By Jeffrey Snider of Alhambra
It is a great myth that before 20th century monetary inventions there were no liquidity safeguards in the country. If the Federal Reserve wasn’t founded until 1913, then it may seem that private currency elasticity before then was non-existent. The several bank panics that occurred with almost regularity in the second half of the 19th century seemingly a testament to the idea.
On September 18, 1873, Jay Cooke and Company failed. Thus began one of those bank panics that led to what was contemporarily called the Long Depression. Jay Cooke was, after all, a household name, having made his reputation during the Civil War selling Treasury bonds to finance it.
His firm’s failure was a great shock, as the New York Times wrote almost a century and a half ago:
The brokers stood perfectly thunderstruck for a moment, and then there was a general run to notify the different houses of Wall Street of the failure. The brokers surged out of the Exchange, stumbling pell mell over one another in general confusion and reached their offices in race horse time. The members of the firms who were surprised by this announcement had no time to deliberate. The bear clique was already selling the market down in the Exchange, and prices were declining frightfully.
It was all just the brutal and messy consequences of wild laissez-faire free markets, right? No. The US Treasury had bought $10 million in bonds from Wall Street to boost their liquidity. President Grant along with Treasury Secretary William Richardson boarded a train bound for New York City the following weekend, meeting with the most prominent industrialists and bankers in the city. They were besieged by pleas for more than the $10 million.
The Treasury Department ultimately did $13 million and no more, for liquidity runs can be a bottomless pit.
The failure of Jay Cooke & Co. on the previous day had inspired such a distrust in wealthy banking firms and in financial institutions of every class, that it soon became evident that the street was completely demoralized, and that there was not the slightest chance for the bulls to resist the onset. The Vanderbilt stocks, which are held at high prices, and which in ordinary times are regarded as among the safest of all investments, gave way shortly, and a tumble of a remarkable nature ensued.
As is so often the case, a lot of attention is paid to what comes after instead of what went on before. That’s Economics, where in the color of modern rational expectations theory what happened leading up to it is regarded as immaterial. This disregard includes often radical monetary evolution, such as there was in the 1860’s and 1870’s, the 1920’s, and the 1990’s and 2000’s.
Jay Cooke was highly regarded for more than just Civil War finance. He introduced to the country several European concepts, including the idea that government debt is somehow equivalent to national wealth. Cooke wrote in 1865 a widely circulated and highly regarded pamphlet titled, How Are National Debt May Be A Blessing.
The funded debt of the United States is the addition of three thousand millions of dollars to the previously realized wealth of the nation. It is three thousand millions added to its available active capital. To pay this debt would be to extinguish this capital and to lose this wealth. To extinguish this capital and lose this wealth would be an inconceivably great national misfortune.
One of the ways in which the US came about such massive indebtedness was by introducing the Greenback; federal government currency unbacked by money. What Cooke advocated, and that which became monetary reality, was that legal tender in the United States would have to expand to include not just Greenbacks and fiat money. Government bonds were a way to do that, placing them as he did on par with gold.
The retention of our National Debt is necessary as the basis of a system of National Banking. The bonds of the United States, accepted throughout the United States as the highest security, and having a uniform value in every one of the States, are the only real and safe equivalent for gold and silver, and the only available basis for a uniform bank-note currency that shall be money all over the Republic. Commerce demands this uniform currency. Politics requires it. …There is not now any other basis for this currency, nor can any other be devised, than the Debt of the whole United States.
Banks had before only multiplied deposits based on what real money sat in their vaults. The addition of government bonds satisfying any legal reserve requirements changed a lot more than most people might appreciate. The reasoning was, and remains, quite simple and recognizable to our modern senses.
A government bond even in the 1870’s was highly liquid. The National Bank system had been established in 1863 on the premise that cash issued by these banks and backed by federal bonds was equal if not superior to that issued on gold.
The record of National Banks proved, on some levels, that was the case. Only eleven chartered National Banks failed during the panic. According to the Comptroller of the Currency, whose office had been created in 1863 specifically to manage this national system, all the National Banks that failed in that crisis year did so because of the “criminal mismanagement of the officers, or to the neglect or violation of the act on the part of the directors.”
Still, the New York Stock Exchange failed to open for eight days at the end of September 1873, to that point an unparalleled closure. Call money was at 7%, a ridiculous proposition for the 19th century. Commercial paper that could find negotiation was selling at 15% to 18%. The overnight lending rate at one point was quoted at a quarter of a percent, or 148% annualized.
The monetary system had for more than a decade expanded often rapidly and in ways that were poorly understood, especially in the interaction between this new way of managing currency and the old way. Human systems never remain so still, meaning that for whatever new may be thought up it will always be applied in some hybrid fashion; a little old and a little new. In some cases like 1873, or 2007, the more there is that is new the more there is that is unknown and taken for granted.
In both cases, the government believed that it had enough covered so as to be able to withstand the inevitable crisis. The National Bank system had in 1873 proved to be a foundation of stability in the same way that the federal funds market was after August 2007; true but entirely irrelevant in systemic terms. What changed over the 20th century especially after the Great Depression was this belief that panics were no longer a given; that central bankers properly deputized and authorized could overcome any monetary wave of irregularity.
It was true only in the respect of where the money system that they knew best applied the most. By the dawn of the 21st century, that just wasn’t the case. It should have been apparent in the 1970’s, though in the Great Inflation for too much (“missing money”) rather than too little. What the evidence really shows consistently is that Treasuries or central banks are only ever as effective as their effective knowledge of money as it is, not as they see it.
Monetary evolution is perhaps the most overlooked aspect of these events, and especially their aftermath. It took the nation four perhaps five years to recover from what was really just a 40-day financial emergency in September and October 1873. In some ways, the irregular growth during and after that recovery made it seems as if the depression continued for far longer than just that one cycle. It proved the long run susceptibility of the commercial system to these defects.
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