") transactions of overseas institutions. A domestic Fortune 500 company holds a large number of short nickel futures orders, so it suffers heavy losses. "The Fall of a Generation of Nickel Kings" has flooded major media headlines. How the story ends, and whether it will have a chain reaction, remains to be seen. (The latest news said that Tsingshan Group has allocated sufficient nickel plates for spot delivery).
Looking back at the United States more than a hundred years ago, the fall of a generation of "copper kings" Heinz also began with "squeezing short" trading, but it occurred in the stock market, and the domino effect it produced triggered the financial panic of 1907 and directly led to the passage of the Federal Reserve Act of 1913 and the birth of the Federal Reserve. Comparing the Great Panic of 1907 with the 2007 financial crisis 100 years later, history is always strikingly similar.
In almost all crises, in advance, certain events are always isolated, and in hindsight, the series between events can always interpret a "perfect storm": the Russian-Ukrainian conflict, the sharp rise in crude oil, financial sanctions, the stock market crash, the "fall of the nickel king"...
The financial panic sparked by the San Francisco earthquake
April 17, 1906, was J.P. Morgan's 69th birthday. The next morning, a rare earthquake and the fires it caused destroyed the entire san francisco, with economic losses totaling about $350-500 million, or 1.2-1.7 percent of U.S. GDP in 1906.
Because San Francisco is an important financial center in the western United States and home to the Western Mint, the secondary impact of the earthquake was a cascade of financial shocks, first manifested in the stock market. Economists predict that the disaster directly or indirectly caused the new York Stock Exchange's market capitalization to evaporate $1 billion, or about 12.5 percent of the total market capitalization. In the two weeks following the disaster, the shares of insurance companies fell by about 15-30%. Insurance companies have been selling securities to finance losses, and the pressure to sell stocks has spread further (Figure 1).
Figure 1: Volatility in the U.S. stock market
Source: Federal Reserve (St. Louis Branch), Orient Securities Wealth Research Center
Bailout money poured into San Francisco. In the United States, New York, as a central reserve city, experienced a severe shortage of funds in the winter of 1906-1907, and the cost of funds rose sharply. At the international level, as many british insurance companies are also involved in san francisco fire insurance, the payouts have led to a total of 65 million gold inflows into the United States – accounting for 14% of the UK's gold reserves, resulting in a liquidity panic in London. On September 13, 1906, the Bank of England was forced to raise the benchmark interest rate from 3.5% to 4.0%, and for fear that cotton imports would further increase the demand for gold, on October 11 and 19, interest rates were raised by 1 percentage point each, and the interest rate was raised to a high of 6%. France and Germany also followed suit with the Bank of England in raising interest rates. This is a very typical "stool-grabbing game" in the field of international finance that uses competitive interest rate hikes as a means.
In February 1907, liquidity tensions intensified and the stock market collapsed at an accelerated pace, staged the "March Panic", with lows not appearing until November 1907. Compared with the high point of September 1906, the stock price index of all listed companies fell by 37%, and the stock price of railway companies fell by 35%. Of course, the stock market crash never happened overnight. At the end of March, J.P. Morgan, the central figure in the panic, believed that "the panic was over." In panic, optimism is never a scarce commodity. In April-May, two exciting news – Finance Minister Cortelyou G. ordered $15 million to be deposited in a New York City bank, and expectations of £4 million worth of gold shipped from London to New York – brought the stock market to a halt. It is only after the fact that people find out that the optimism of panic times is the most deadly.
In June-July, a new series of collapses began, as the Bank of England began tightening capital controls, prohibiting the United States from issuing bonds (or notes) in London and prohibiting their circulation. The trend of gold flowing from the UK to the US was reversed. To pay off the london stock of notes, U.S. gold reserves fell by 10% (about $30 million). This not only falsified previous positive expectations, but also further widened the liquidity gap in the United States. Coinciding with the autumn season again for agricultural capital demand, the National Bank of New York City was in a cash rush, with a municipal bond subscription rate of less than 10% on June 28. In September, after J.P. Morgan's mediation and repeated postponements of the issuance date, the New York City government finally successfully issued a $40 million bond. Cortliu also made a deliberate commitment to inject $40 million to $50 million in gold into banks to ease liquidity pressures in capital markets.
The fall of a generation of "Copper King" Heinz
Panic is the fertile soil for speculation, and speculation will amplify panic, which can easily trigger the "domino effect".
After the Civil War, the process of industrialization in the United States advanced rapidly. At the end of the 19th century, the industrial added value of the United States surpassed that of agriculture, and it became the world's largest industrial country.
From the end of the 19th century to the beginning of the 20th century, the "big king" of the American business industry was born, familiar with the "steel king" Carnegie, the "oil king" Rockefeller, etc., and the other less well-known was the "copper king" Fritz A. Heinze）。 Most of them have built business empires quickly through mergers and acquisitions and have complex equity relationships with financial institutions such as banks. In a title lawsuit, Heinz beat Standard Oil Holdings' merged copper company to $12 million in legal fees before shifting the "battlefield" to Wall Street. His partner was Charles W. Morse, a speculator who was "extreme in industrial and banking activities, even by American standards," under the name of The National Bank of North America and the National Bank of New Amsterdam. Through the "chain bank" model (holding one bank first and then buying shares in another bank through equity pledges), Morse controlled at least 6 national banks, 10-12 state banks, 5-6 trust companies and 4 insurance companies.
Heinz merged the remaining interest in the mine with United Copper, whose actual controller was Augustus. In October 1907, in a speculative transaction of "squeezing shorts", due to a mistake in judgment, the stock price of The United Copper Company plummeted, and Heinz also suffered heavy losses. The first fallen domino was the brokerage firm Gross Krieberg; the second was Augustus, whose president, the businessman Mercantile National Bank, sparked a run on depositors for lending to Heinz; the next third was Morse. Ultimately, they had to resort to the New York clearing house. Despite the Actions and Assurances taken by the New York Clearing House, panic is spreading and runs continue unabated.
Speculation binds banks, trusts, industries and the stock market, and the collapse of the stock market affects the whole body. In the single banking system with an "inverted pyramid" structure, there is a shortage of liquidity at the top of the pyramid, and the rural banks at the bottom are also not spared. In 1907 alone, 156 banks went bankrupt – 24 national banks and 132 non-national banks. Trust companies have been hit hard, as most of them have fallen out of the liquidation system. In 1903, the New York Clearing House required trust companies to hold at least 10% of the reserves, causing a large number of trust companies to give up their clearing house membership and use the national commercial banks of the Morgan Group to settle instead. In October 1907, the State Bank of Commerce announced the suspension of liquidation relations with Nick Burke, the third largest trust company in New York with deposits of more than $60 million. Its president, Charles Barney, was also a big speculator, having worked with Heinz to trade United Copper's shares, but failed. On October 22, Nick Burke went bankrupt and Barney ended his life. This opened up a run on trust companies. The next day, the top two trust companies were also run. At one point, the short-term rate was raised to 150%, and panic reached a climax.
During the panic period, residents' liquidity preferences increased significantly, with a total of nearly 300 million yuan of currency withdrawn from circulation, and the premium rate of currency relative to deposits was as high as 4%, which can be manifested as an increase in the currency-deposit ratio or a decline in the reserve-deposit ratio. Fearing bankruptcy, banks have chosen to hoard liquidity and sharply increase their reserve ratios, with banks in regions such as San Antonio raising their reserve ratios to 35 percent, and one Indiana bank even boasting a reserve ratio of 67 percent. In the face of depositors' withdrawal needs, some banks have suspended withdrawal services, and some require depositors to give 60-90 days' notice before withdrawing funds. Cash in circulation was extremely short, and it once returned to the era of barter. Clearing houses across the country have issued certificates, and banks have issued various temporary cash/payment checks to make up for the shortage of means of circulation.
In his seventies, J.P. Morgan played the role of "Fire Captain", coordinating the concerted action of the Treasury, banks, trusts and industries to inject funds into national banks and trusts, and finally stopped the spread of panic in early November. The stock market also bottomed out in November 1907, but the recession cycle did not end until June 1908. During this period, the index of U.S. industrial production fell by 16 percent, and real net national production fell by 11 percent. Some say that J.P. Morgan alone plays the role of the "Federal Reserve Bank." A reasonable speculation is that without Morgan, the financial panic of 1907 would probably have turned into a Great Depression.
The Rhymes of History: The Panic from 1907 with the Crisis of 2007
A review of the financial panic of 1907 reveals that the 2007-2009 financial crisis a hundred years later has striking similarities in many ways, for example, both crises were related to financial innovation, except that the former was a trust business and the latter was "shadow banking" (subprime mortgage business).
Trust companies are state-licensed financial intermediaries that compete with banks in terms of deposits. Trust companies are not a core component of the payment and clearing system, and the amount of check clearing is relatively small, and the cash reserve ratio they hold is only about 5%, which is significantly lower than the reserve ratio of the national bank of the central reserve city (25%). Because deposit accounts can also withdraw cash, trust companies are just as vulnerable to runs as banks. Trust companies are also more deeply involved in the stock market than banks, issuing large amounts of unsecured credit to brokers on the New York Stock Exchange. These brokers buy shares and then use them as collateral to apply for a short-term loan from the National Bank to repay the trust company's loans. This invisibly binds the National Bank, the trust company, and the stock market together, and the bailout of the clearing house against the National Bank alone is not enough to stop the panic (Moen and Tallman, 1999). In contrast to the 2007-2009 crisis, the suppliers of short-term loans became shadow banks (hedge funds and money market mutual funds), and the demanders were other shadow banks (investment banks).
Another example is the process of crisis. At the beginning of the year, the shares of non-bank financial institutions that were widely used as collateral in some transactions fell by more than half. At first, financial markets ignored the issue. But in the summer, as the market stabilizes, two new challenges emerge. Soon after, a non-bank financial institution collapsed and financial markets fell into panic. Meanwhile, a large financial firm is also in trouble, but is considered salvageable. A bailout agreement was reached. Market participants believe that this will prevent the collapse of other financial dominoes. The panic was finally stopped, but the real economy fell into recession.
In the panic of 1907, the non-bank financial company with the stock price slashed was the Union Pacific Corporation, the two major challenges in the summer were the decline in copper and bond prices, the bankrupt non-bank financial institution was the Knickerbocker Trust, and a large financial company that was bailed out was the American Trust. In the 2007-2009 crisis, Bear Stearns replaced Union Pacific, Fannie Mae and Freddie Mac replaced copper and bond prices, Lehman replaced the Nick Burke Trust, and American International Group (AIG) replaced the American Trust Company (Elias and Jordà, 2013). As Krugman puts it, "It should be obvious that [the subprime mortgage crisis that began in 2007] resembles the Great Financial Panic of 1907." "The similarities of financial crises are roughly reflected in the strong economic growth and blind optimism before the crisis, as well as the information processing patterns of complex economic systems during the spread of the crisis, people's excessive panic or overconfidence, and the failure of collective action (Bruner, 2016). A number of seemingly unrelated factors converge to form a financial "perfect storm."
In fact, policymakers have long been aware of the shortcomings of the national banking system, such as the inelastic money supply, the lack of money management institutions, and the fact that the bank pay-as-you-go mechanism has not really been established. But only a stormy crisis can bring about real change.
The financial panic of 1893 provoked popular discontent with the monetary system. They organized general strikes to increase the circulation of money. Congress (Banking and Monetary Commission), the Ministry of Finance (with the Comptroller's Office of the Currency), banking associations, and industry have all put forward monetary reforms from their own standpoint. The representative scheme is for the industry to present the Indianapolis currency report based on the real bill theory. The report proposes that commercial banks should lend rather than government bonds based on the needs of farmers, merchants, and factories, because after the McKinley Tariff Act of 1890, U.S. tariff revenues rose sharply, fiscal surpluses were achieved, and the currency was tightened. Therefore, money and bank credit should be allowed to "automatically and timely self-adjust" to meet business needs.
Congress held a series of hearings, but no action was taken. Although the idea of building a large bank of a private nature similar to the Bank of England has taken root in the United States. But in the wave of progressiveism and antitrust, any promotion of concentration of power and corporate monopoly is not politically feasible. "Central bank" was a sensitive word in that period. The specter of Jacksonism still hovers over the United States.
Over the next decade or so, politicians, bankers and businessmen did not stop trying, but with little success. It was not until the outbreak of the Great Panic and the resulting recession in 1907 that banking and monetary reforms in the United States were actually initiated. The lessons of the National Bank era (1864-1913), especially the reflections brought about by the Great Financial Panic of 1907, profoundly shaped the Fed, making it initially positioned itself to provide a resilient currency and deal with financial panic, but the legislative process was destined to be another "tug-of-war" between different political-economic interest groups.
Historians often say that time is like fine wine, giving people a sense of detachment. This is considered a virtue of the discipline of history, because it is always easy to read and examine history from the perspective of a bystander. The narration of the witness comes with its own authority. Latecomers cannot really stay in "history". Perhaps it is this abuse of hindsight and alienation from the bystander that makes history always rhyme. Therefore, Hegel said that the only lesson that history has taught people is that mankind has never learned a lesson. This, in turn, is vividly reflected in the history of financial crises. So much so that former U.S. President Harry Truman said, "There's only one problem in finance that's new, and that's that we haven't read history through yet." ”
Imagining the future can only be achieved by deconstructing history. Even if only vague impressions of the future can be obtained, even if the predictions are wrong in hindsight, it makes sense. The "Fall of the Nickel King" and the "Fall of the Copper King" are fundamentally different in cause or existence, but this does not play a decisive role in the process and outcome. The financial crisis evolved roughly like a similar path — from madness to panic to collapse , and was filled with blind optimism and overconfidence.
Shao Yu is the chief economist and assistant to the president of Orient Securities, and Chen Dafei is a macro researcher and general manager of wealth research center of Orient Securities.