Download “Silver risk”, currency speculation and bank failures in

“Silver risk”, currency speculation and bank
failures in 19th century America: a third generation
currency crisis?
by Paul Sharp
Source: “Labor Advocate”, 12 September, 1896 [http://projects.vassar.edu/1896/0912la.jpg]
Project for “International Monetary Economics”
Professor: John Kennes
Institute of Economics, University of Copenhagen
March 2004
Contents
I. INTRODUCTION
3
II. THE BANKING CRISIS OF 1893
4
III. THEORIES OF CURRENCY CRISES
5
IV. A FORMAL MODEL
6
V. AN ALTERNATIVE VIEW
9
VI. CONCLUSION
10
REFERENCES
12
Abstract:
In this paper I provide a brief historical overview of the coincidence of banking and currency
crises in the United States in 1893, and relate this to two theories linking the “twin” crises. I
conclude that there is reason to believe there was a link and thus evidence of a third
generation crisis. An additional conclusion is that the gold standard probably exacerbated the
economic hardship endured.
I. Introduction
The last quarter of the 19th century was one of the most exciting in American economic
history, seeing as it did a dramatic conflict between supporters of two rival economic policies.
After the Civil War, the American government decided to adhere to the gold standard, which
meant a fixed exchange rate in relation to, for example, the British pound. Returning to the
pre-war parity meant deflation in the United States, which was exacerbated by a worldwide
shortage of gold. By 1896, the price level was about 40 per cent below its 1869 level.
Unsurprisingly, a coalition of debtors (who saw the value of their debts increase in real
terms), agricultural producers (who saw the price of their goods fall even faster than the
general price level, and who were often also debtors) and silver producers campaigned for a
return to the gold/silver bimetallic standard, which the US had adhered to prior to the Civil
War. The logic was that, by allowing the minting of silver as well as gold, the money supply
would expand, pushing prices up and ending deflation. The opponents of this idea were
mainly eastern financiers who saw “sound money” and the gold standard as the surest way of
integrating America into the world economy. 1
The supporters of “free silver” did not ultimately succeed. However, as I argued in my
bachelor dissertation (Sharp (2003)) (and also suggested by Friedman and Schwartz (1963)),
expectations of inflation, caused by an anticipation that the “free silver” campaign might be
successful in causing devaluation and an exit from the gold standard, precipitated a currency
crisis which meant that the US Treasury2 was forced to pursue a policy of monetary
tightening, which thus led to a worsening of deflation.
In this paper, largely due to time and space limitations, I focus on one particular year:
1893. This saw the peak of speculation that the US might be forced off the gold standard. The
Sherman Silver Purchase Act of 1890 (which allowed for increased purchases of silver by the
1
A fuller account is given in Sharp (2003).
2
In this period the US Treasury is the nearest thing the country had to a central bank.
Treasury), and a free silver coinage bill in 1892 (which, although it never became law, helped
fuel speculation that the US might be prepared to abandon the gold standard) exacerbated
these fears. 1893 also saw the coincidence of a stock market crash, banking failures and of
course an increase in currency speculation.
We are interested in examining whether this year provides evidence of a link between
banking crises and currency crises. If the answer is yes, then this is a conclusion that lends
historical support to recent models of currency crises, which stress the importance of the
“twin” crises. However, due to time limits, this paper can only hope to be a brief analysis and
exploration of a possibility. It should be seen as a basis for future research and a summary of
some relevant literature, and not a definitive conclusion.
II. The banking crisis of 1893
Since I have already detailed the gold outflow and shrinking Treasury gold reserves
associated with the currency crisis in Sharp (2003) I will not use space describing them here. I
will instead give a brief account of the banking crisis of 1893 and afterwards I will provide
two possible explanations of the relationship between the two.
A short explanation of the banking system is needed first. Large cities, for example
New York, constituted reserve centres. Here, so-called reserve banks played an important
role, holding up to three-fifths of the reserves of smaller, local institutions. 3 The US Treasury
had a de facto role as the central bank.
The immediate background to the crisis was the stock market crash of May 5, 1893,
which severely affected the liquidity of the commercial banks. Seeing this, depositors in the
interior began to distrust their banks and started to convert balances to cash. The banks
responded by reducing loans and at the same time turned to the New York reserve banks for
funds to satisfy their depositors. The weakness of the banking system was thus exposed – the
New York reserve centres were subject to this demand for funds when their own needs were
greatest.
Despite introducing tight credit, banks started to fail: fifteen of the larger “national”
banks failed in June, twelve in July, and seventeen in August. By the end of the year sixtynine national banks had failed. Including smaller “country” banks the total reached 642.
3
Steeples (1998), p. 34
4
Steeples (1998), p. 34
4
What started in New York soon spread around the country. Credit became so short that,
at its worst, farmers in California were unable to secure the customary advances that would
have allowed them to harvest and ship their crops and Southern cotton growers were
reportedly unable to find buyers. 5
By the first week in August, New York banks announced that they would suspend cash
payments and in November the Senate approved a law repealing the Sherman Silver Act.
Pressure on the gold reserves and the banks subsided for a while, but the country had entered
a deep depression. By the end of the year there had been 15,242 business failures with total
liabilities of $357 million – an enormous sum for the time. Tight credit had meant that firms,
which might otherwise have survived, were forced into bankruptcy.6
Considering the scale of the financial crisis, which hit the United States in 1893, it is
important to ask what the link between the currency crisis and the banking crisis was. If there
was a link, then the contraction in credit caused by the banking crisis, which helped
precipitate terrible economic hardship, might be blamed on the gold standard, and this
provides evidence that the 19th century gold standard might not be the stabilizing force it is
often considered to be.
We start by looking, rather informally, at a formal model linking banking crises to
currency crises. However, before we do so, it is worthwhile considering briefly the history of
theories of currency crises, in order to understand the origin and relevance of this exploration
of the “twin” crises theory.
III. Theories of currency crises
Gandolfo (2002) provides a general introduction to the theoretical models developed to try
and explain currency crises. He classifies them into three groups: first, second and third
generation.
First generation currency crisis models are perhaps the best known and can be found in
any standard international macroeconomics textbook7. The central bank is pursuing policies,
which are incompatible with the maintenance of a currency peg (usually financing the
government budget deficit). International reserves are gradually depleted until they reach a
5
Steeples, p. 36
6
Steeples, p. 37
7
See, for example, Krugman and Obstfeld (2003), pp. 527-530
certain level, when they are exhausted in a final speculative attack, forcing the central bank to
abandon the fixed exchange rate.
Second generation models8 incorporate much of the same elements as first generation
models, only they no longer require the devaluation to be inevitable. The collapse of the
currency peg is conditional on speculators’ expectations – if each speculator expects the other
to sell, then the peg will collapse, otherwise it will survive. There can therefore be two
equilibria – one where the fixed exchange rate survives and one where it fails. There is a
“self -fulfilling” element. These expectations are influenced by goals (other than the cur rency
peg), which might also be important for the central bank (such as employment), but which is
in conflict with the goal of pegging the currency. A high rate of unemployment might cause
the central bank to relax monetary policy, although a tightening might be needed to protect
the exchange rate. Because speculators understand this conflict of aims, they might be
tempted to believe in devaluation even though the economic fundamentals do not make this
inevitable. 9
The Asian crisis of the late 1990s could not be satisfactorily explained within the two
previous structures. The Asian economies enjoyed budget surpluses (or limited deficits), thus
ruling out a first generation explanation, and output growth, employment and inflation were
not at levels, which could suggest a second generation explanation. The new element in these
models is the importance of the “twin” crises: currency and banking. However, whether the
causation runs from currency to banking crises or vice-versa, or indeed whether both crises
simply have common roots is not certain.
IV. A formal model
The third generation model we choose to look at here is one developed by Chang and Velasco
(1998) to describe financial crises in emerging markets. The key point they make, which we
also wish to consider in an historical perspective, is that a currency crisis might occur,
because “if and when a bank crisis comes, stabilizing the banks and keeping the exchange rate
peg become mutually incompatible objectives” 10. This idea has some similarities to a second
8
As for example described in Obstfeld (1996)
9
A second generation explanation of the American currency crisis in the 1890s was suggested in Sharp
(2003).
10
Chang and Velasco, p. 4
generation currency crisis, where a central bank is also torn between two conflicting aims, for
example full employment and a currency peg.
It is of course a reasonable question as to why a third generation model is chosen here,
as opposed to a first or second generation model. As discussed in Sharp (2003), a first
generation model is simply not appropriate because of the “inevitability” element: the gold
standard did survive in the US after the 1893 speculation (with a few short intervals) until the
1970s. A second generation model is more appropriate, because it allows for a “grey” area,
where the currency peg is not necessarily doomed, but can be overthrown if expectations
coalesce around this equilibrium. However, although macroeconomic fundamentals are
considered important when using a second generation model, it is unclear whether a
nineteenth century government would have had the information or the inclination to weight
them particularly highly. Indeed, maintaining the gold standard was never seriously
questioned by the governments of the time. The point is that if the government had abandoned
the gold standard, then it would have had to have been forced - and it is here that the “twin”
crises explanation, where banking crises also play a key role, is important.
Sadly, there is not enough space to describe Chang and Velasco’s model in detail, but
an attempt is made here to provide some of the intuition from the model.
The model is based on the assumption of a small, open economy, which, as explained in
Sharp (2003) is appropriate for the US in this period. There are a large number of ex ante
identical agents and there are three periods: t = 0, 1, 2. There is one good, which can be
consumed and invested. We normalize the price of consumption to be one unit of foreign
currency (1 pound sterling11). Domestic residents are born with an endowment of the good.
Each domestic agent can choose to invest in a constant return long-term technology,
which, when invested at time t = 0, gives a yield of r < 1 pounds in period 1, and R > 1
pounds in period 2. In this way we model an illiquid technology. It is very productive if
invested in for two periods, but it gives a loss (of (1 − r ) > 0 per pound invested) if it is
liquidated early.
There is also a world capital market where one pound invested at t = 0 yields one pound
in either period 1 or period 2. Domestic agents can invest as much as they want in this market,
but they may only loan up to a certain credit ceiling.12
11
Chang and Velasco denote the foreign currency as one dollar, but the pound sterling is of course a more
appropriate choice here.
12
This can be given institutional or uncertainty justifications.
At time t = 1 each domestic agent discovers her “type”. With probability λ she is
“impatient” and only receives utility from period 1 consumption. With probability (1 − λ ) she
is “patient” and derives utility only from per iod 2 consumption. Type realizations are i.i.d.
across agents, and there is no aggregate uncertainty. Each agent’s type is private information.
Domestic residents therefore face uncertainty about the timing of consumption. Those
that are impatient would prefer to invest in the world market and those that are patient would
prefer to invest in the domestic technology.
We now need to introduce a commercial bank. There is a good reason for doing this in
the economy described above. If each agent acted in isolation, they would bear individual risk
(in particular from early liquidation of the technology asset). Because there is no uncertainty
in the aggregate, however, it makes sense for agents to act collectively, for example through a
“commercial bank”. This ban k has no other objective than to pool the resources of the
economy in order to maximize the welfare of its representative member. In so doing, the bank
assigns a consumption stream to each agent, dependent on her type. However, because type is
private information, the bank must find a way of eliciting this information.
The mechanism modelled by Chang and Velasco is that of “demand deposits”. These
are contracts, which state that each agent must surrender her endowment and her capacity to
borrow abroad to the bank in period 0. The bank then invests in the long term technology and
borrows abroad in periods 0 and 1. In return, the agent is promised the option to withdraw
either ~
y in period 2, where ~
y≥~
x.
x units of consumption in period 1 or ~
In addition, there is a sequential service constraint, which requires that the bank must
attend to the requests of the depositors on a first come first served basis.
The timing of events is thus as follows. In period 1 depositors arrive at the bank in
random order. Upon arrival, each agent may withdraw ~
x if the bank is still open. The
commercial bank services withdrawal requests sequentially, first by borrowing abroad, then
by liquidating the long term investment. If withdrawal requests exceed the maximum
liquidation value of the bank, the bank closes and disappears. Finally, if the bank did not close
in period 1, in period 2 the bank liquidates all of its remaining investments, repays its external
debt, and pays ~
y dollars plus any profits to agents that did not retire their deposits in period
1.
It can be shown that such a banking system can be subject to a run. In particular,
domestic agents will decide to attempt to withdraw their deposits in period 1 if they expect all
others to do the same. This behaviour is individually optimal, since it may force the bank to
run out of resources and fail and they would therefore not receive anything in period 2.
Whether the bank does fail or not depends crucially on the banks liquidity: the bank will fail if
the potential short term obligations of the bank exceed its liquidation value.
We now consider how we can move from banking crises to currency crises. Chang and
Velasco consider two scenarios. One where the central bank (or the US Treasury, in our case)
decides to step in when there is a bank crisis and act as a lender of last resort, and one where
they decide not to. If they choose the second option, then bank crises can occur under the
conditions stipulated above. Under a fixed exchange rate, however, they cannot act as lender
of last resort without precipitating a balance of payments crisis. This is because, although the
Treasury could (and did) issue new dollar bills it could not produce additional gold reserves
with which to back the demand deposits13. Eventually the domestic and foreign demand on
their gold reserves forced them to make a choice, and they chose to leave the commercial
banks to their fate.
In conclusion, therefore, Chang and Velasco show that, as they put it, “the combination
of an illiquid financial system and fixed exchange rates can be lethal” 14 If the central bank
commits not to serve as a lender of last resort, then bank runs can occur. However, if it acts as
lender of last resort in domestic currency, bank runs are eliminated at the cost of causing
currency runs. So the situation we have described in 19th century America, with fixed
exchange rates and insufficient reserves (that is, illiquidity), made crisis unavoidable when
investor sentiment turned negative; the only choice authorities faced was what kind of crisis
to have. In 1893 they chose to cling to the gold standard and suffer a bank crisis.
V. An alternative view
Miller (1996) provides an alternative view, which predates the third generation currency crisis
literature. She looks at this period from another direction: she asks why, despite the pressure
there was on the dollar, the US was nevertheless not forced to devalue. Intriguingly, she
believes that the answer lies with the commercial banks.
The argument goes like this: At the height of the currency crisis, in 1893, there were a
large number of bank failures. It could have been that this was endogenous to the silver issue.
Fears of devaluation could have led to an “internal drain”, whereby depositors converted their
13
In Chang and Velasco the situation described is one where a central bank can choose to issue more
domestic currency, but cannot produce the extra foreign currency needed to back it up.
14
Chang and Velasco, p. 41
currency to gold leading to a drain in commercial banks’ reserves and bank failures, as the
banks required currency to purchase gold from the Treasury. In this way the “internal drain”
was endogenous to the “external drain”, whereby gold left the country. This scenario is
reminiscent of the model we looked at in section IV. Alternatively, it could be argued that the
internal drain was unrelated to the external drain, and was in fact entirely due to insolvency
fears15. However, whether the bank failures were endogenous or exogenous to the silver issue
is irrelevant for Miller’s argument.
Due to the internal drain, banks tried to hold on to their reserves by a contraction of
credit. Tight money conditions led to an increase in interest rates: in June 1893 to an average
of 8.3 per cent in contrast to just 3.6 per cent a month earlier16. In addition, from August 3 to
September 2, banks restricted cash payments, which meant that the sale of gold and currency
was at a premium to deposits. Since this premium was not expected to last very long, it gave
rise to a dramatic inflow of gold: during these four weeks alone, $40 million of gold flowed
into the US.
In November 1893 the Sherman Silver Act was repealed, and although speculation
continued, it was never again to reach the levels of 1893. According to Miller, the actions of
the commercial banks had helped save the gold standard at the time when it was most under
threat and she supports this conclusion using sophisticated econometric analysis, which is
sadly beyond the scope of this paper. However, as stated in section II, if the restriction of
credit saved the gold standard then the cost was very high indeed.
VI. Conclusion
We have considered two possible explanations linking the banking crisis of 1893 to the
currency crisis of the same year. Due to space limitations, this paper only gives a brief
overview of these theories, but nevertheless, it appears that there is plenty of (theoretical)
evidence to suggest that there was some sort of link.
There are two lessons to be drawn from this. First, we have shown that there might be
older historical evidence supporting third generation currency crisis models than that
available from Asia in the late 1990s. Second, if we conclude that the banking crisis, and
15
However, Friedman and Schwartz (p. 109) make it clear that insolvency fears may themselves have
been caused by the general uncertainty due to deflation and devaluation fears, of which gold outflows were one
symptom.
16
Miller, p. 652
associated economic hardship, was a product of attempts to defend the gold standard, then we
have some grounds for suggesting that the gold standard – so often considered to be the
foundation of economic progress and stability in the 19th century – might in fact (at least in
this case) have been quite the opposite.17
17
In fact, if we believe that the deflation of these years (which was undoubtedly a product of the gold
standard) had real (negative) economic effects, then this conclusion has double the weight. See Sharp (2003).
References
Chang, R. and Velasco, A., “Financial crises in emerging markets: a canonical model”, NBER
Working Paper 6606, June 1998
Freidman, M. and Schwartz, A., “A monetary history of the United States 1867 -1960”,
NBER, 1963
Gandolfo, G., “International finance and open economy macroeconomics”, Springer, 2003
Krugman, P. and Obstfeld, M., “International Economics”, Addison Wesley, 2003
Miller, V., “Exchange rate crises with domestic bank runs: evidence from the 1890s”, Journal
of International Money and Finance, 15, 1996
Obstfeld, M., “Models of currency crises with self -fulfilling features”, European Economic
Review, 40, 1996
Sharp, P., “How ca n expectations of inflation explain the American deflation of 1880-96?”,
Bachelor dissertation, 2003 (http://keynes.dk/images/USDeflation.pdf)
Steeples, D.O., “Democracy in desperation: The depression of 1893”, Greenwood, 1998