The instability and chaos that accompany financial panics damage more than just the banks that are directly involved. Fear of losing one's savings is a great disincentive to making bank deposits, and fewer deposits means smaller banks and fewer loans. Everyone is slow to regain confidence in the financial system after a panic, making it hard for anyone to get financing. New businesses can't get the resources they need to get started; established companies can't find the financing they need to expand. The more frequent the panics, the worse the situation gets, and the slower the economy grows.

This was the position the United States found itself in during the late 19th and early 20th centuries. Between 1870 and 1907, the nation experienced 21 financial panics of varying severity. In the mostly agrarian economy of the time, a typical crisis began with either a crop failure that left farmers with nothing to sell or a bumper crop that drove prices down below costs. Either way, farmers defaulted on their loans. The losses damaged the balance sheets of rural banks, leading them to withdraw funds from larger banks in New York or Chicago, where they held deposits. If the rural banks' withdrawals were large enough, the urban banks would be forced to call in their own loans or to refuse renewal of loans that were coming due. As word of the financial difficulties spread, other banks would become concerned and begin to call in their loans as well. Finally, when average people (small depositors) heard of the problem, they would flock to their local banks, demanding to receive their balances in the form of currency or gold.¹

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SOURCE: ©2004 Robert Mankoff from http://cartoonbank.com. All Rights Reserved.

Unless confidence in the system was restored quickly, such runs left bankers with no choice but to close their doors. During the Panic of 1907, an astonishing two-thirds of banks found themselves temporarily unable to redeem deposits in cash. The situation led one prominent German banker to observe that the U.S. banking system was at the same point in the early 1900s that Europe's had been in the 1400s. In the intervening centuries, Europeans had developed a system of central banks; Americans hadn't.

The prevailing philosophy of many 19th-century Americans was that centralized government of any form should be kept to a minimum. But the punishing effects of frequent financial panics led people to reconsider the merits of a powerful central bank. In 1913, Congress passed the Federal Reserve Act, which created the U.S. Federal Reserve System. As the central bank's knowledge of how policy mechanisms worked grew, its governance improved. By the 1990s, the Fed was widely recognized as a key promoter of low inflation and high sustainable growth.

While central banking had stabilized European financial systems before 1900, the 20th century was another story. In that century, Europe experienced high inflation, low growth, high and volatile interest rates, and unstable exchange rates. After two world wars, governments' free spending led to unrelenting fiscal deficits. When European economies stagnated in the 1970s and 1980s, a consensus built that inflation was the fundamental problem and poor monetary policy was to blame. Leaders came to believe that the only way to ensure both political and economic stability was to forge closer ties among the continent's countries. They decided the best solution was a common currency and a single central bank.² The result was the European monetary union, with its common currency, the euro, and its central bank, the European Central Bank (ECB).

Europe's monetary union was the natural outgrowth of a decades-long process that established the free movement of goods, services, and capital throughout the continent of 450 million people. Like the Fed, the ECB is based on principles that support the goal of price stability (principles we learned about in Chapter 15). We turn now to an examination of these two central banks to see how their structure helps them to meet their objectives.

¹The process could also go the other way, from the big banks to the small ones. A large loan default in New York, for example, would force the large city bank to try to acquire reserves from the small country banks. The small banks would then be forced to start calling in loans, and the process would go on from there.