Financial Crisis Past financial crises provide us with a framework for understanding the best responses to future crises. There are three types of responses, and the best response will contain some form of all three. These are monetary policy, fiscal policy and regulatory policy. The latter is more a long-term response, essentially learning from the crisis and adjusting the legal/regulatory environment to reduce the odds of a similar future crisis emerging. More important from an economic point-of-view are the monetary and fiscal policy responses, and these will be the focus of this paper. In a forward-looking examination, it will be challenging to get much useful from 1907, because the environment then was different in every meaningful way from how it is today, but the responses can still provide some insight into financial crisis response. While all of the crises are different, they all have similar conditions -- there is panic in financial markets, which creates a basic need for stabilization, and there is recession, which creates the need for mechanisms to improve the health of the economy in the short and medium terms.

The 1907 financial crisis was spurred by a crisis of faith in the U.S. banking system. The stock of United Copper was manipulated, and then its price began to fall rapidly. This led to a bank run on banks that were heavily involved with that stock, which ultimately put the financial markets at risk. The banking system at the time was underpinned by the gold standard, meaning that gold was the source of value for currency. The 1907 crisis would eventually lead to monetary reform, something that would bring about the Federal Reserve, and eventually the fiat currency, where the value of the U.S. dollar was based on the taxation power of the federal government, rather than on its stockpile of gold (Chen, 2010).

The most important response to the 1907 crisis was thus political. After the financial system was stabilized in the wake of the bank runs, the political response would ultimately take a tremendous amount of work and many years to achieve, with the efforts aimed at reducing the likelihood of future crises of a similar nature (Chen, 2010). The idea of a central bank was used to provide stability in the future, especially as there appeared to be a certain amount of resistance to the idea of fiscal policy as a lever by which the financial crisis could be addressed. Vested interests have long made reform of any kind difficult -- either legislative reform or even short-term fiscal policy. In 1907, it was JP Morgan who organized the response to stabilize the system. The creation of a central bank was made in part to increase the role of the central government in creating a stable economy.

In the Great Depression, again once the initial stabilization had been undertaken, the stock markets were relatively healthy in the 1930s, but the economy as a whole was not. The heavy use of fiscal policy to spur economic growth was, at the time, a fairly novel intervention, but transformed our understanding of crisis response. By the time much of the fiscal policy was being implemented, however, the initial financial crisis was years old, so the response was specifically to the long-run economic crisis, which was beginning to take a strong social toll as well.

The response to the Depression gave rise to different schools of economic thought. First, Keynes argued that both monetary and fiscal policy could be used to influence an economy. Government spending, it was argued, as a part of the GDP, and therefore could be used to offset some of the negative effects of recession. Monetary policy, however, has still played a critical role, but the two are usually taken together in response to financial crises today.

The Japanese experience provided another test of economic doctrine, another learning opportunity if you will. Remember that one of the long-run policy responses to the 1907 crisis was the founding of the Federal Reserve and the eventual move away from the gold standard, after the Depression. Such moves were intended to give government greater capacity to manage the economy in times of crisis. This has typically been done with monetary policy as a first response, a mechanism by which the amount of money in the economy is increased and the cost of money lowered as a means to spur economic activity. Monetary policy can be changed quickly, because central banks need not confer with legislators. Thus, they can work faster and furthermore they do not have to explain themselves to people whose understanding of economics is usually not very good. So central banks move quickly to try to stabilize an economy, by cutting interest rates and using other methods of monetary policy.

The problem...

Essentially, even though the money supply was increased and rates dropped basically to zero, there was no credible reason for people to invest in an economy that was not growing. At that point, monetary policy response is limited -- a condition known as the liquidity trap (Bernanke, 1999). Worse, such conditions when prolonged created expectations for long-run low rates, again reducing the incentive to invest in the short-run, unless there were returns available, which there were not (Svensson, 2005). As such, the response was insufficient. Yet, fiscal policy response was challenged by political considerations. Again, there are many legislators whose understanding of economics is minimal at best, and blocked most attempts at credible fiscal policy. They have all kinds of money for their pet projects, but nothing for actual stimulus response. Indeed, many would even rail against the use of monetary policy to address the crisis.
The most recent financial crisis is thus another example of how difficult it can be to garner an effective political response to financial crisis. First, political response can be slow, whereas financial crises can unfold quickly. In both the fall of 2008 and in 1907, the crises unfolded in a matter of a few weeks, with the entire financial system on the brink in both cases. Fiscal policy response, dependent on politicians, cannot typically respond fast enough to a financial crisis to stabilize the situation. Even if money was earmarked for this purpose, actually getting that money out into the economy is a relatively slow process. Monetary policy is the best mechanism for this, as it gets money into the economy more quickly. Where the central bank and central government can get involved is basically any area where they can move without having to answer to elected officials. This has included orchestrating loans and bailouts for financial institutions.

This situation generally holds true globally as well. The best ways to manage a crisis are to avoid getting into one in the first place. This typically means learning from past crises, and building a regulatory framework that takes into account the lessons from the past. The crises have typically emerge in nations where poor banking controls have led to speculative activities -- the same in 1907 as in 2008. So nations that have built stability into their banking systems -- Canada and Australia included (Critchley, 2012) withstood the most recent crisis. Both countries followed up with rate cuts (monetary policy) to ensure medium-term stability as well, but neither had much need for fiscal policy, which is good because it is widely understood on the basis of history that fiscal policy is difficult to implement at all, and almost impossible to implement quickly, even though educated people know that it works.

All told, there is a need to take preventative measures for financial crisis management. The responses will be challenged. Fiscal policy is hard to enact and there is evidence of that from around the world. Monetary policy, as seen in 2008 and in Japan, runs the risk of creating a liquidity trap. But the long-run regulatory response can actually work to manage financial crises. The commonality in the responses, though, to these different events is that the central government has played a role in managing the financial system, and that role has provided stability when needed to avoid the worse of crises, or at the very least to respond more quickly when a crisis emerges. The work that Paul Warburg and others did after 1907 to bring about a central bank was insightful, in terms of understanding the sort of mechanisms by which a government can ensure a stable financial system for the nation.

References

Chen, L. (2010). Banking reform in a hostile climate: Paul M. Warburg and the National Citizens' League. Harvard University. Retrieved July 5, 2015 from http://www.fas.harvard.edu/~histecon/crisis-next/1907/docs/Chen-Warburg_Final_Paper.pdf

Bernanke, B. (1999). Japanese monetary policy: A case of self-induced paralysis. Princeton University. Retrieved July 5, 2015 from http://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf

Svensson, L. (2005). Monetary policy and Japan's liquidity trap. Princeton University, CEPR and NBER. Retrieved July 5, 2015 from http://www.esri.go.jp/jp/workshop/050914/050914Svensson.pdf

Critchley, B. (2012). Differences in Canada and Australia's approach to financial crisis resolution. Financial Post. Retrieved July 5, 2015 from http://business.financialpost.com/news/fp-street/differences-in-canada-and-australias-approach-to-financial-crisis-resolution