March 26 (Bloomberg) — More government is the remedy that the U.S. Congress is reaching for as it moves to evaluate the Bear Stearns Cos. disaster. Yet as the story of another banking catastrophe reminds us, government involvement can also be a curse. What's especially problematic is when the role of public officials and institutions is unclear.

In 1913, Congress was busy creating a central bank for the U.S., the Federal Reserve Board, to serve as lender of last resort. The Fed was supposed to provide an additional source of liquidity to banks that formerly relied on state-level networks alone, such as the New York Clearing House.

Defining "chutzpah" for those not yet familiar with the concept, a group of Jewish small-timers in New York called a bank they were chartering that same year "Bank of United States."

Observers made their irritation known. It started with the name's odd article-less-ness. "Bank of United States," instead of "Bank of the United States," sounded illiterate.

Worse, though, was the sense that such a name would trick gullible immigrants into believing their deposits were government backed. The founders were recalling the Fed's predecessors, the First and Second Banks of the United States. "Such an honored name should not be dragged in the mud on the Lower East Side of the city," an opponent told the New York Times.

The Bank of United States confounded the critics by keeping its name and proving a success story. It identified markets that more traditional banks ignored — the garment trade, for example — and profited from that insight. Its branches proliferated. Its immigrant depositors thrived. Its shares were traded on the Curb. And its executives likely believed they were making headway in penetrating that old New York establishment.

Diamond Kings

On July 12, 1930, a Bank of United States baseball team even trounced Chase National Bank 5-1 in a game at Ebbets Field in Brooklyn, the team's fifth-consecutive win.

Several vulnerabilities, however, were emerging. As with Bear Stearns, real estate or related instruments were a problem, with the bank over-investing. Bear lacked access to the Fed's discount window; similarly, Bank of U.S. was shut out of a source of liquidity because it wasn't a member of the clearinghouse.

A year into the Depression, in the autumn of 1930, the runs on the bank began, and in December, the Bank of U.S. closed its doors. There were late-night merger efforts. Manufacturers' Trust — one of the multiple banks in the DNA of today's JPMorgan Chase & Co. — was a possible partner. In the end, the clearinghouse banks turned their backs on the newcomer. The Fed was missing in action.

'Let It Fail'

"Let it fail, draw a ring around it so that the infection will not spread," a clearinghouse member argued, as economist Allan Meltzer points out in his "History of the Federal Reserve," volume two of which appears later this year.

Shareholders bore the consequences. Time magazine's editors wrote one day about the time of the closing that "if the Bronx merchant who had tried to sell his Bank of United States stock the day before had succeeded, he would have received $11½ a share. After the closing, he would have been lucky to get more than $3. Last year this stock sold at $240."

As with Bear, there was the question of whether the failure had to happen at all.

Joseph Broderick, the New York State superintendent of banks, pleaded with banking executives to help the Bank of U.S. Broderick's account of his argument caught the eye of Milton Friedman and Anna Schwartz, who reprinted it in their own monetary history.

Domino Effect

"I said it had thousands of small borrowers, that it financed small merchants, especially Jewish merchants, and that its closing might, and probably would, result in widespread bankruptcy among those it served," Broderick said, according to the book. "I warned that its closing would result in the closing of at least 10 other banks in the city and that it might even affect the savings banks."

Broderick pointed out that they were rescuing other troubled banks — why not this one?

"I asked them if their decision to drop the plan was still final. They told me it was. Then I warned them that they were making the most colossal mistake in the banking history of New York."

The liquidation of the bank lasted 14 years, even longer than the Depression.

It would be wrong to push this analogy too far. Bigotry was part of the 1930 story. It isn't today. Bank of U.S. was operating amid deflation. Bear Stearns is operating amid probable inflation.

Off to Prison

Several Bank of U.S. executives were sent up to Sing Sing Prison, convicted of misdirecting funds. No one is charging, let alone convicting, Bear executives yet. The Bank of U.S. didn't come back. Bear may.

Still, one similarity remains: the arbitrary quality of the actions by government and fellow banks. The cocky immigrants who gave Bank of U.S. its name were culpable. But so was the young Fed, which was still defining what was and what wasn't "last resort."

"There's never been clarity on that, and there isn't now," says Meltzer of the Fed's role in crises. And the Fed keeps changing the rules. This time, the discount window was available to commercial banks, but not Bear.

Knowledge of this probably emboldened Jamie Dimon of JPMorgan Chase as he closed in. In the past, as now, the very institutions that are meant to prevent instability helped to cause it.

(Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

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