Victorian Financial Crises and Their Implications for the Future
Kuttner, Kenneth N., Business Economics
Banking crises were a relatively common occurrence in 19th century England. Like the Federal Reserve today, the Bank of England struggled to quell panics by acting as the lender of last resort, while at the same time maintaining monetary stability. This article surveys the events leading up to and the Bank's response to the four post-1844 crises, highlights some of the similarities between the Victorian era panics and the 2007-08 crisis, and draws on the 19th century experience to illustrate the dilemmas facing modern central banks.
Keywords: financial crises, lender of last resort, central banking
History does not repeat itself, but it does rhyme.--Mark Twain
Central bankers can be forgiven for believing in 2007 that systemic financial crises were a thing of the past. Crises did occur from time to time, of course: well-known episodes in the United States include the Latin American debt crisis, the Continental Illinois failure, the thrift crisis, and Long-Term Capital Management. These were damaging, to be sure, but none seriously threatened the financial system as a whole, nor did any create a widespread panic or scramble for liquidity. Only the Continental Illinois failure required the U.S. Federal Reserve to use its powers at the lender of last resort. (1)
Decades of relative stability gave rise to a narrow view of monetary policy in which the short-term interest rate was adjusted to achieve low inflation and dampen business cycles. Monetary policy was free to focus on macroeconomic objectives, unconstrained by any imperative to maintain or restore financial stability. Heavy regulation contributed to this perception: deposit insurance would prevent panics and runs, while prudential regulation and the separation between commercial and investment banking would prevent excessive risk taking.
The 2007-08 financial crisis demolished the belief in an inherently stable financial system. The underlying causes of the crises will surely be debated for years to come, but it has become abundantly clear that a clean separation between conventional monetary and financial stability policies no longer exists. The current conventional wisdom is that low interest rates earlier in the decade contributed to the crisis. The validity of this view is debatable, but what is beyond dispute is that the Federal Reserve and other central banks have been compelled to lend vast sums in their efforts to shore up a financial system on the verge of collapse. The Federal Reserve's balance sheet has undergone a transformation from an $800 billion portfolio of Treasury securities to a $2 trillion collection of mortgage-backed securities, agency issues, commercial paper, loans, and even ownership stakes in private companies. These asset purchases have potentially large monetary implications, such as near-zero short-term rates and a $1.1 trillion surge in the monetary base.
It would appear that we have entered a messy new world in which central banks are forced periodically to intervene aggressively to ensure the functioning of financial markets, and perhaps even engage in the occasional bailout. But what we have seen could instead be a return to an older world of chronic financial instability. As described vividly in Kindleberger , until relatively recently periodic financial crises were the rule, not the exception. In this unstable environment, central banks were quite often forced to take an active role in stemming those crises.
The financial turmoil of the 1930s is familiar and has been thoroughly studied by Friedman and Schwartz  and Bernanke , among many others. The panic of 1907 is another oft-cited and well-researched crisis. But while these episodes are interesting in their own right, they are of limited value in understanding central banks' responses during the present crisis. The Federal Reserve's passive response to the collapse in the 1930s failed to avert a systemic crisis. …