Financial Panic 1907

Introduction

There is a notion that the financial panics occur when various factors—such as poor financial conditions, unsound fiscal policy, business failures or even just rumors of problems—lead to a loss of public confidence in the nation's economy. When the public loses confidence in banks, there can be a "run" on the banks, during which many customers withdraw their savings. Such a financial panic occurred in October 1907, leading many legislators to conclude that the banking system should be reformed to prevent similar panics from occurring in the future (Sobel, 1972, 12-39).

However, calls for a central bank intensified following the Panic of 1907, when a large number of customers lost faith in banks and withdrew their deposits during "bank runs." Because banks were required to keep only a portion of customers' deposits in their vaults, and could loan out the rest, banks often did not have enough cash on hand during bank runs. As a result, a number of banks failed. The impact of the bank failures of 1907 spread throughout the economy, and the nation fell into a severe recession the following year (Sobel, 1972, 12-39).

Legislators said that the Panic of 1907 showed the need for banking reform. In particular, they called for a more "elastic" money supply, so that in times of crisis, more money could be injected into the economy quickly. Their proposed solution was the Federal Reserve System, for which proposed legislation came before Congress in 1913. It was envisioned as consisting of as many as 12 Federal Reserve banks, each serving a different region of the country; the system as a whole would be overseen by a Federal Reserve Board (later renamed the Board of Governors). Private Banks could join the system by contributing a portion of their capital to the Federal Reserve (Caporale, & McKiernan, 1998, 1110-1117).

Situation Prior to 1907 Panic

The nation's first experiment with a government bank occurred in 1791, as the new nation established its financial system. Treasury Secretary Alexander Hamilton proposed a government-run national bank to ensure the nation's money supply and help the government carry out its financial duties. During the Revolutionary War (1775-83), the colonies had experienced problems raising money to fight the war, convincing Hamilton of the need for a national bank. The bank would issue the nation's currency and loan the government money when needed. Currency took the form of paper money that was backed by gold at a set exchange rate, a policy known as the gold standard. Individuals were able to exchange their cash for gold at banks at any time. However, with the support of Hamilton and the Federalists, the national bank bill passed despite the objection of the Democratic Republicans, who largely represented farmers' interests. However, the bank's charter would expire in 20 years if Congress did not renew it. By 1811, the Democratic Republicans had taken control of the presidency and Congress, and they narrowly defeated the bank renewal bill (Pope, 1981, 75-87).

However, just as the problems presented by financing ...