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CHAPTER 1
Long before the New Deal
The introduction presents two basic ideas about the regulatory response to financial crises. The extreme rarity of crises and the fact that reforms are enacted hastily after a crisis ensures that all reforms appear to make things better. This fact gives a surface plausibility to market failure narratives in which a corrupt and lightly regulated financial system brought misery and ruin to unsophisticated investors until intrepid reformers stepped in to restore order. Those narratives, formulated by government officials and "policy entrepreneurs" (Romano 2005) often become the main sources on which later historians and journalists rely.
The second key point is that financial firms are adept at using the legislative and regulatory processes to disadvantage their existing or potential rivals even when the financial industry's public standing is at a temporary low point. This is easy to see when legislators care primarily about mollifying an angry public. But it is true even when legislators or regulators try in good faith to cure market failures that they necessarily understand less well than the regulated industry.
Subsequent chapters describe in detail how these phenomena played out during the New Deal era. But I hope to persuade the reader that both points are of more general applicability. One way to see this is to look at the earliest, most comprehensive, and most influential treatise on the federal securities laws, Louis Loss's Securities Regulation (Loss, Seligman, and Paredes 2014). The treatise opens with a chapter on the historical antecedents of the New Deal securities laws. These include a pair of English statutes: a 1697 statute regulating stockbrokers and the Bubble Act of 1720. Both are described as reactions to chicanery—by stockbrokers and corporate promoters, respectively. The treatise discusses at greater length the "blue sky" or state securities laws of the early twentieth century, which it also describes as a response to fraud in the sale of new issues of securities.
As I will show, the market failure narrative of each of these three incidents is incorrect. Each episode does, however, fit nicely into the analytical framework of this book. This chapter takes up the first two incidents briefly in order to illustrate the broad applicability of my framework and the remarkable inaccuracy of the histories on which most lawyers have been raised. The analysis here is qualitative. The blue sky laws, which we can analyze quantitatively to a limited extent, are the subject of chapter 2. Subsequent chapters will provide qualitative and empirical assessments of the New Deal financial reforms.
A Modern Financial Crisis in the 1690s
The London securities market grew up in the late seventeenth and early eighteenth centuries. Following the Glorious Revolution of 1688, England shifted from haphazard short-term borrowing by the Crown to a more organized national debt authorized by Parliament and issued with longer maturities. Secondary trading in the shares of financial and overseas trading companies increased during the same period. London merchants began to act as securities brokers and some specialized in this new form of intermediation. Initially, they met at the Royal Exchange or in nearby coffee houses to buy and sell; the creation of a dedicated facility would not come until the late eighteenth century.
Dickson (1967) describes the regularization of public finance after the Glorious Revolution as a "financial revolution" that increased the government's credibility and therefore creditworthiness. North and Weingast (1989) focus on a broader set of institutional changes, such as the growth of parliamentary government and an independent judiciary, as a central reason for England's increased capacity to borrow to finance its late seventeenth- and early eighteenth-century wars.
Neither the development of an organized securities market nor the improvement in public finance, however, was a guarantee against financial crisis. In 1689 England's new king, William of Orange, brought it into the Grand Alliance fighting France in the Nine Years' War (1688–97). Government spending increased substantially during England's participation in the war, resulting in large shipments of specie overseas. Money was therefore in short supply at home.
The government responded in part by creating the Bank of England, chartered in 1694 expressly to lend money to the government. The Bank would later also purchase government debt in the secondary market and present it to the government to be refinanced. The creation of the Bank was also a response to the shortage of specie; as a fractional reserve bank, it issued banknotes in excess of its gold and silver reserves, thus expanding the money supply.
The government's shipment of money overseas was not the only reason for money scarcity. Given the market price of silver, the English mint created relatively too few coins from an ounce of silver. This created an additional incentive to export silver coins to the continent where they could be sold at market prices, exacerbating the shortage of silver coins in England. The English mint also minted gold coins, but these were imperfect substitutes for lower-value silver coins for everyday transactions.
The practice of "clipping" silver coins, or shaving off small amounts of metal, was also common. The shavings from many such operations could be collected and melted into bullion (Kleer 2004). Clipping became endemic in the 1690s. By 1696, contemporaries reported that the average coin in circulation was less than half its original weight (Li 1963, 56–57). The government accordingly announced and implemented the "Great Recoinage," calling in all underweight coins to be melted down and recast as full-weight, milled coins (that is, coins with a serrated edge that deterred clipping by making it obvious). Legislation implementing the Great Recoinage provided that unmilled coins would be accepted in payment of taxes until May 4, 1696. Any remaining unmilled coins could be taken to the mint to be weighed and sold to the government on the basis of their silver content.
Contemporary and modern accounts agree that the Great Recoinage was badly mismanaged. Individuals who owed money to the government could rid themselves of clipped coins by the deadline, but others were not so lucky and stood to suffer significant losses. The process of minting milled coins and calling in unmilled coins was more cumbersome than expected. As May 4, 1696 approached there were not enough milled coins in circulation to meet demand. Moreover, the new milled coins were still undervalued and therefore could be profitably exported, so insufficient money entered circulation.
The shortage of money in early 1696 touched off a rush to liquidity. Consequently, holders of Bank of England notes sought to redeem them for specie. By May 6 the redemptions had turned into a full-fledged run on the Bank, which had to suspend payment of its notes temporarily. As in the early 1930s and late 2000s, the banking crisis was accompanied by declines in asset prices and an economic downturn.
Not surprisingly, merchants criticized the government for this state of affairs. In late 1696 petitions poured in to Parliament from around the kingdom asking that the old coins be once again accepted for government payments. The criticism clearly stung. Parliament took the trouble to denounce one pamphlet arguing that the silver content of coinage had been mismanaged. Not stopping there, Parliament ordered the pamphlet burned and petitioned the king to offer a reward to anyone who would expose the anonymous author and publisher.
Like Congress in 1933–34 or 2009–10, Parliament in late 1696 and early 1697 hastily considered and enacted a number of bills in response to the crisis. One new act empowered fiduciaries acting on behalf of creditors to settle with debtors for less than the full value of a debt. There is an interesting parallel here to recent events. As mortgaged homes fell in value after 2006, doubts were raised whether the servicers of securitized mortgages had the authority to restructure those mortgages without the consent of all holders of the mortgage-backed securities. Similarly, Parliament in 1696 worried that trustees, guardians, and others acting in a fiduciary capacity did not have clear authority to settle debts owed to their beneficiaries at below face value. Parliament acted to provide that authority.
One act offered a temporary premium price on clipped silver coins delivered to the mint. Other acts extended the period in which clipped coins would be accepted at face value for payment of taxes and debts to the Crown and imposed new taxes to make up for the decrease in revenue occasioned by the government's acceptance of clipped coins at face value.
Parliament also appointed various committees to investigate allegations of abuse and incompetence in the receipt of old coins and minting of new. Of particular interest for our purposes, a committee was asked to consider the broader question of the health of the economy. This committee would provide the market failure narrative on which Loss and other modern authors have relied.
The committee reported back to Parliament in November 1696.2 Its report said nothing about deflation or the effects of exchange rates on exports, both of which would have laid blame in part at Parliament's own door. Instead, it identified two purported causes of the downturn in economic activity. The first was outsourcing (although of course not referred to as such). Rather than manufacture woolen cloth in England, the producers of raw wool were increasingly exporting it to take advantage of cheaper foreign labor. The committee strongly condemned this practice.
The second was "the pernicious Art of Stock-jobbing," or, in other words, misconduct by securities brokers and traders. According to the parliamentary committee, securities professionals purchased newly issued securities and sold them to "ignorant Men, drawn in by the Reputation, falsely raised, and artfully spread, concerning the thriving state" of the business. By this means, the legislators argued, the management of businesses "comes to fall into unskillful Hands" to the detriment of the economy as a whole. Parliament thus argued that the fall in asset values accompanying the run on the Bank of England was actually orchestrated by securities traders.
Parliament responded with "An Act to restraine the Number and ill Practice of Brokers and Stock-Jobbers," which took effect on May 1, 1697. The act required licensing of stockbrokers and limited the number of licensed brokers to 100. It also included provisions for the stated purpose of eliminating unfair or fraudulent practices, including a cap on brokerage fees and a ban on the growing trade in time bargains (essentially futures and options contracts in which the purchaser had either the right or the right and obligation to acquire shares of stock at a future date).
This episode may seem remote and irrelevant to present-day concerns, but it nicely illustrates several common features of financial crises and the political and regulatory response. They are worth our careful attention because they will reappear in connection with other financial downturns discussed in this book.
The Role of Monetary Policy
Monetary policy frequently plays a key role in a financial crisis. With the benefit of hindsight, we can identify decisions by the monetary authority that set the stage for the crisis. To be clear, this is only to say that after the fact, with the benefit of additional information and the absence of time pressure, we can identify policy mistakes. It is not to say that policymakers at the time should have been expected to know more and act differently to avoid the crisis that later unfolded. We can only answer that question on a case-by-case basis and it is beyond the scope of this book to do so.
Failed monetary policy necessarily brings criticism to bear on the government. Policymakers have a strong interest in deflecting blame andcriticism. It is not politically feasible to respond by saying "it is hard to get monetary policy right all the time and we did our best but failed." The universal response, therefore, has been to argue that the fault really lies with nongovernmental actors. Certain targets of this redirected blame occur almost inevitably—foreign trade and securities markets being especially popular.
Blaming the Messenger
Securities markets are an ideal target to which policymakers can redirect public anger after a financial crisis. A stock market crash is typically the clearest signal to the general public that a crisis is underway. A market crash is both visible and painful to voters who have money invested in equities. The stock market is therefore a tempting target for blame, even when it is just the messenger. Stock price declines also raise the cost of capital for the affected businesses, opening the door for politicians to play a "Main Street versus Wall Street" theme that is evident in the November 1696 parliamentary committee report.
Even in the best of times, the public views securities markets with suspicion. Securities markets involve middlemen who trade assets with volatile prices, which throughout history has been a recipe for unpopularity. The public sees middlemen and price volatility and concludes that the former cause the latter, rather than volatility attracting traders who attempt to profit from differences in price across time and space. Banner (1998) notes the traditional suspicion of "speculators" in agricultural commodities and identifies the many ways English law and policy attempted to regulate them. He then observes that the English public took a similar attitude toward the new securities market and surveys literary works from the late seventeenth and early eighteenth centuries that portrayed securities trading as a type of alchemy practiced by the dishonest. When governments attempt to blame securities markets for financial crises, then, their work is half done before it begins.
The first part of the standard market failure narrative is the claim that a financial crisis was the work of unscrupulous financiers who tricked investors out of their money and destroyed the underlying businesses or asset markets. While this is not a book on psychology, we can imagine that this claim resonates with investors who have lost money and are themselves looking for someone to blame. This was no less true in the seventeenth century than today. One of Daniel Defoe's first published works, An Essayon Projects (1697), surveyed the growing diversity of business ventures in England and offered policy suggestions. His contemptuous descriptions of the role of financial intermediaries could have been published after the dot-com collapse of 2000–2002 with remarkably little updating:
There are, and that too many, fair pretences of fine discoveries, new inventions, engines, and I know not what, which—being advanced in notion, and talked up to great things to be performed when such and such sums of money shall be advanced, and such and such engines are made—have raised the fancies of credulous people to such a height that, merely on the shadow of expectation, they have formed companies, chose committees, appointed officers, shares, and books, raised great stocks, and cried up an empty notion to that degree that people have been betrayed to part with their money for shares in a new nothing; and when the inventors have carried on the jest till they have sold all their own interest, they leave the cloud to vanish of itself.
Defoe himself had invested large sums in ventures that ultimately failed, including a diving-bell company, no doubt enhancing the bitterness of his commentary (West 1998).
Parliament in 1697, like the US Congress in 1933–34, 2002, and 2010, blamed the messenger. Nevertheless, I am aware of no objective evidence supporting the proposition that misbehavior by participants in the new and small securities market contributed to the run on the Bank of England, declines in asset prices, and economic slowdown of the mid-1690s. By contrast, there is substantial evidence to support a different explanation: The government's insistence on maintaining a mint price of silver that encouraged its shipment abroad, the Crown's own shipments of specie abroad to finance a war, and a badly designed and implemented recoinage did considerable harm to the Bank of England, financial markets, and the economy.
(Continues…)
Excerpted from "Wasting a Crisis"
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