On May 10th, 1837, an extraordinary panic began with New York banks, and sparked a recession that lasted several years. It was in many ways a classic example of a self-sustaining feedback loop, in which depositors, fearing for the safety of their deposits, rushed to withdraw their deposits, and by their actions weakened the banks and made deposits unsafe.
The chain of events that triggered it started with the Bank of England response to a fall in its monetary reserves. It decided to edge interest rates up from 3 percent to 5 percent to attract specie and curb lending. US banks had to follow suit or risk losing out to the higher rate of the Bank of England. When New York banks did so, and cut back on lending, it led to some businesses defaulting and started a wave of bankruptcies. The cotton industry of the South was particularly hard hit, but the effect rippled to most of the US.
On May 10, 1837, banks in New York City announced they would no longer redeem commercial paper in gold and silver at full face value. It caused panic and hysteria as people rushed to withdraw deposits. Banks collapsed, businesses failed, prices fell, and there was mass unemployment, maybe as high as 25 percent in some places. The recession lasted about seven years.
Psychology played a part, as it did in the 2008 Financial Crisis. I vividly remember walking past the Northern Rock branch in Cambridge watching the queues stretching round the block as people withdrew their deposits as quickly as they could. When Lehman's went down it triggered a financial earthquake. Fortunately, some had learned the lesson of the 1929 crash, and responded by loosening credit rather than tightening it. Thus there was no ten-year Great Depression repeated.
It does indicate the somewhat precarious nature of modern financial structures. Some have responded by urging an end to fractional reserve banking, or even a return to the gold standard. Others, including ourselves, have urged that the system be more open to competition and easier for new banks to enter. Yet others have more modestly urged requirements for banks to have greater reserves to cushion against future shocks, but few have confidence in the current system's ability to cope with future shocks. There will be shocks, though, because people grow complacent in prosperous times and less careful about the risks they undertake. It takes the next shock to remind them and to moderate their behaviour.
Those who take these shocks as proof that the whole financial system should be replaced seem to overlook the benefits it has brought in terms of unparalleled advances in living standards over centuries. There have been few major international crises, and world finance has survived then, recovered, and learned their lessons. The point is that the future cannot be controlled because it is unpredictable. What can be controlled to some degree is our ability to learn from events and to adapt to the challenges they present.