Lessons from the Financial Crisis of 1907

Abstract

In reflecting on the crash and panic of 1907, this article considers these market forces, both their interaction with one another in the past and their possible relevance to market conditions a century later. The story of the panic and crash of 1907 suggests that major financial crises can be the result of a convergence of certain market forces - forces of the market's "perfect storm," if you will - that cause investors and depositors to react with alarm. The storm begins with a highly complex financial system, whose very complexity makes it difficult for anyone to know what might be going wrong. By definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, due partly to the demand for capital and partly to the tendency of some institutions to take more risk than is prudent. Leaders in government and the financial sector implement policies that inadvertently or otherwise elevate the exposure to risk of crisis. When an economic shock hits the financial system, the mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral. Collective action by leaders succeeds in arresting the spiral, thought he speed and effectiveness with which they act ultimately determines the length and severity of the crisis.

In reflecting on the crash and panic of 1907, this article considers these market forces, both their interaction with one another in the past and their possible relevance to market conditions a century later.