Published by EH.Net (May 2019)

Gary B. Gorton and Ellis W. Tallman, Fighting Financial Crises: Learning from the Past. Chicago: University of Chicago Press, 2018. x + 234 pp. $45 (hardcover), ISBN: 978-0-226-47951-4.

Reviewed for EH.Net by Sriya Anbil, Division of Monetary Affairs, Federal Reserve Board of Governors — and Angela Vossmeyer, Department of Economics, Claremont McKenna College.
Financial crises are devastating events that have long plagued market economies. The existence of short-term debt means that financial crises are inherently here to stay. Thus, Gary Gorton (Yale School of Management) and Ellis Tallman (Federal Reserve Bank of Cleveland) did not write a book about how to prevent future financial crises, but instead, they wrote a book about the tools regulators can use to combat crises. More interestingly, Gary Gorton and Ellis Tallman tell us what we can learn from history about fighting future financial crises.

The authors review five panics from the National Banking Era (1863-1913), detail the timeline of events around the beginning and end of each panic, and review the New York Clearing House Association’s actions. These events and actions involve the suppression of bank-specific information, issuance of loan certificates, suspension of convertibility, and existence of a currency premium. From these experiences, the authors provide five guiding principles for fighting financial crises. The National Banking Era is of interest because there was no central bank or deposit insurance, allowing the authors to observe which policies were most effective at mitigating banking panics. Today, banks, firms and households expect the central bank or the government to intervene during a banking panic. This potential intervention makes modern crises very difficult to study because effective policy at fighting a panic is confounded with the public’s expectation that the central bank will intervene if a panic continues. As a result, the authors appropriately use examples from the National Banking Era where the public had no such expectations about central bank intervention.

The authors’ first guiding principle is to find the short-term debt. Doubt about the value of short-term debt is the root cause of financial crises. When short-term bank debt loses its “money-like” use and becomes sensitive to information about the value of the assets backing the debt, holders of short-term debt no longer use the debt as money. This transition from information-insensitive to information-sensitive is the point at which a panic begins. During the Panic of 1873, bank deposits were the key form of short-term debt, while during the Panics of 1837 or 1857, bank-issued currency experienced a run. Identifying the form of short-term debt at risk, the institutions that hold it, and what information influences the valuation of the assets that back the debt are all important for determining the appropriate response to combatting a financial crisis.

The second guiding principle is to manage the information environment. The authors suggest suppressing bank-specific information and the identities of banks that are receiving assistance from emergency facilities, so debt holders cannot make inferences about potentially weak banks. Instead, released information should focus on the general solvency and stability of the banking system as a whole. Later and when appropriate, information can be revealed that a specific bank has been examined by regulators and is considered sound.

The third guiding principle is to open emergency lending facilities that accept a broad set of counterparties. During the National Banking Era, the New York Clearing House Association was not legally obligated to lend to members or nonmembers during a panic, but it voluntarily provided emergency loans and supported the banking system when needed. The authors also suggest that these emergency lending facilities should accept a broader set of collateral to decrease the probability of fire sales and support liquidity in money markets.

The fourth principle, which is one we know well today, is to prevent systemically important institutions from failing during the crisis. The specific example provided by the authors is the decision of the New York Clearing House Association to issue loan certificates to Metropolitan National Bank, a large interconnected institution, during the Panic of 1884, which likely mitigated a nationwide financial panic.

Lastly, the fifth guiding principle suggests that laws and regulations need not apply or should be temporarily relaxed during a crisis. For instance, in the National Banking Era, demand deposit contracts were not enforced when a suspension of convertibility occurred. Even though this violated a legal contract, it was a necessary measure to calm the panic.

Chapters 1 through 10 nicely review much of the economic and historical literature on the National Banking Era and the role of clearing houses. Chapter 11 relates the key historical findings to post-1970 financial crises from Indonesia and Argentina to the U.S. Panic of 2007-8. The book then concludes by summarizing the principles for fighting crises and their relevance for today. The book is an excellent read and the authors do a phenomenal job demonstrating how history can inform modern policy. The book should be part of graduate curricula in finance and macroeconomics. While history is often an elective in many programs, the contents of this book should be taught in a core class that overviews central banking and financial systems.

The overarching theme of the book should not be ignored — researchers and policymakers need to do a better job documenting the events and responses surrounding financial crises. Oftentimes, decades of time separate crises, so when it comes to responding to a panic, important lessons and concepts are forgotten. We agree completely with this goal of the book and hope that the authors continue to document lessons from crises beyond the National Banking Era. We would be especially interested if the Dodd-Frank Act, stress testing, or Basel III regulations sufficiently use the five guiding principles. To conclude, a copy of this book should at least be on the shelves of all economists at all central banks.
Sriya Anbil is a senior economist in the Division of Monetary Affairs the Federal Reserve Board of Governors. She has published work in the Journal of Financial Economics on managing stigma and depositor reactions during financial crises.

Angela Vossmeyer is an assistant professor in the Robert Day School of Economics and Finance at Claremont McKenna College. She has published work on disclosure and bank participation at emergency lending facilities in the Journal of Money, Credit and Banking.

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