2.98 Cheers for Bob Murphy

Kudos to Bob Murphy for his incisive exposé and demolition of Krugman’s statistical legerdemain in today’s Mises Daily.  It is not only an enlightening piece but also a delightful read.

I have one small but obtrusive nit to pick with Bob, however.  Bob links to a blog post by Steve Horwitz, which he praises as “a good job explaining why Krugman’s understanding of US banking history is flawed, because we didn’t have laissez-faire banking in the late 1800s.”  Clicking on the link I found that Horwitz started out promisingly enough, arguing, contra Krugman, that late 19th-century America “was emphatically not a land of minimal government in banking” and that “the federal and state governments played a huge role in the banking industry and it was those regulations that  were responsible for the pre-Fed panics.”  I was excited to read more, but then my heart sank when Horwitz listed the two “most relevant regulations” in generating these panics as:

 1) the prohibition on interstate banking, which created overly small and undiversified banks that were highly prone to failure; and 2) the requirement that federally chartered banks back their currency with purchases of US government bonds, which made it prohibitively expensive to issue more currency when the demand rose, leading to the currency shortages and resulting panics that culminated in the Panic of 1907.

Huh?  These regulations were of almost no significance in causing the cyclical booms that culminated in the Panics of 1873, 1884 1893, and 1907.  Horwitz never mentions the underlying cause of these cyclical fluctuations: the establishment of a quasi-central banking cartel among seven privileged New York banks resulting in the almost complete centralization of U.S. gold reserves in their vaults by the National Bank acts of 1863-1864.  This New York City banking cartel was able to expand willy nilly the monetary base and the overall money supply by expanding their own  notes and deposits on top of gold reserves.   Their notes and deposits were then used as reserves by lower tier banks (Reserve City Banks and Country Banks) on which  to  pyramid their own notes and deposits. This is well understood even by mainstream monetary historians.  For example,  John J. Klein (Money and the Economy, 2nd ed., 1970, pp. 145-46) pointed out:

The financial panics of 1873, 1884, 1893, and 1907 were in large part an outgrowth of . . . reserve pyramiding and excessive deposit creation by reserve city and central city [New York City] banks.  These panics were triggered by the currency drains that took place in periods of relative prosperity when banks were loaned up.

Moreover, banks, especially the larger ones, were encouraged in their inflationary credit creation by the firmly entrenched expectation that they would be freed from fulfilling their contractual obligations in times of difficulty by the legal suspensions of cash payments to their depositors and note-holders that recurred during panics throughout the 19th century.  In addition, under the National Banking system,  the New York banking cartel had formed the New York Clearing House which was empowered to issue euphemistically designated “clearing house certificates.”  These were in essence extra bank reserves that were created out of thin air to bail out errant banks during panics.  Ludwig von Mises identified these cartel certificates as an inspiration for the formation of the later Federal Reserve System as a lender of last resort to over-expanded banks, a function that introduced moral hazard into the banking system.  Commenting on the intentions of the advocates of a central bank for the U.S., Mises wrote (p. 126)  in 1928:

Among the reasons leading to the significant revision of the American banking system [i.e., the Federal Reserve Act of 1913], the most important was the belief that provisions must be made for times of crisis.  In other words, just as the  emergency institution of Clearing House Certificates was able to save expanding banks so should technical expedients be used to prevent the breakdown of the banks and bankers whose conduct had led to the crisis.  It was usually considered especially important to shield the banks which expanded circulation credit from the consequences of their conduct.

Horwitz seems to imply that the panics were  isolated events that were somehow caused by sudden monetary stringency when in fact the very opposite was true.  As Rothbard shows in his masterful discussion of the National Banking era in A History of Money and Banking in the United States (pp. 132-79), every panic was preceded by an expansion of the money supply. And during the panic of 1873, there was no contraction of the money supply, while there was a very mild one in 1884.   As a free banker, I would have expected Horwitz to  counter Krugman’s nonsense by pointing to the inflationary, quasi-central  banking cartel that existed during the Gilded Age, rather than carping about minor regulations that may have curbed the ability of banks to inflate their way out of difficulties caused by previous inflation.  And why no mention of the banking cartel’s “clearing house certificates” as fostering systemic moral hazard and undue credit expansion among banks?  Doesn’t Horwitz ascribe to the oft-repeated free banker doctrine, “Every bank on its own bottom.” Finally, how does Horwitz square his idiosyncratic financial-regulation theory of panics and recessions with the Austrian Theory of the Business Cycle?  He sounds like a supply-sider to me.

Getting back to  to Bob,  I would suggest that for a complete refutation of Krugman’s disingenuous claim that laissez faire banking reigned supreme during the 19th-century, he should  direct readers to Rothbard’s discussion mentioned above.



  1. While it could certainly be that he was talking about industrial cycles, “panics” could also be referring to large-scale bank runs, which can be caused by “currency shortages” (i.e. people fear for their deposits). Banks issuing their own currency, or alternatively intra- (made difficult due to anti-branching legislation) and -interbank lending, can mitigate a panic.

    • “Banks issuing their own currency, or alternatively intra- (made difficult due to anti-branching legislation) and -interbank lending”

      I don’t understand this. Banks do not issue money, but claims on money. Now, imagine this: banks do not have the money to cover their previous issued claims on money, but they issue even more claims on money to cover those claims on money … I don’t know, it’s just weird. The intra-inter etc … in the end that’s why you have a central bank, as a lender of last (first) resort and this theory lends credibility to the logic that professor Horwitz theory of free-banking will lead to central banking.

      I’ve just finished professor Horwitz book and I didn’t find much of value in it. It is a shame, I had high hopes.

      • We have a lender of last resort, because of the mechanisms by which banks themselves can protect themselves against panics were regulated (i.e. branching laws and currency issue). Evidence suggests that when people make runs on banks at first the demand is not for outside money, but for deposited inside money. It becomes a run on outside money when they find that banks don’t even have their deposits of inside money on hand (i.e. what the literature calls a panic v. what is originally an “information-run”).

    • I agree here. Horowitz’s explanation is poor and Catalan’s response doesn’t save it.

      First on branch banking. Of course nobody believes branch banking should be banned, but its awfully peculiar that a “free bank” can’t just stand on its own. It needs multiple branches to remain solvent. What other businesses operate this way? And yeah, if my New Jersey bank is having liquidity issues, I can save it by taking reserves from my Pennsylvania branch, but this just increases the likelihood of liquidity issues at my PA branch. Branch banking is just a patchwork attempt to salvage a faulty system.

      Second, of course there could only be a “currency shortage” if one buys in to some version of sticky wages and prices. Many of us find the monetary equilibrium theory to be untenable (and I thought you did too Johnathan!?). But if we make that heroic assumption that there is a currency shortage, how does this cause a bank run? If people wish to increase their cash holdings, but can’t because there is a “shortage”, how does it make sense to go to the bank and exchange one type money for another (notes for gold coins)? This won’t increase the total money supply in the hands of the depositor. It hardly seems rational to do so and free bankers are pretty explicit in proclaiming that the public will have no desire to hold gold. So this notion that a currency shortage is responsible for the bank panic is also untenable. The only way to salvage the free banking theory here is to just accept Joe’s explanation. Public policy engendered excessive credit expansion which ended in bank panics. But of course its hard for a free banker to admit there was excess credit expansion because this puts their own theory on shaky ground.

      • And once a run does occur because people fear the bank can’t make good on its contractual obligations, how does issuing more paper money and more claims to the same gold solve this problem?

      • Well, fiduciary overissue aside, you don’t think individual branch managers can make entrepreneurial mistakes? There are plenty of reasons why one individual branch might find itself with a liquidity shortage. Also, bad entrepreneurial actions of another bank in the area can lead to an information-run on “sounder” banks, pressuring them as well.

        And, wrt to currency shortages, we’re talking about two different things. I’m not talking about monetary disequilibrium; I’m talking about a shortage of available deposited inside money that the bank has to meet withdrawals (which, at first, are for inside money). And, again, I should stress the difference between runs on banks and panics that can result from these runs.

      • Fwiw, while we might disagree with the specific argument, Austrian free bankers (Horwitz included,as far as I know), do believe that fiduciary overissue leads to business cycles. Which is why I did find Horwitz’ comments strange, but I thought that it might be that he was distinguishing between industrial cycles in general and the panic that might result from an information-run.

  2. Xanas,

    I have just finished this book for the second time. It is an astounding summary of the historical players and actions of our banking industry, in concert with an expanding federal government.

    The parallels with current events are obvious and beyond disturbing. Also, shills like Krugman were a major force in the eventual demise of our monetary system.

    Not only does he go into the specific acts, their sequence, and various interests of those who promoted and opposed the changes, but the political connections of the major players and stakeholders.

    I am often a critic of Rothbard’s political philosophy, but his work on the history of money and banking is phenominal.

  3. I definitely need to complete reading “A History of Money and Banking In the United States” which I have looked at but not thoroughly.

    Does Rothbard go into more detail about the specific laws that helped this cartel function? With words like “empowered” I assume that some state-level laws were in play.

    Also, I’d like to know if there is more information on the specific incidents where cash payments were suspended.

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