Financial Crises

In a general sense, almost all monetary crises are caused by excessive speculation. An irrational level of optimism creates a demand to have a certain thing (stock, bond, or money itself) causing buyers to bid up the price. When good sense sets in and it is realized that the item will not be worth what was expected, there is a rush to get rid of it, causing prices to plummet even more steeply than they rose. Fortunes are lost by those who were irrationally enthusiastic and their mindless followers - and made by those who recognized and exploited the mania.

Now speculation itself is not always evil, as there is a speculative element in all business transactions or any plan for the future. We take action expecting to achieve a positive outcome, and if our analysis and logic are sound, we generally achieve it. Without speculation, there would be no growth, nor any level of productive activity at all.

Speculation becomes dangerous when the amount staked is very large, there has been very little consideration of probabilities, etc. Speculation on the part of multiple parties (rather than a few risk-takers) increases the damage done by unexpected results. And when speculation is done on credit, the damage is spread to the lenders.

The discovery of the Americas was an era of grand speculation, about the rich mines and fertile fields of a distant land, and America remains "the home of the speculator" where there is great potential to begin tabula rasa and build a commercial empire. In Europe, capital and resources have been maintained by a small number of people for centuries, and denying others access to their resources has been their means of retaining power. In America, there are many unexploited resources and the wealthy class is more inclined to provide financing for entrepreneurs and visionaries.

Britain itself has benefitted greatly from speculation in the age of empire, commissioning companies to establish commercial operations the world over, and this has resulted in a dramatic increase of the wealth of the nation. It has exceeded the growth of other European nations, whose behavior has been to loot foreign lands and horde the profit rather than to make a growing and ongoing investment in development.

Back on topic: it is in the nature of the adventurer to speculate, but it is the responsibility of the banker to bring a degree of sobriety to speculation by considering his own lending processes. The banker must galvanize himself against the level of gold-lust that blinds me to high risk and low probabilities of success. The banker must be an experienced and practical man of business who recognizes a good opportunity but is not prone to flights of fancy.

Raising interest rates is a first step to safeguard against crisis, as adventurers tend to be reckless with cheap money but become more timid when their margin is thinned by a high cost of capital. There is no guarantee this will work, as boldness defies rationality and there is a tendency of men who see failure coming to take panicked and desperate measures, including borrowing at an extremely high rate of interest to save a sinking enterprise. He cautions moderation - interest functions like the brake on a bicycle, in that slow and steady pressure will bring it under control whereas a sharp and sudden application will cause a crash.

Another safeguard against crisis is to provide favorable rates on money to established industries, which encourages the direction of resources and investments to less risky ventures that will remain stable even should the high-risk ventures fail. It must not be forgotten that failure in one industry does not mean failure in them all, and money provides a buffer that will protect stolid firms from being damaged by the failure of others.

The last recourse in the wake of a crisis is stabilization of the monetary supply by suspending the Act of 1844 (requiring gold in reserve to back notes), enabling the central bank to restore stability to the system, by ensuring that money is available to enable "legitimate converse" to continue to engage in business as usual. He mentions the crisis of 1890, which was not noticed by the public until the danger was passed by virtue of swift intervention by the central bank.

He enumerates a number of minor financial crises of the previous century, and suggests that the common factor in each of them was "extravagant lending" and the recovery was slowed by miserly behavior in the aftermath, with banks keeping a "distinctly larger percentage" of liquid assets and refusing to lend.