Bailout Nation (5 page)

The nation's third foray into central banking came about with the National Currency Act (1863), later amended to the National Banking Act (1864 and 1865). This legislation provided for the creation of nationally chartered banks. Requirements included stringent capital minimums, lending limits, and regular bank examinations by the Office of the Comptroller of the Currency. Near-modern banking regulation and supervision thus came into existence.

Although these national banking acts were a significant improvement over the previous regulatory regime, eventually they too proved inadequate. Currency growth was tied to the bond market, not the broader economy. For a rapidly growing young nation, this proved insufficient. An inelastic currency and nonexistent national reserve system led to wild swings in the economy, with oscillating periods of booms and busts. Depressions became a surprisingly common cyclical phenomenon.

These “early experiments in central banking,” as the Federal Reserve Bank of Boston called these pre-twentieth-century attempts, were almost quaint in comparison to modern times. The Boston Fed explained:

H
ow did we end up with such a powerful central bank if the country was originally so opposed to one? After those first three attempts failed, we need to fast-forward to the Panic of 1907. In its aftermath, we find the genesis of the modern Federal Reserve Bank.

As so often happens, a long stretch of cyclical growth led to a boom, bust, panic, and renewal. Rapid industrial growth was the key to the recovery from the depression of 1893. Soon, twentieth-century America was booming. From the mid-1890s to 1906, the nation's annual growth rate was 7.3 percent.
¹⁰

How did the country go from prosperity to panic? It would take a complete book to explain (I recommend Bruner and Carr's
The Panic of 1907
). In brief, the San Francisco earthquake revealed trouble beneath the surface of the nation's finances. The massive scope of the damage impacted financial activity around the world. Relief funds were sent to help resolve nearly $500 million in damages caused by the quake and the ensuing fires. London, Germany, France, New York City, and other financial centers saw significant capital migrate westward.

But it was primarily in London, the capital of the British Empire and the financial center of the world, where the monetary problem gestated. Insurance companies were shipping enormous amounts of gold to San Francisco as policies were paid out. As a result, the money supply in England was becoming inordinately tight. With capital scarce, bankers in the United Kingdom decided to do something about it. Printing presses and helicopters were not a ready solution in 1906; instead, the Bank of England raised rates from 3.5 to 6 percent to attract capital. Soon after, other European banks followed. Money flows to where it's treated best, and after the rate hikes, lots of money found its way back to England.

Consider this modern example of how the more things change, the more they stay the same. In October 2008, after its banking system was devastated by the credit crunch and investment losses, Iceland's central bank hiked its rates to 18 percent for the same reason the Bank of England did a century earlier: to attract capital.

To those who regularly advocate for the dismantling of the Federal Reserve, perhaps the previous tale may prove instructive. Unless all nations agree to do so simultaneously, the dissolving of a central bank amounts to the economic equivalent of unilateral disarmament.

In the United States in 1907, there was no such comparable mechanism to compete with the Bank of England. While the promise of great riches attracts capital during a boom, liquidity flees once the boom turns to bust. The legacy of economic uncertainty tracing back to the 1893 depression, combined with America's acute need to attract capital, set the stage for what came next.

In 1908, Congress was desperately searching for an answer to the ongoing financial crises. Its response was to create the National Monetary Commission, a panel studying potential solutions to the nation's monetary problems. It took five years of political maneuvering, public debate, and legislative proposals to decide whether the United States should have a central bank, and what that bank should look like. It would take yet another book to explain precisely how the Federal Reserve was created in 1913 (and G. Edward Griffin's
The Creature from Jekyll Island
¹¹
is the Fed hater's standard tome).

For the purpose of understanding how the United States became a Bailout Nation, we need only note that the Federal Reserve System was indeed created, granted extraordinary powers, and set loose upon the world. As we will see, the results of this act will have unforeseen consequences that were not remotely imagined back in 1913.

Capitalism
is not really the best word to describe this arrangement. (The term was coined in the late 19th century as a way to describe the ideological opposite of communism.) Some decades later, people began to use a better term,
“the American system,”
in which the government involved itself in the economy primarily to develop what we would now call infrastructure—highways, canals, railroads—but otherwise let economic liberty prevail. I prefer to call this spectacularly successful arrangement
“financial democracy”
—a largely free system in which the U.S. government's role is to help citizens achieve their best potential, using all the economic weapons that our financial arsenal can provide.

—Robert J. Shiller
¹

 

 

T
he United States as a Bailout Nation is a relatively new phenomenon. In the early and middle parts of our history, the country did not engage in rescue operations of corporations; speculators who got into trouble were on their own.

Government assistance was more likely to be made available during the birth pangs of a new industry—not during a single company's death rattle.

Venture capital firms were nonexistent in the nineteenth century. The early days of the republic did not have the equivalent of a Sand Hill Road. Sometimes Congress was called upon to fund start-ups and new technologies. Classic examples can be found in the expansion of the nation's railroads westward and in the development of the telegraph industry. Both of these industries found a coaxable benefactor in Washington, D.C., and received a helpful push from taxpayer subsidies. Commercialization of the first telegraph line was jump-started by congressional funding; railroads received land grants and other forms of enabling assistance to help them expand westward.

The government's preference was to fund industries that would facilitate the nation's physical expansion, stimulate infrastructure development, and aid economic growth. Once these industrial sectors were up and running, however, they were left to succeed or fail on their own.
How charming! How quaint! What a novel idea!

Inventors and entrepreneurs were a key part of this process. The telegraph industry began when Samuel F. B. Morse, the inventor of the Morse Code, managed to wrangle $30,000 of taxpayer money out of Congress in 1844. He was credited with establishing the first telegraph line between Washington, D.C., and Baltimore.
²

So too began the railroad industry. Government grants in 1850 provided lands to Illinois, Mississippi, and Alabama in aid of the Illinois Central Railroad, along with the Mobile and Ohio Railroads. Illinois Central obtained these subsidies through the efforts of a young country lawyer by the name of Abraham Lincoln. The Illinois Central Railroad later repaid the favor by helping Lincoln get elected president in 1860. Perhaps it wasn't such a favor after all; once in office, Lincoln signed land grants to railroads totaling more than 150 million acres of public land. Of the five transcontinental railroads of the day, four of them owed their existence to these enabling subsidies.

The life cycle of all new industries is the same: New technologies experience a period of rapid growth. The opportunities attract competitors. The new industry expands rapidly and soon makes lots of money. This attracts further competition: more companies, people seeking jobs in these growth areas, and even more capital and greater investment. Fresh competition helps the industry develop and mature. Eventually, the boom reaches the point where overinvestment and excess capacity become endemic, leading to brutal price competition and shrinking margins. Strong firms survive while most of the weaker companies fail. Those with poor management, insufficient capital, or inferior technology soon find themselves on the wrong side of Darwin's law. This is a cycle that repeats over and over in the system of free market capitalism.

Beyond the telegraph and railroads, this boom-and-bust cycle has been repeated across all industries. The same pattern has played out in all new technologies: radio, steel, automobiles, television, aviation, electronics, computers, and, more recently, Internet companies. The boom-and-bust cycle in subprime mortgage originators, mortgage brokers, and even real estate agents is no different than prior cycles. And we can expect the same cycle to occur during the next few decades in solar power companies, gene therapy research, electric car manufacturers (again), nanotechnology, stem cell medicine, and all manner of alternative energy production.

Believe it or not, there was a time when this great nation of ours actually believed in allowing consumers in the marketplace to choose the winners and losers of an industry. History has repeatedly shown us that this is a more efficient allocator of capital than representative governments or dictatorial central planners. Alas, it is a lesson easily forgotten.

T
here is a temptation to compare the present-day Bailout Nation—an era of big government bailouts and bigger corporate rescues—to the Great Depression and the New Deal. But there are many obvious differences between the two periods: In the 1930s, the United States was an industrial powerhouse. Steel, manufacturing, railroads, and coal were the dominant industries. Stocks were not that widely owned, so the market crash was initially seen as affecting only the wealthy. The modern era is diametrically different.

There are some similarities between the government's response to the current crisis and Franklin Delano Roosevelt's New Deal, particularly the seemingly endless array of new programs with acronyms like TARP and TAFFY. But massive government response to a crisis is the effect. What is truly different between the two eras is the cause of the crisis, who got bailed out, and why.

The 1929 stock market crash eventually led to a worldwide depression. It was particularly acute in the United States, where unemployment rose to 25 percent, and nearly one in five homeowners faced foreclosure. Through no fault of their own, the vast majority of Americans were in economic distress. The recipients of government aid had not gotten into these difficult situations by virtue of their own recklessness, speculation, or outright stupidity. Rather, they were the victims of a broad economic collapse, and not its architects. The
Great Gatsby
era certainly had its fair share of excesses; however, the average citizen was not, as Citigroup's Former CEO Chuck Prince once stated, “compelled to dance so long as the music played.”