Kuttner analogizes Victorian financial crises to today’s recession

Kenneth Kuttner, professor of economics, gave a lecture Thursday titled “What Can Ben Bernanke Learn From Mary Poppins? Victorian Financial Crises and their Lessons for the Future.” Kuttner, who has served as research department assistant vice president for the Federal Reserve Banks of both Chicago and New York, began by dubbing financial crises “a kind of grim fascination.” According to Kuttner, large-scale systemic crises seemed to have been a problem of the past until recently. He also made the point that most past crises did not cause such financial damage on a global scale as our recent crisis has.

“People knew that a housing bubble was brewing in 2005 and 2006,” Kuttner said. “But nobody expected that its collapse could bring the whole financial system down.”

Kuttner explained that such an event is not unprecedented, and referred to the Bank of England in 1907, which “found itself repeatedly combating crises in the 19th century and before.” According to Kuttner, banking and finance of the Victorian Era – Mary Poppins’s time – can teach us plenty about today’s financial crisis.

Describing the role of central banking, Kuttner said that “In non-crisis times, central banks serve to print money, while during panics, they are called upon as the “lender of last resort.” In a panic, clients rush to take out their money because of the self-fulfilling fear that if they don’t hurry to the bank, others will do so ahead of time and take all the available money. Kuttner said that while this type of bank run was portrayed in the film Mary Poppins, it did not characterize exactly England’s 1907 crisis, which was “not a retail crisis,” but rather a “wholesale run on institutions.” Instead of deposits in the bank, individuals kept bills of exchange. In such a panic, when doubts arise in terms of the quality and worth of these bills, lenders are skeptical of the bills of exchange and in turn, individuals refrain from trading them.
Kuttner said that in cases like the panic of 1907, the central bank should have stepped in and lend cash. “Liquidity, or cash stockpile in the system, helps maintain financial stability,” he explained. But, according to Kuttner, the Bank Act of 1844 severely limited the Bank of England’s ability to lend, thus imparing its ability to act as the much-needed “lender of last resort.”

The quick and easy solution to this setback, according to Kuttner, was to ask Parliament to suspend the Bank Act and thus allow the Bank of England to print more money. This suspension had been implemented in 1847 when the nation questioned the merit of continuing to build (and thus invest in) railways; in 1857 when bank failure rocked the United States; and in 1866 when the London wholesale bank Overend, Gurney & Co. failed. In 1897, when the Baring Brothers needed a bailout after its failure with Argentine railway bonds, the Bank of England did not ask Parliament to suspend the Bank Act, but instead opted for a bailout.

Next, Kuttner discussed the relationship between easy money bubbles and panic. He explained that the Bank Act’s adherence to gold standard essentially warded off easy money bubbles – or easily-accessible loans – in the Victorian Era, as the Bank of England could not simply re-print as much money as it wanted.

“The Bank discovered that it’s very hard to deflate a bubble gently,” Kuttner said. “By the time the Bank of England had gotten around to attempting to pop the bubble, the damage had already been done.” Kuttner said the “damage” was largely due to misuse of the credit system and the frequent departures (as implemented with England’s multiple suspensions of the Bank Act) from the gold standard. Kuttner compared the Victorian financial climate with that of modern-day America, which he said is suffering because of an explosion of “exotic assets,” for which the Victorian equivalent would be the problematic bills of exchange.

Kuttner then posed a follow-up question: “Should bailouts be ruled out?” He examined the question with both more queries about the past and present: Should the Bank of England have bailed out Baring Brothers and thus “avoided a full-out panic,” while letting other companies fail? Similarly, should AIG receive assistance while Lehman Brothers is allowed to fail?

After that, Kuttner summed up several main points. He said that “irrationality, hubris and incompetence,” just like financial crises, are not uncommon to the 21st century. He also added that central banks are limited in managing the expansion of credit; they are often “lulled into complacency by decades of financial stability” and forget to serve as the lender of last resort.

Kuttner suggested that central banks make known their willingness to “lend freely and provide liquidity” because, as in Victorian times, just the hint of liquidity was enough to quell the panic. He additionally proposed that central banks should also compel private sector institutions to participate in bailouts. Finally, Kuttner reminded the audience of the cyclical nature of the economy, suggesting that the financial sector would do well to “prepare for the next big one.”