How Eurozone governments have failed to produce confidence and end the crisis – lessons from 19th century US commercial banks

by Adalbert Winkler

Vox
November 6, 2011

The Eurozone crisis is escalating as governments have failed dismally in their attempts to restore confidence. This column argues that the interventions have been too little and too weak, leaving the EZ crisis with no end in sight. To back up its case it looks at 19th century finance in the US.

For nearly two years Eurozone governments have been fighting a crisis in the sovereign debt markets. New instruments and institutions have been designed but have failed to bring about an end to the panic. At first glance this is not surprising as the governance of the Eurozone, as enshrined in the Maastricht Treaty, is something of an oddity. When it comes to financial stability, its peculiarity can be summarised by noting that Eurozone governments issue bonds in domestic currency without having access to a lender of last resort (De Grauwe 2011).

Financial history suggests that this governance structure is fragile. As evidence, we can look at the series of financial crises in the nineteenth century when banks, performing maturity-transformation services, operated without a central bank. Most prominently, this was the case in the US, a latecomer among today’s mature economies in establishing a central bank. As a result, when facing financial turmoil US banks made use of clearinghouses as a co-insurance mechanism. To fight financial panic, clearinghouses issued loan certificates jointly guaranteed by all member banks to refinance weak member banks. Thus, they co-insured debt and replaced the open capital market with an internal one. The main motivation for transforming the clearinghouse into a co-insurance mechanism was to fight the risk of contagion from weak to strong institutions. This is also why in a crisis no member bank was allowed to fail even if it was insolvent. It was feared that any incident of insolvency would confirm the very concerns of depositors and other bank investors that had triggered the turmoil in the first place and would deepen the crisis. At the same time, the support by fellow member banks to weak institutions was not free. Banks receiving loan certificates had to place collateral and were put under a special regulatory and monitoring regime.

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