Moral suasion and other exhortatory devices

The dominant argument against the a priori view that panics can be
cured by being left alone is that they almost never are left alone. The
authorities feel compelled to intervene. In panic after panic, crash after
crash, crisis after crisis, the authorities or some ‘responsible citizens’ try
to halt the panic by one device or another. The authorities may be un-
duly alarmed and the position might correct itself without serious harm.
The authorities may be stupid and unable to learn. (The Chicago School
assumes that the market participants are always more intelligent than the
authorities, in large part because the authorities are motivated by short-
term political objectives.) The uneven distribution of intelligence cannot
be tested against crisis management because authorities and leading fig-
ures in the marketplace both exert themselves in the same direction to
halt the spread of falling prices, bankruptcy, and bank failures. If there
is a learning process at work—and the assumption of rationality requires
one—the lesson has been that a lender of last resort is more desirable
and less costly than relying exclusively on the competitive forces of the
market.
One insight from the historical record is that there are many examples
when the authorities initially were resolved not to intervene but eventu-
ally reluctantly did so. Lord Liverpool threatened to resign as Chancellor

of the Exchequer in December 1825 if an issue of Exchequer bills was

provided to rescue the market after he had warned against excessive spec-

ulation six months earlier.22 William Lidderdale, Governor of the Bank

of England at the time of the Baring crisis, refused categorically to accept

a ‘letter of indemnity’ to permit the Bank to exceed its lending limit.23

On both occasions face was saved by finding some other approach to

avert the panic. The initial strong moral stand not to intervene was re-

versed on many other occasions as the panic escalated. These included

the intervention of Frederick II in the Berlin crisis of 1763,24 the Bank of

England’s refusal to discount for the ‘W banks’25 and the U.S. Treasury’s

decision in 1869.26

In a run, each depositor rushes to get his or her money from the bank

before the bank is forced to close because its money holdings have been

exhausted. Banks are often reluctant to pay the depositors because their

money holdings are always much smaller than their short-term deposit

liabilities. During the Great Depression, banks took their time to pay

off depositors, hoping, like Micawber, for something to turn up. The

technique goes back to the eighteenth century.

Mcleod’s Theory and Practice of Banking describes how the Bank of

England defended itself in September 1720 against a run brought on by

its reversal of a promise to absorb the bonds of the South Sea Company

at £400. The Bank organized its friends in the front of the line and paid

them off slowly in sixpence coins. These friends brought the cash back to

the Bank through another door. The money was deposited, again slowly

counted, and then again paid out. The run was staved off until the feast

of Michaelmas (September 29). When the holidays were over, so was the

run, and the Bank remained open.27

A second story, which may well have the same origin and is likely

to be more accurate, is that the Sword Blade Bank, a supporter of the

South Sea Company, resisted attempts to redeem its paper with silver

coins. When the run started on September 19, the bank brought up

wagonloads of silver that it paid out ‘slowly in small change.’ One de-

positor is reported to have received £8,000 in shillings and sixpences

before the bank closed its doors on Saturday September 24.28 The cir-

cumstances suggest one story; the dates, two. Since the Sword Blade

Bank and the Bank of England were mortal enemies, it is unlikely they

cooperated.

The lessons of 1720 were not lost on the Bank of England a quarter cen-

tury later. The Young Pretender (Charles Edward, grandson of James II)

landed in Scotland in July 1745, unfurled his banner in September,

invaded England in November, arrived in Carlisle on November 15,

and reached Derby on December 4. Panic broke out on Black Friday,

December 5, 1745. British consols fell to 45, the lowest price on record,

and a run began on the Bank of England. The Bank resisted, partly by

paying off its notes in sixpence coins. The time gained was used to in-

duce London merchants to proclaim their loyalty and readiness to accept

Bank of England notes. The second half of the prescription, collecting

pledges of faith in notes, was used again in similar circumstances when

the French landed at Fishguard in 1797. On that occasion, 1,140 signa-

tures of merchants and investors in government stock were collected in

a single day.29 The time gained in 1745 by both the slow payout and the

petition of support enabled the government to organize the army that

defeated the Young Pretender at Culloden in April 1746.

One way to stop a panic is to stop trading by closing the market. Trading

on the New York Stock Exchange was halted in 1873, and in London

and many other cities at the outbreak of war in 1914. In both cases the

motivation was to stop a run by providing the market participants with

more time to think through whether it was necessary or desirable to sell

at what were almost certainly depressed prices.

However, shutdowns may drive the trading underground and intensify

the panic. Moreover, short-run and long-run goals are in conflict. Closing

the stock market during one panic may exacerbate the next, as investors

sell their stocks or withdraw their money from the call money market

because they are fearful that trading will be halted. The New York Stock

Exchange was closed in a panic in September 1873, but a financial editor

suggested that fear that trading on the exchange might be halted in

October 1929 was a factor in hastening the withdrawal of call money by

out-of-town banks and other market participants.30 The closing of local

stock exchanges in Pittsburgh and New Orleans for two months in 1873

had fewer serious consequences, since they traded only the securities of

the local firms that had brought on their difficulties.31

The New York Stock Exchange and the other stock exchanges in the

United States were closed for a week after the bombing of the World

Trade Center towers on September 11, 2001 because the communications

and the technical support systems were inoperative. Many of the same

securities could have been traded on the regional stock exchanges in the

United States but these exchanges would have been overwhelmed.

The declaration of a legal holiday by the government is another tech-

nique for closing the market, which was used during the panic of 1907 in

Oklahoma, Nevada, Washington, Oregon, and California.32 The device

was the forerunner of the bank holidays that started at the local level in

the fall of 1932 and were generalized throughout the country on March

3, 1933, the day that Franklin D. Roosevelt was inaugurated as president.

(A bank holiday closes only the banks, while a legal holiday shuts down

all business.)

Another device is to suspend the publication of bank statements, as

in 1873, in the hope that ‘what you don’t know won’t hurt you.’ The

technique was designed to hide the large losses of reserves of a few banks

since the fear was that accurate news would further reduce depositor

confidence.33

Some commodity and financial markets set daily limits on the maxi-

mum change in prices; when the limit is reached, trading is suspended

for the rest of the day. Specialists in individual stocks have often taken

a ‘time out’ whenever the imbalance between the buy orders and the

sell orders has been exceptionally large. This ‘circuit breaker’ was rec-

ommended for U.S. stock markets after the meltdown of Black Monday,

October 19, 1987. The proposal for the New York Stock Exchange was

to postpone trading for a stated interval—such as twenty minutes—in

those stocks whose prices increased above or declined below the limit.

Time has been gained by moratoriums on payment of all debts or on

particular types of obligations, such as bills of exchange that have less

than two weeks to run. The most ubiquitous measure of this sort is that

the bank examiners ignore bad loans in the portfolios of banks as long as

they can, an implicit moratorium on marking the loans to their market

value. Regulatory forbearance was used in the U.S. savings and loan

debacle in the 1980s. The International Monetary Fund and the World

Bank continued to allow the indebtedness of many of the poor African

countries to increase by the amount of the interest that was due; if these

institutions had declared the loans in default, they would have had to

recognize the losses on the loans. The banks that were the lenders to the

Real Estate Investment Trusts (REITs), landlords of mortgaged shopping

centers and the owners of mothballed Boeing 747s allowed the interest

due on their bank loans to compound because they wanted to delay the

recognition of the losses on these loans to a more propitious moment

when their own capital would be larger. But the lenders need forbearance

from the bank examiners.

Official moratoriums may be less effective than informal ones, how-

ever. A moratorium on the settlement of differences in payments due on

the 1873 Vienna Stock Exchange lasted a week, from the stock market

collapse to May 15. A guarantee fund of 20 million guilden was put to-

gether by the Austrian National Bank and the solid commercial banks;

these imitations of earlier measures were of little assistance.34 Another

moratorium was noted in Paris after the July Monarchy when the mu-

nicipal council decreed that all bills payable in Paris between July 25

and August 15 should be extended by ten days. This moratorium ster-

ilized the commercial paper in banking portfolios and did nothing to

discourage a run by holders of notes, who demanded coin.35