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Born of Panic: The Crisis that Gave Us the Fed

Written By Brian Hicks

Posted March 6, 2008



bank panic


New to banking panics?

Well the truth is that they used to happen all of the time. The big one though was the money panic of 1907.  In some ways, it was the last straw.

 So here’s part 3. It’s about how what happened in 1907 put us where we are today.

It ran in Gold World on October 4, 2006

Born of Panic

Author’s Note: This story is the third in a series of articles about the creation, the workings, and the ramifications of the Federal Reserve Bank- one of the least understood but most powerful institutions ever created. We hang on its every word and our financial markets rise and fall on its every decision. Even the very value of the dollar itself is in its hands. Yet we know so little about it…

BALTIMORE, MD — Not many people are familiar with the name F. Augustus Heinze. But it’s not all of that surprising since Heinze has become something of a footnote to history.

But for those that do recognize his name, Heinze is synonymous with the 1907 money panic. And it was that monetary crisis that ultimately led to the "duck hunting" expedition to Jekyll Island, Georgia that I discussed in last week’s story on the Fed.

That’s because like most bureaucracies, the impetus for the creation of the Fed didn’t spring from a vacuum. It took a series of crises and panics to create the environment necessary to establish the Federal Reserve.

And while there were certainly numerous money panics throughout the 1800’s, it was the panic of 1907 that served as the final straw and the logic behind the creation of the
Federal Reserve.

At the epicenter of this panic was, naturally, one F. Augustus Heinze, a successful western mining speculator turned trust owner.

His brush with destiny began in 1906.

It was then that Heinze moved to New York and bought Knickerbocker Trust for the sum of $12 million. And in doing so he set down the course of his own undoing. That’s because at the time, trusts represented the development of the type of competition that banks really weren’t interested in.

And because of this, banking industry leaders, threatened by the developing trusts, staged a financial attack on Heinze’s Knickerbocker Trust.

They did so by starting rumors about Knickerbocker’s solvency.

Their motive, of course, was simple. It was to sway public and congressional opinion against the trusts and to eliminate them from the competition.

But in reality, these rumors of solvency not only managed to engulf Heinze, but they also created one of the largest runs on banks in U.S. history when one of Heinze speculative copper ventures collapsed making the rumors a reality.

And like Mrs. O’Leary’s cow, the ensuing collapse of Knickerbocker Trust set off a firestorm of banking panic as depositors everywhere attempted to withdraw their savings.

And since no bank, even then, had the liquidity necessary to meet all of the requests for withdraws numerous banks ended up collapsing in the aftermath.

It was, in short, a disaster. And the ensuing panic that it set off threatened to throw the country into a deep depression.

That’s because the banks then were totally dependent upon on their own currency resources. And for this reason they could be jeopardized by rumors or special financial crises, despite their good financial condition. There were, in effect no preparations, official or otherwise, for such an event. And to end the panic, what was needed was liquidity in the terms of cash… lots and lots of cash.

In fact, to bring relief to the situation, the U.S. Treasury earmarked $35 million of Federal money to quell the storm but even then it was not enough to end the panic.

It was only when famed financier J.P. Morgan stepped in that the complete ruin of the national economy was averted.

Morgan organized a team of bank and trust executives. The team redirected money between banks, secured further international lines of credit, and bought plummeting stocks of healthy corporations.

And within a few weeks the panic passed, with only minimal effects on the country.

In fact, by February 1908 confidence in the economy was restored.

But, the fact that so powerful an institution as the Knickerbocker Bank could fail for lack of currency, even though it owned sound assets, made an impact on congressional conservatives. They perceived that no institution was secure simply by virtue of its size if it lacked the liquidity it needed in times of trouble

And it was this congressional follow up to the panic that led to the creation of the National Monetary Commission.

It was headed by none other than Senator Nelson Aldrich.

You may remember him. He was one that booked that train to Georgia.

His efforts led to the passage of the Federal Reserve Act.

And the Federal Reserve has been providing the liquidity to the banking system ever since then.

It does so with a giant and magical checkbook that creates money out of nothing.

And as we know, it’s no longer tied to gold.

Next week I’ll tell you how it all works.

As for Heinze’s part in the story….it ended in 1914.

He died of cirrhosis of the liver.

I guess being the epicenter of money panics is enough to make you drink.