1

Wicksell on the American Crisis of 1907

Mauro Boianovsky (Department of Economics, Universidade de Brasilia)

Abstract. The article discusses Knut Wicksell’s interpretation of the American crisis of 1907,

presented in a piece published in Swedish in 1908. Wicksell advanced, probably for the first time

in the literature, a clear distinction between the “solvency” and “liquidity” of banks, and

discussed its implications for the interpretation of crises. Moreover, he called attention to a third

desirable attribute of a bank – “flexibility”, that is, the ability to satisfy credit demand at an

adequate rate of interest. Wicksell linked that up with his better-know concept of the cumulative

process and the stabilization policy associated to it.

Acknowledgments. I would like to thank Jérôme de Boyer des Roches, Rebeca Gomez

Betancourt, Harald Hagemann, Geoff Harcourt, Stephen Meardon, Ricardo Solís, Hans-Michael

Trautwein and (other) participants at a seminar at Dauphine University (Paris) and at the HES

meetings (Denver) in June 2009 for their comments on earlier drafts, and Guido Erreygers for

bibliographical support. I have also benefited from helpful reports from two referees. Financial

support from the Brazilian Research Council (CNPq) is gratefully acknowledged.

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The financial crisis in America is really a moral crisis, caused by the series of

proofs which the American public has received that the leading financiers who

control banks, trust companies, and industrial corporations are often imprudent,

and not seldom dishonest. They have mismanaged trust funds, and used them

freely for speculative purposes. Hence the alarm of depositors, and a general

collapse of credit (The Economist, November 2, 1907, p. 1856).

I. INTRODUCTION

The 2007-09 economic crisis has led economic historians and historians of ideas alike to look for

episodes in the history of the American economy that could shed some light on current events.

At first some parallels were drawn with the Great Depression sparked off by the stock exchange

crash of 1929, but attention has gradually moved to another episode which also started in New

York City - the bank panic of October and November 1907 (see e.g. Krugman 2009, pp. 155,

160). Business contraction had begun in May 1907, but it was only after October that a sharp

drop in output and employment took place, until the lower turning point in June 1908 (see

Friedman and Schwartz 1963, pp. 156-68). The immediate cause of the crisis was the failure of

the third largest trust company in New York, the Knickerbocker, which was followed by

contagious panic, runs on other trusts, and pressure on banks’ minimum reserve requirements,

culminating with a concerted refusal by the banking system to convert deposits into currency

(Goodhart 1969, chapter 4; Wicker 2000, chapter 5; Bruner and Carr, 2009, chapters 9-11). Trust
 3

companies had grown swiftly since their emergence as a financial innovation in the 1890s

(Sprague 1910, p. 227; Conant [1927] 1969, p. 707; that is part of chapter 25, introduced from

the 4th [1909] edition of Conant’s book). The lower reserve requirement and looser regulation of

trust companies, as compared to other commercial banks, led them to holding portfolios of

riskier assets, using, among other sources, collaterized loans. Similar to modern day investment

banks, mortgage companies and hedge funds, the trust companies concentrated their portfolios

on large positions in risky assets. Depositors’ perception of increasing risk of insolvency led to

intense withdrawals from the trust companies, which ignited the panic of 1907 and brought about

the failure of 17 trust companies and 25 banks in less than two months (Moen and Tallman

1992).

The crisis of 1907 was widely discussed by contemporary American economists - the

best-known analysis was provided by Oliver Sprague (1908; 1910, chapter 5) - leading

eventually to the creation of a central reserve of lending power in 1913, the Federal Reserve

System. Panic conditions and the suspension of cash payments induced the export of a

considerable amount of gold from London into New York, which pushed the English bank rate to

its highest level since 1873 and helped turning the panic into an international crisis (Conant

[1927] 1969, chapter 25; Goodhart, op. cit.). Hence, the American crisis became a matter of

concern for European economists as well, particularly Knut Wicksell. In May 1907, Wicksell

had delivered in Oslo a lecture on “The Enigma of Business Cycles”, his main piece on the topic

of economic fluctuations. He would refer for the first time to the “present world crisis” in a

German version of that lecture written later that year and published only recently (Wicksell

[1907] 2001, p. 336). In the following year Wicksell wrote three articles in the Ekonomisk

Tidskrift motivated by the (monetary) causes and (real) effects of the 1907 crisis. Two of them,
 4

about price stabilization and unemployment, respectively, have been translated into English

(Wicksell [1908a] 1997; [1908b] 1999) and referred only indirectly to the crisis in the United

States. The other one, published in Swedish in February 1908, discussed at length the main

features of the American banking system that had led to the panic of 1907.

Wicksell’s (1908c) “Lesson on Banking Legislation” was a reflection on what could be

learned from the American events concerning the efficient regulation of banking. Although the

theme of the organization and reform of banking and monetary systems is conspicuous in

Wicksell`s writings (especially in connection with his concept of a pure credit system; see

Boianovsky 1998; Boianovsky and Erreygers 2005), the 1908 essay is the main source of his

views on the basis of a “rational” banking system (Wicksell 1908c, p. 42). Wicksell advanced,

probably for the first time in the literature, a clear distinction between the “solvency” and

“liquidity” of banks, and discussed its implication for the interpretation of crises.1 Moreover, he

pointed out the role of available reserves of legal means of payment, especially when the demand

of agents for liquidity in the form of cash (as opposed to credit instruments) increases during

economic crises.

II. SOLVENCY AND LIQUIDITY

The first lesson drawn by Wicksell from the American 1907 crisis was that a good bank should

have three attributes – it should be solvent, liquid and flexible (1908c, p. 42; the original Swedish

words are “solvent”, “likvid” and “kulant” respectively). A bank “is solvent if it offers full

security for its deposits or - in the case of a bank that issues notes - for the conversion of its notes
 5

under any circumstances” (ibid), even if it must temporarily suspend its payments, permanently

liquidate its business or go bankrupt. “Whether its share holders are able to get their money back

is only relevant for the bank’s prosperity as an enterprise, not for its solvency as a bank”. This is

a further elaboration of the definition in Interest and Prices that banks are solvent “in the

ordinary sense of the word”, if their “assets exceed their liabilities” (Wicksell [1898] 1936, pp.

115-16). A bank is liquid if it can “fulfill its obligations on demand or within a day”, and pay,

against a rate of discount, obligations which are not due yet (1908c, p. 42). Finally, a bank is

flexible if it is “under any circumstances prepared to satisfy all reasonable credit requests,

against suitable guarantee and at an adequate - that is, not too high or too low - rate of interest”

(ibid).

Wicksell pointed out that although the flexibility requirement may look like a paradox, it

is the “core and utmost basis” of both solvency and liquidity, because of its implications for

aggregate economic stability as elaborated further below. Bank legislation had usually aimed at

just one of those three characteristics, that is, liquidity.2 In this connection, banks were often

forbidden to lend money for a long period, and were requested by law to keep as cash balance a

certain amount of currency (see also Wicksell [1906, 1915, 1929] 1935, p. 80). As observed by

Wicksell (1908c, p. 42), in that regard the American legislation was stricter than the European

practice. The American national banking law of 1863 required a minimum amount of legal

tender - inaccurately called “reserves”, according to Wicksell, as they could not be freely used -

of 25% to deposits for banks in New York and other central reserve cities (Chicago and St.

Louis) banks, whereas the country banks and reserve city banks could hold part of their -

respectively 15% and 25% - reserve in deposits in central reserve city banks (see also Sprague

1908, p. 366; Hawtrey 1913, pp. 171-72).

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Although liquidity may be important for “psychological” reasons, severe requirements

“may easily jeopardize solvency itself”. The higher the fraction a bank must keep as cash without

interest, the higher the temptation to risk the remaining assets (in order to get enough interest

income) and to hold a lower amount of own capital. Moreover, liquidity ultimately depends on

the bank’s solvency, or better, on the depositors’ confidence on the existence of such solvency

(1908c, p. 43). When confidence is lacking, the most severe regulations will not prevent a loss of

liquidity, especially if distrust becomes general and entails a run on several banks

simultaneously. Wicksell (p. 44) referred to a statement often repeated by The Economist in the

last months of 1907 about the fact that the monetary system and the economic life of any country

cannot depend on gold but on confidence.3 “This is true, but it requires, of course, that banks are

worthy of the public’s confidence, that is, that they are undoubtedly solvent. There cannot be

suspicion in that regard - a bank must be like Cesar’s wife” (ibid; italics in the original).

The conditions for a bank’s solvency are not generally easy to define or control.

However, one of these conditions - sufficient own resources in relation to the bank’s business -

can be measured through a “barometer” expressed by the level of its profit payments. If those are

exceptionally high, it indicates that the bank’s operations are either too large or too risky in

relation to its capital. According to Wicksell, that was exactly what happened in the American

panic of 1907. Whereas the capital of regular banks in the US represented in average 1/4 or 1/5

of their loans - a number similar to European banks - the situation was different for the trust

banks, which featured high leverage. The capital of the Knickerbocker trust bank was 1,200,000

dollars, against deposits of 62 million dollars (see also Sprague 1908, p. 360). Moreover, in the

months before the panic the bank paid profits to its share holders as high as 50% (Wicksell
 7

1908c, p. 45). Because of their original features as hedge funds (“trustees of shares”, a

translation of “förmynderskap på aktier”, the original Swedish expression used by Wicksell,

ibid), trust banks were not as regulated as the other banks - except in part for the reserve

requirement of 15% instituted in 1906, of which only one-third needed to be in the form of

currency (see Moen and Tallman 1992, p. 614). In contrast with the banks that formed the

national banking system, trust banks did not have access to the New York clearing house, except

indirectly through a clearinghouse member bank.

As noted by Wicksell (1908c, p. 45), the relatively small capital of trust banks made them

an “easy prey” for speculators, who acquired a substantial amount of the shares of one or several

trust banks in order to use the public’s deposits in bold enterprises. Indeed, the 1907 panic began

with the failed stock manipulation scheme to corner the market in the United Copper Company

in mid October, in which many banking institutions had become deeply involved. On October 21

one of the directors of the Knickerbocker trust was forced to resign because of his ties to the

copper speculators. At the same day the trust – whose assets were to a large extent locked up in

enterprises which could not be immediately liquidated - applied for aid to the Clearing House.

The National Bank of Commerce, which attended to the clearings of the Knickerbocker trust,

refused to clear for it because of a heavy unsettled balance against the company, which was

followed on October 22 by a bank run and suspension of operations by the trust bank (Conant

[1927] 1969, chapter 25; Wicker 2000, chapter 5; Bruner and Carr 2009, chapters 10 and 11).

The run spread to other trust banks (including the Trust Company of North America, the second

largest), which caused severe strain upon the clearing-house banks. As reported by Sprague

(1908, pp. 363-64), everywhere in the US “the banks suddenly found themselves paying out

money in response to the demand of frightened depositors, and were in turn forced to draw upon
 8

their reserves deposited with other banks... Banks as well as individuals throughout the country

were evidently hoarding money, and trying to collect still more.” As a result, specie payments

were suspended, and a premium of 3 to 4% was paid for money (Wicksell 1908c, p. 46). The

connection between the solvency problems and the general strive for liquidity was clear enough.

III. FLEXIBILITY, MONETARY POLICY AND RESERVES

The crisis was made worse by the fact that the sudden demand for legal tender money had

reduced most of the banks’ reserves below their statutory limit, and the banks in that position

were “according to the law prescription, forced to reduce their supply of credit, just when an

increase was needed” (Wicksell 1908c, p. 46; italics in the original).4 This is related to the third

characteristic of an efficient banking system listed above - flexibility. Wicksell (ibid) criticized

the fact that the flexibility of banks - that is, the “unimpeded but not unconditional granting of

credit” - was largely overlooked in the banking and monetary literature, with the partial

exception of Bagehot (1873). The topic was part of the broad Wicksellian theme of price level

changes as the link between monetary capital (credit) and real capital (saving). Wicksell (1908c,

pp. 46-48) restated his theory of the cumulative process and its policy corollary that the banks’

rate of interest should be raised as soon as the price level starts to increase. If the banks’ interest

rate is not raised promptly (cf. Wicksell [1898] 1936, p. 189), the inflationary process will

induce agents to become too optimistic about their profit prospects and form false expectations

about the natural rate of interest (1908c, p. 48; see also Boianovsky and Trautwein 2001, section

4). When those expectations are proved wrong and the boom comes to an end,
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General confidence is replaced by general distrust, loans to buy shares are

rejected, underwritten shares must be paid, liquid cash is demanded where before

goods were easily bought on credit, etc. Now comes a difficult and dangerous

time for banks, which get credit requests from all over. Such credit is increasingly

granted in the form of hard currency or notes, which for the time get “stuck” in

circulation instead of returning to the banks. The crisis has arrived (Wicksell,

1908c, p. 49).

The crisis (and the upper-turning point of the price level) is associated with a real balance effect

caused by an increase in the demand for money balances, which “appear much too small in

relation to the new level of prices. The demand for goods contracts, their supply increases, and

prices fall...” (Wicksell [1898] 1936, p. 62; see also Boianovsky 1995, p. 398). Under these

circumstances, banks may also increase their own preference for liquidity and try to strengthen

their cash position by rejecting credit requests (or imposing conditions so severe that they are

impossible to meet), refusal to renew old loans etc. However, this is a “dangerous” policy, since

ensuing bankruptcy and reduction in the value of collateral of businessmen will affect the savers’

confidence in the banks’ solvency. The right policy, according to Wicksell (1908c, p. 49) is quite

the opposite: “full flexibility, free and unimpeded credit to the last cent, although charging an

interest rate adjusted to the circumstances and higher than usual, but without unnecessary

difficulties”.5 He referred to Bagehot’s Lombard Street as the classic source of those ideas,

which he had described elsewhere as “conventional wisdom” (see Boianovsky and Trautwein

2001, pp. 347-48, 359).6 Of course, the crisis itself could be prevented if banks raised their

interest rates at the start of the upward price movement (ibid). Moreover, in order to attract
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deposits and be able to increase their credit activities banks should raise not just the interest

charged on loans but also the interest paid on deposits (1908c, pp. 49-50).

Even if the banks’ lending policy is the right one, there remains the matter of the higher

demand for “ready money” during crises. Wicksell ([1907] 1953, pp. 58-59) had discussed

before how the “general lack of confidence, concern over one’s personal security etc” paralyzes

the velocity of circulation of money.

But this aspect of the matter is also the one in respect of which economists ... have

made most headway. The remedy ... lies in having a sufficient reserve of legal

tender - whether of metal or of paper money is a matter of indifference - which is

put to use only in times of economic recession and of threatening panic, in order,

for the time being, to meet the urgent shortage of credit. This is an economic

discovery by means of which, as we may hope, crises will for all time have lost

some of their worst impact.

However, against Wicksell’s expectations, a few months after he delivered his Oslo talk

the American panic of October 1907 indicated that the lesson had not been learned just yet. As

pointed out by Wicksell (1908c, p. 50), banks should keep an “available reserve” of legal means

of payment, which was often mixed up with the banks’ cash reserve for redemption of their

notes. In Sweden, France and most other European countries, the available reserve consisted of

the private banks’ stock of central bank notes plus the central bank’s “unused right” to issue

notes. In the case of the centralized British banking system, it corresponded essentially to the

stock of gold and notes of the Banking Department of the Bank of England. The second lesson

from the 1907 panic was the absence of any regulations in the American banking system about
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such available reserves, which were even discouraged by the bank legislation. The strict reserve

requirements meant the opposite of available or true reserves, observed Wicksell (1908c, p. 51),

referring to a remark he attributed to Bagehot: “a reserve is to be used, otherwise it is better that

it does not exist”.7 Although Wicksell’s view - that the American bank legislation effectively

discouraged keeping available reserves – was not supported by contemporary commentators (e.g.

Sprague 1908, 1910) and economic historians (e.g. Wicker 2000), there was a consensus that it

did pose a legal obstacle in the path of reserve availability in periods of financial emergencies

(Wicker, p. 126). Sprague (1908, p. 366) referred to the fact that the arithmetical reserve ratio in

he U.S.A. had become a “sort of fetish to which every maxim of sound banking policy is blindly

sacrificed”.

After some detailed comments on plans for reform of the American banking system on

the wave of the 1907 panic - mostly based on reports from The Economist - Wicksell (1908c, p.

54) mentioned an emerging consensus about the centralization of the system according to the

European pattern, which would be the only way - with a relatively small available reserve - to

supply the market during periods of money scarcity. Indeed, as an outcome of the 1907 crisis, the

Federal Reserve System was established in the United States a few years later. As pointed out by

Charles Rist ([1938] 1940, p. 421), for the first time the concept of a central bank was linked up,

not with the issue of notes, but with the centralization of a country’s gold reserve.8

In contrast with Rist, Wicksell did not support the gold standard as the best monetary

system. It is well-known (see Boianovsky 1998) that he believed the financial systems of his day

were approaching what he called the “pure-credit” or “ideal banking system”, which should be

complemented by a monetary reform replacing gold by banknotes as the standard of value. The

steady progress in the direction of an increase in the (virtual) velocity of circulation of money
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should be distinguished from periodic fluctuations arising out of the “exaggerated use of credit

and followed by a reaction known as a credit or money crisis, which arises from a lack of

confidence between individuals” (Wicksell ([1906, 1915, 1929] 1935, p. 67). Such lack of

confidence means that the demand for a medium of payment turns more towards hard cash and

banknotes in times of crisis (ibid, p. 90). The relevant question was whether reserves of gold

should be kept to be used in periods of instability. Wicksell’s (ibid, p. 122) answer was that such

reserves would be entirely unnecessary even as a precaution for unforeseen circumstances. He

explained:

The distrust of banknotes, even those of central banks, which so often appeared in

former days in times of unrest, has now completely vanished ... What the business

world is afraid of nowadays in times of crisis is that the banks’ credit facilities

will be exhausted and credit thereby become stringent, and not that their

instruments of credit will lose their value and their purchasing power. Nowadays

we never hear of a “run” on gold by the public, but frequently of a run by

businessmen and bill brokers to get their bills discounted at the central Bank, in

case the bank reserves or the unused portion of the statutory note issue falls

unusually low and the private banks begin to restrict credit in consequence.

The American crisis of 1907 was a partial exception to that, but it did not warrant the view that a

pure-credit system was not feasible. In a passage added to the second 1915 edition of vol. II of

the Lectures, Wicksell observed that

The famous panic in the U.S.A. in 1907 was clearly connected with the peculiar

banking conditions in that country, and no repetition of the occurrence is likely

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since the American banking system has been reorganized on a more rational basis

(ibid).

Of course, Wicksell could not anticipate that a hundred years later the proliferation of

unregulated financial innovations would bring about another wave of intense instability in the

American economy.

IV. THE AMERICAN CRISIS AND THE APPROACH TO ECONOMIC

FLUCTUATIONS

At the outset of his 1908 essay, Wicksell (1908c, p. 41) suggested that the fundamental cause of

the American crisis of 1907, like most other crises, was probably something that we “could call,

in a more comfortable than precisely clear way, overspeculation or overcapitalisation, not to

mention the more popular but even less precise concept of overproduction”. This pointed to

capital scarcity as a main factor behind the 1907 upper turning point, but the connection is not

straightforward. Indeed, in his 1914 lecture on economic crises, Wicksell would tell his students

that at the beginning of the 20th century the American economy enjoyed a boom, mainly caused

by huge investments in railroads. “The capital used exceeded the country’s own savings, so that

a great deal of European capital had to be brought in. In 1907, with the collapse of the copper

syndicate and the fall of the Knickerbocker trust, a serious financial crisis set in... At the same

time production declined swiftly.” Recovery was also “very rapid, so that by 1909 a new boom
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had already set in” (modern accounts confirm Wicksell’s description; see e.g. Bruner and Carr

2009, pp. 7-8, 143-44).

As claimed by Wicksell (1908c, p. 46) against the underconsumption approach, the 1907

crisis was not preceded by overproduction of goods (see also Sprague 1908, p. 355, for a similar

opinion). On the contrary, “industries found themselves with large orders, but did not dare to

deliver the goods out of fear that they would not get paid. At the same time, they could not get

credit to pay their workers... Most firms (e.g., the Westinghouse big steel factory) had tied up

their own available assets in new plants during the boom.” Hence, the crisis was associated with

widespread illiquidity brought about by the collapse of credit in the financial market.

Wicksell’s sense of “overspeculation” may be inferred from his remark - written a year

after the 1908 essay - that its origins “are to be found in the monetary sphere, in the wrong

choice of monetary and banking policy” which is part of the cumulative process of price change

caused by a difference between the natural and bank rates of interest. The business cycle, on the

other hand, results from changes in the natural rate of interest itself as caused by irregular

technical progress (Wicksell [1909] 1999, p. 44, n. 2). As explained in the article about the

American crisis, once the cumulative process of price change starts to affect the price

expectations of agents, one may observe “the phenomenon which almost always precedes a

crisis: the chances of gain generated by the price rise bring about an almost feverish atmosphere

of excitement.” New ventures are started up which, “because of their high construction costs,

have in reality smaller prospects of profit than ever before, or which completion may perhaps

exceed the existing capital resources of the country” (Wicksell 1908c, p. 48). It is implicit in this

argument that inflationary expectations will make longer (capital-intensive) production methods

more profitable, with the continuation of the cumulative process until it is brought to an end by a
 15

crisis (see also Boianovsky 1995, pp. 394-96, for Wicksell’s analytical distinction between

business cycles, caused by oscillations of the natural rate of interest, and economic crises,

provoked by miscalculation about the value of the natural rate induced by price level

movements).

Interestingly enough, Dennis Robertson ([1934] 1940, pp. 87-88) would argue that the

capital scarcity hypothesis provided “an almost completely satisfactory explanation of the sharp

short set-back of 1907”. In Robertson’s framework, the upper turning point is caused by a shift

leftwards of the curve of supply of loanable funds back to its original position - after the initial

income transfer from wages to profits is reversed - and the ensuing rise in the market rate of

interest above its “quasi-natural” value. However, as pointed out by Robertson, a crisis may also

be brought about by saturation with existing capital goods, which was his sense of

“overproduction”. Instead of capital scarcity, the saturation hypothesis was Robertson’s

preferred explanation for the 1929 crisis, as opposed to the 1907 one (see Boianovsky and

Presley 2009). The assumption of a temporary saturation of investment opportunities, when no

positive market rate of interest may equilibrate saving and investment at full employment,

played an important role in Wicksell’s ([1907] 1953) interpretation of the cyclical downturn (see

Boianovsky and Trautwein 2006, pp. 178-79, on Wicksell’s notion of a negative natural rate of

interest in the depression).

The 1907 crisis also attracted the attention of Irving Fisher, who wrote an anonymous

short note about it in that same year in the November issue of the Yale Review. (Fisher’s

authorship was established in I. N. Fisher 1961, p. 23). According to Fisher (1907, p. 229), in

order to understand the crisis one should not be distracted by factors such as the “organization

and promotion of trusts with their ‘undigested securities’ and their arbitrary effect on prices, and
 16

the particular characteristics of the individuals and firms who have failed”, which were merely

“precipitating causes”. The general explanation should be found in the “progressive rise in prices

due undoubtedly to the increasing supplies of gold.” Fisher then developed his well-known

argument about the imperfect adjustment of the nominal rate of interest to the anticipation of

prices increases, which causes the real rate of interest to decline and brings about the upswing.

The upper turning point comes along when the nominal rate of interest adjusts itself completely

to the rate of price increase, and borrowers are unable to repay their loans. “The fundamental

factor in the situation is that the business world has not forecast the general rise in prices... Many

who have plunged into speculative ventures find that their expenses, especially for interest, have

unexpectedly risen and have begun to withdraw from their ill-fated enterprises... We are entering

upon a commercial crisis, and if our analysis is correct the effect will not be confined to New

York City or this country.”

Although there are some common points between Wicksell’s discussion of

overspeculation and Fisher’s notion that the real rate of interest comes down during the boom, it

is worth noting that their respective theoretical frameworks are distinct. Wicksell’s was not a

monetary theory of the business cycle, in contrast with Fisher’s. The peculiar characteristics of

the American financial system, which Fisher acknowledged but considered of secondary

importance, played a crucial role in Wicksell’s interpretation of how the strive for liquidity

pushed the bank rate of interest upwards and eventually overshot the natural or equilibrium rate.

Illiquidity explained the turning of the cumulative process of rising prices – started by a

divergence between the natural and markets rate of interest, and accelerated by upward price

expectations – into a downward one accompanied by output contraction.9

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V. FINAL REMARKS

The two lessons drawn by Wicksell from the 1907 American crisis - to recapitulate, the

attributes of an efficient banking system, and the pivotal role of available reserves - may be

found in part in previous contributions made by other monetary economists (especially Henry

Thornton and Walter Bagehot). However, Wicksell articulated those elements in a new way,

which reflected his concept of a pure credit economy and his model of the cumulative process. In

particular, although the notions (if not the words) of bank’s liquidity and solvency had been

often deployed in discussions about bank runs in the 18th and 19th centuries (see de Boyer

2009), Wicksell’s clear distinction between them opened new ground - or so it would, had his

1908 essay become available in one of the major European languages.

The terms “solvency” and “liquid” could be found in contemporary narratives of the 1907

crisis (see e.g. Sprague 1908, pp. 857 and 360), but they were not systematically related to one

another. Indeed, the issue of the interdependence between insolvency and illiquidity of financial

institutions has resurfaced as part of the analytical effort to understand the 2007-09 crisis (see

e.g. Morris and Shin 2009). Wicksell’s argument about the interaction between flexibility,

liquidity and solvency, which points to the microeconomic effects (on banking firms) of

macroeconomic instability, also broke new ground. His notion of bank’s flexibility was related

to Bagehot’s and Thornton’s views about the role of the lender of last resort, but added new

elements to it, such as the stabilization of the price level as a goal of monetary policy. Moreover,

Wicksell’s discussion of the 1907 crisis makes it clear that the concepts of solvency and liquidity

apply also to a pure credit economy, where financial markets are not complete and other riskless

nominal assets are not perfect substitutes for the liabilities of the central bank (Boianovsky and
 18

Trautwein 2006, section 2). Wicksell’s interpretation of the historical episode of 1907 is

consistent with the later developed hypothesis (see e.g. Gorton 1988) that panics result from

reassessments of the riskiness of the banking system when a new piece of information becomes

available (such as the failure of a particular corporation with links to the banking system) and

agents, who cannot tell the value of a bank’s assets, are not able to distinguish the degree of risk

of one bank from another.

NOTES

Translations from Wicksell (1908c) are my own.

1. Bagehot, for instance, used the term “solvent” only incidentally in his classic Lombard Street.

“On the wisdom of the directors [of the Bank of England], it depends whether England shall be

solvent or insolvent”. “If it is known that the bank of England is freely advancing on what in

ordinary times is reckoned a good security… the alarm of the solvent merchants and banks will

be stayed” (Bagehot [1873] 1915, pp. 36; 188-89). Wicksell ([1906, 1915, 1929] 1935, p. 89)

referred in passing in the first 1906 edition of vol. II of his Lectures to the “solvency or

liquidity” of banks, without any detailed discussion of the distinction between the two concepts.

It is worth noting that in most of his monetary writings Wicksell focused on the theoretical

aspects, with only passing discussion of the actual working of the money market. For that, he

referred the reader to Bagehot’s book, which, “although not up to date, is unsurpassed from the

point of view of exposition” (Wicksell [1906, 1915, 1929] 1935, p. 59). As reported by Torsten
 19

Gårdlund (1958, pp. 69, 220-21, 279-80), Wicksell often sought help about the practical working

of the banking system from his former university colleague Theodor Frölander (b. 1856, d.

1908), who developed a successful career as a banker in Sweden.

2. Liquidity was the attribute stressed by Bagehot, although he did not use the term. “In banking,

where ‘liabilities’, as promises to pay, are so large, and the time, if exacted, is so short, an instant

capacity to meet engagements is the cardinal excellence” (Bagehot [1873] 1915, p. 22).

3. “It must be remembered that a large stock of gold is only required when the abuse of credit

has destroyed confidence. While credit and confidence exist unimpaired we need not be too

anxious about our reserves. If credit and confidence disappear as they have done in America,

there is no possibility of obtaining sufficient gold. The cash famine in America will have to

continue until confidence returns… Public credit really depends on public confidence, just as

private credit depends upon private confidence” (The Economist, 1907, pp. 1854 and 1856).

4. In the same vein, Hawtrey (1913, pp. 171-72) criticized the “illusory” character of the

American system of statutory bank reserves as a safeguard in times of crisis. “If a sudden

demand for legal tender money reduces some of the reserves below the statutory limits, the

banks which are placed in this position are precluded from lending any more money until they

have restored themselves to a legal footing”.

5. This was similar to Bagehot ([1873] 1915, p. 187), but the English economist stressed that in

times of panic loans should “only be made at a very high rate of interest. This will operate as a
 20

heavy fine on unreasonable timidity and will prevent the greatest number of applications by

persons who do not require it.” Since Bagehot lacked Wicksell’s concept of natural rate of

interest, the meaning of a “very high rate of interest” was not made precise.

6. “The best way the bank or banks who have the custody of the bank reserve to deal with a drain

arising from internal discredit, is to lend feely. The first instinct of every one is the contrary”

(Bagehot [1873] 1915, p. 48). As pointed out by Wicker (2000, pp. 130-31), although Sprague

did not refer to Bagehot, he subscribed to the latter’s principles of banking policy. Sprague

(1910, pp. 91-101; see also Wicker, pp. 127-30) supported the so-called Coe Report, prepared in

the same year of publication of Lombard Street by a committee of the New York Clearing House

chaired by George Coe, president of the American Exchange Bank. The report pointed to the

role of pooling the bank reserves and issuing Clearing House Loan Certificates in the restoration

of bank liquidity in periods of crises. Wicker’s discussion indicates that since 1873, when

deciding about the issuing of loan certificates, the Clearing House implicitly distinguished

between solvency and liquidity, even if the terms were not used.

7. The passage in Lombard Street that comes closest to the meaning Wicksell ascribed to

Bagehot is the following: “The ultimate banking reserve of a country is not kept out of show, but

for certain essential purposes, and one of those purposes is the meeting a demand for cash… we

keep our treasure for the very reason that in particular cases it should be lent” (Bagehot [1873]

1915, p. 53).
 21

8. However, the creation of the Federal Reserve was not followed by the adoption of a bank rate

policy of the kind advocated by Wicksell, Hawtrey and others. Instead, the view that prevailed

was the real-bills doctrine. As pointed out by Kindleberger and Aliber (2005, pp. 234-35), the

lesson the leading bankers of New York (Frank Vanderlip, Myron Herrick, William Ridgely,

George Roberts, Isaac Seligman and Jacob Schiff) drew from the panic of 1907 was that the

difficulties arose from lack of elasticity of the money supply. Hence, there should be a central

bank with an elastic currency based on the discounting of trade bills.

9. Pareto ([1907] 1967) was another prominent economist who interpreted the 1907 crisis in the

context of his own approach to economic fluctuations. Italy was one of the European countries

most affected by the 1907 crisis. In fact, signs of economic downturn were already present in the

Italian economy even before 1907 (see Kindleberger and Aliber 2005, pp. 138-39). According to

Pareto, the crisis should be understood as part of cyclical changes in aggregate production driven

by oscillations in consumption and saving, caused by influence of the forces of inertia (habit

formation) in the decisions of economic agents (see also Boianovsky and Tarascio 1998).

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