Financial meltdown: So what else is new?

Posted: Thursday, January 08, 2009

To listen to the pundits, one would think that today's banking crisis and financial meltdown is something rare and exotic. But people who stayed awake in history class know that financial panic is a familiar "plot device" in the drama of modern capitalism. Speculation has been followed by collapse at least as far back as the South Sea bubble of 1720. The American experience with such wholesale crises began in 1819.

The Panic of 1819 followed a period of exuberance during which ordinary, nose-to-the-grindstone people found themselves tempted to risk too much. In the years leading up to 1819, a booming demand for cotton fueled a price spike. Men with money got rich buying and selling land and slaves as cotton prices rose dramatically. Men without money borrowed to invest, betting on the windfall from next year's crop.

While the tide rose, poor men grew rich and thousands of speculators rushed in to grab a share, pushing prices far higher than could be sustained. By the time the bubble burst, as bubbles do, speculators had cashed out, leaving the real producers to watch the value of their not-yet-harvested crops plummet by half. Banks failed and money disappeared, until perfectly sound businessmen could not collect receivables, buy raw materials or locate the cash to pay wages. An estimated four-fifths of Philadelphia's skilled artisans faced the winter of 1819-20 without work - in an age with no benefits, no welfare, no Medicaid.

Our ancestors first interpreted panics as punishment for licentiousness. But experience showed that virtuous men and women suffered the most distress. What kind of an economic system rewarded the crooks and ruined the folks who toiled that others may eat?

Panics always subsided, then they came back again. A cotton boom recurred in the 1830s, collapsing in 1837. Unemployment spiked once more, but now three times as many Americans lived in cities and relied on wages for food, shelter and fuel. Working-class savings banks failed - many small sums laid by against hard times had been squandered by the banks in real estate speculation. (Sound familiar?) Some cities, such as Lowell, Mass., discovered that a handful of large employers completely controlled their fortunes. They had grown "too big to fail."

The next three big panics - in 1857, 1873 and 1893 - fed off railroad development accompanied by currency and stock speculation. Every boom fed the dreams of small-town boosters, that one more mile of shiny rails would buy them a seat at the rich man's table. Each panic squeezed out the excess but also cut to the bone of subsistence for men and women who lived from payroll to payroll. In the speculators' game, the hammer always falls but rarely on those who deserve it.

In the 20th century, we erected safeguards against these devastating cycles. In 1913, our Federal Reserve system was established to rescue banks from such sudden crises of confidence. Still, the Crash of 1929 yielded a worldwide Great Depression. New Deal reforms - especially the Glass-Steagall Act of 1933, which created the Federal Deposit Insurance Corp. and barred commercial banks from Wall Street speculation - helped limit the effect of panics on ordinary people.

But capitalists always invent new ways to cheat on the rules, such as the now-infamous "credit default swaps." Beginning in the 1980s, the enemies of New Deal policies stripped away regulations and allowed speculators to take outrageous risks that former Fed Chairman Alan Greenspan claims he could not have imagined. Too bad he never looked in the rearview mirror!

Since the early 19th century, we Americans have enslaved ourselves to complex markets. There is a core economy producing basic goods and services, but onto that "real" economy we have grafted a game of chance. Producers make things of value while various agents assist legitimate transactions and profit from the value added by their services. Alas, these facilitators also can profit from random fluctuations in supply and demand, imperfect information or moments of distress. Such speculative gains can be innocuous - or they can drive the machine off a cliff.

In short, financiers play a dual role as servants of the system and interested profiteers. True gamblers will bet on anything. (What are the odds you will be dead tomorrow? Behold the birth of life insurance.) Just as surely, gamblers angle to game the system. (Who can I pay to make sure you're dead tomorrow? Enter regulation.) Not all bankers are crooks - but sometimes, some bankers are. This is why markets require regulations.

Panics expose how the game of chance can ruin the core economy. These days, we cannot retreat into semi-subsistence, grow our own food and sit tight under our own vine or fig tree - advice freely given in 1819. Still, there is no reason to submit to absurd abuses by self-serving gamblers who toy with the people's welfare.

The history of panics ought to remind us that independence was the first objective of America's founders. A market economy can be made to serve the common good, but when you license it to make a killing, you just might get killed.

• John Lauritz Larson teaches history at Purdue University.



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