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A Brief History of Doom

Page 14

by Richard Vague


  New Yorkers appealed to President Van Buren in Washington, noting the growing crisis impact: 250 commercial failures; 20,000 newly unemployed workers; a loss of over $40 million in real estate values.48 They asked for a reversal of the Specie Circular that Jackson had issued, a postponement of lawsuits against any debtors of the federal government, and an emergency session of Congress to address the issues. Van Buren insisted the problems were best solved at the state level and refused to act.

  By the following Monday morning, the panic was “palpable.” Angry depositors descended on Dry Dock only to be told it had failed, though an address by Mayor Aaron Clark from the steps of the bank eased tensions by promising that New York’s other banks would receive and pay bills drawn on Dry Dock. In New York City, the monetary reserves of the deposit banks fell almost 80 percent between September 1836 and May 1837—leaving very little to insulate the nation’s financial system in the event of another external shock.

  A general run on all New York City banks followed the news on the Dry Dock Bank. On May 8 and 9, banks’ directors reported that they had distributed over $1.3 million in specie to anxious depositors, or roughly half of their total reserves.49 Realizing that another day or two like that would wipe out their specie reserves entirely, the bankers agreed that as of Wednesday, May 10, all New York City banks would suspend specie payment. Instead of violent mobs, this day of “panic” was surprisingly calm. The stock market even finished the day up 15 percent. Perhaps New Yorkers were relieved that something definitive had been done to combat the anxiety and uneasiness of the preceding months.

  But in the next months, 343 of the 850 U.S. banks failed, while British investors were left with losses in excess of $130 million.50 Bank failures in New York hovered around $100 million, just sixty days into the panic. The Bank of England’s directors convened in the spring of 1837 to discuss the fates of the Three Ws, as London waited anxiously. They resolved that the bank should stop making advances to commercial houses that lacked appropriate security. Given the unique position of the American houses in the financial world, however, they would be exempt from this policy. The Bank of England’s directors proceeded to bail out Wildes & Company, despite the firm’s inability to produce any collateral, and reached similar arrangements by the middle of May with both Wilson & Company and Wiggin & Company.

  The bank’s actions were again condemned, especially for its preferential treatment of companies that many saw as the source of the crisis in the first place. The Courier was especially critical: the American houses, it stated, had “conducted their business with the most reckless improvidence.” The bailouts and criticism might well have been grabbed from the headlines of the 2008 financial crisis.

  News of the Mechanics’–Dry Dock scandal in New York City finally reached London at the end of May, just as the Bank of England’s directors were meeting once again to determine how to address the plight of the Three Ws. When they received this news, they reconsidered their earlier decision and officially ended their support for Wildes, Wiggin, and Wilson on June 2. All three firms suspended payment the next morning. Credit simply ceased.

  The once robust cotton trade collapsed, as demand shrank and prices were slashed daily. The Times observed that the “more immediate and severe loss will fall upon” the private banks that, along with the Bank of England, had been keeping the companies afloat for the preceding two months. This acknowledgment aside, a certain sense of relief permeated London—as had happened in New York just a few weeks earlier—if for no other reason than longstanding uncertainty, at last, had been removed.

  Henry Stephen Fox, British ambassador to the United States, lamented in a speech in London about the economic peril of America: “It would be difficult to describe, or render intelligible in Europe, the stunning effect which this sudden overthrow of commercial credit and honor of the nation has caused.”51

  The year 1837 was the beginning of a long, harrowing, transatlantic meltdown that slid into what some called the First Great Depression. Unemployment was a desperate, de facto state for 500,000 thousand Americans; 39,000 went bankrupt, out of a national population of 16 million. The accumulating bad news created a climate of genuine rage. Agreements seemed meaningless, and the earlier heady optimism—“Go West! Plant Cotton! Build a Railroad!”—evaporated. President Van Buren, though often blamed for the financial collapse and subsequent misery of millions of Americans, was more the inheritor of the years of profligate lending that had preceded him.

  By the end of 1837, concerns had partially receded. This calmer mood pushed the Bank of England’s specie reserves up to the highest level in five years. Encouraged, directors lowered its discount rate to 4 percent early in 1838 and again to 3.5 percent in November.52 But these moves showed the bank to be motivated more by the dazzling glint of its growing treasure than true economic recovery.

  Even as it was making credit easier and money cheaper, banking collapses in Belgium and ongoing concerns in the American financial sector had renewed caution; meanwhile, a poor autumn grain harvest forced Britain to import grain. All of this once again led to a rapid drain on bullion, which fell from £10.52 in March 1838 to only £4.12 million less than two years later.53 Britain soon fell into a familiar spiral, as higher wheat prices forced its citizens to spend more on food, which drained bullion and left less for manufactured goods, which depressed the textile industry, which drove down the price of cotton. By June, with bullion reserves down to just over £3 million, the Bank of England quickly raised its discount rate to 5.5 percent and then 6 percent—its highest ever—and swallowed its pride just enough to accept an emergency loan of £2 million from France. Credit continued to be tight into 1840.54

  After hitting its low point in 1837, the U.S. stock index rose 15 percent through the end of 1838, though the subsequent depression until 1841 took the index to new lows, before rising again during the mid-1840s. This was part of a brief U.S. recovery in 1838 and 1839 that was fueled in part by a second debt surge—a second wave that sometimes happens in a financial crisis. This one was in large-scale canal construction in nine of the nation’s twenty-six states and, to a lesser extent, the earliest establishment of that newfangled investment that would dominate the rest of the century: railroads.

  This second, staggered wave, which is sometimes an element of financial crisis, speaks to both denial and opportunism. As we will see, in the mid-2000s, as housing loan problems were first emerging, commercial real estate lenders adamantly insisted that emerging housing problems were a separate issue and would not affect the quality of their loans. And those suffering early housing loan concerns were eager to find earnings growth in another category of lending. They flocked to commercial real estate, using the logic that the only way out of a credit problem is to grow earnings elsewhere. Lenders and investors will try to recoup losses in one sector by lending and investing more in another.

  Figure 4.4. United States: State and Private Canal Investment, 1830–1845

  Source: H. Jerome Cranmer, table 3, column 1, in the chapter “Canal Investment, 1815–1860,” in Trends in the American Economy in the Nineteenth Century, Studies in Income and Wealth, volume 24, Conference on Research in Income and Wealth (Princeton, NJ: Princeton University Press, 1960), 555–56.

  A very similar psychology lay behind the canal expansion in the late 1830s and early 1840s. The phenomenon of second waves underscores the fact that a crisis rarely occurs in a single year but instead often unfolds over several years, in some cases because lenders seek to recoup losses by lending more elsewhere.

  The canal expansion was largely financed by state-issued bonds. In the 1830s, state bonds were much more widely employed than U.S. federal bonds, and state governments held more power vis-à-vis the federal government than they would later. In this instance, the state debt for canals functioned much more as a commercial loan—debt to finance construction rather than to finance the governments’ operating needs.

  The Erie Canal, financed by New York state b
onds, opened in 1825, and the investment was a resounding financial success. Entrepreneurs hoping to duplicate that success next proposed thousands of miles of canals, mostly between Atlantic ports and inland waterways, such as the Great Lakes and the Ohio River.

  Total investment in canals, which had averaged $4.3 million a year between 1831 and 1836, shot up to $8.2 million in 1837, before peaking at $14.3 million in 1840. As would be true a few years later with railroads, expenditure on the canals was met or exceeded by construction spending, with associated debt, on the new towns and farms that sprang up along the canal’s path. A majority of this funding (61.5 percent from 1825 to 1841) came from the individual states in which they were built and used bonds sold largely to wealthy citizens of Britain. Economic historian Alfred Chandler writes that from the start, railroad and canal promotors relied on “Eastern commercial centers and especially . . . money markets in Europe for funds,” and far from an “afterthought,” investors preferred bonds over stock since they seemed more secure.

  In 1835, the total amount of outstanding state debt was $81 million. This ballooned to $230 million in 1841, with approximately $100 million held abroad, primarily in Britain.55 In this same year, for comparison, federal debt was only $14 million and total private debt was $674 million.

  The brief 1838 and 1839 recovery occurred in both the United States and the United Kingdom. It was a fleeting rebound. During these years, Europe, and especially Britain, was swept up once more in dizzy enthusiasm for American bonds and securities. They bought state bonds and financial stocks, such as that of the Bank of the United States (now simply a Pennsylvania state bank), and railroads.

  But in the wake of the Erie Canal, too many canals were built for demand, and there were too many cost overruns. By December 1838, increasingly troubled American debt valued at about £6 million “hung over” a nervous London money market “like a Damoclean sword.” When British investors rightly became skeptical, “the new inflow of foreign capital” came to a halt in 1839, “and the manifold projects of the states were abandoned.”56

  All of the new canals were besieged by cost overruns, delays, and lack of business, and the bonds to finance them had to be restructured. Investors “lost fortunes.”57 Pennsylvania’s canal bond interest bill was almost as large as the entire state budget otherwise and quickly fell into default. The Illinois canal default in 1842 left ghost towns scattered along the banks of the Illinois River.58

  The enormous canal and railroad projects of state governments were thrown on the unfinished pile, heavy in debt. A rash of state bankruptcies, or close calls, followed. In truth, most of the canals were ill conceived, as there was never enough business to justify them, and canals were soon rendered partially obsolete by railroads. As with real estate booms in the 1920s, debt rather than genuine demand had been the driver of growth.

  According to an 1841 estimate, the overall U.S. crisis of this period caused 33,000 business failures and a staggering half a billion dollars in losses.59 Total capital of American banks dropped 40 percent between 1839 and 1843. Figures from the 1841 U.S. Almanac went further, suggesting that the total extent of U.S. losses on real estate, stocks, and bank deposits between 1837 and 1841 “approached one billion dollars,” in an economy that itself was only $1.8 billion. But that loss figure cannot confidently be validated.

  Loan data from this period are difficult to obtain and assess, but it appears that loan losses, whether from bank loans, bonds, or other forms, reached as much as an astounding 25 percent to 50 percent of all loans. In a bank, it is a cause of concern if commercial loan losses constitute even 2 percent of the portfolio.

  The financial crisis of 1837 inspired financial modernization. President Van Buren ushered in corrective changes in the U.S. monetary policy. Abandoning the Jackson administration’s “pet banks” system, a U.S. Treasury system debuted in 1840, principally to distribute government monies. It became a fixture in 1846 and ended the era of public funds held in private banks.

  Whigs made bankruptcy legislation a central issue in William Henry Harrison’s 1840 presidential campaign, and in 1841 a Whig-controlled Congress passed the first federal law to allow voluntary bankruptcy, extinguishing $450 million of debt from about a million creditors.60 Although meant to be a curative, this law shocked and confused many holders of this debt, especially British banks and other foreign investors. They were left unsure if their contracts would ever be enforced again. Harrison died after only a month in office, and his vice president and successor John Tyler overturned this law in 1843, much to the Whigs’ dismay.

  Also in 1841, Lewis Tappan created the very first commercial credit reporting agency, the Mercantile Agency, which was a forerunner of Dun & Bradstreet. With this agency, lenders could check on applicants’ solvency. Overborrowing by states and the default of so many state canal bonds led to the prohibition of state bankruptcy and the creation of caps on debt in many states. A number of individual borrowers who were unable to pay—many from Tennessee—fled the United States to the recently established independent country of Texas, slashing the initials GTT (“Gone to Texas”) on their doors as they departed. The Constitution they helped write in their newly adopted state went further than that in the United States to restrict the rights of creditors.

  The devastating depression lasted until 1843, when U.S. GDP growth returned, boosted further by the Mexican American War and the Gold Rush that began in 1848. U.K. GDP resumed its growth in 1844. Lenders can make bad credit judgments in any era, but it would seem that in the earliest years in the establishment of a newly industrial economy, lenders are especially prone to large-scale lending misjudgments.

  But in so many other respects, the underlying dynamic of financial crisis in the 1830s, grounded in overlending and overcapacity, looks very familiar to the series of crises that the next chapter explores. For the next seven decades, a period in which Western economies reached dizzying heights of achievement, it was railroad fever that brought massive waves of speculation. This lending episodically overwhelmed the industrial world, transforming landscapes, filling the countryside with new cities and towns, and driving crisis after crisis.

  CHAPTER 5

  The Railroad Crises Era

  1847–1907

  Perhaps no other invention has transformed the world as dramatically as the railroad, accompanied by its indispensable adjunct, the telegraph. Together, they collapsed the human experience of time and space. They completely consumed, disrupted, and transformed the nations that embraced them. Railroad companies quickly became the largest components of the equity and debt markets of the era, issuing a nonstop flood of new stocks and bonds to finance their capital-intensive enterprises. By 1899, railroads had become 60 percent of the market capitalization of the New York Stock Exchange.1 In 2018, by contrast, no single industry was much more than 20 percent.2

  Railroads, together with the construction of new depots, towns, and farms along their lines, became the biggest single component of the world’s debt, much of it in the form of bonds rather than bank loans. From the Transcontinental Railway to the Orient Express, entrepreneurs and legislators raced to build new railroads. Fortunes were made and lost, and then made and lost again. Railroads involved the biggest names in business and banking, from Cornelius Vanderbilt to J. P. Morgan.3 The legendary Union Pacific Railroad, part of that first transcontinental line, captivated the attention of the world in the 1860s before falling into financial distress in 18734 and then bankruptcy in 1893.5

  Railroads incurred massive debt to establish and maintain their operations, but the debt required for the land sales and housing and commercial construction in the towns and farms along railroad routes was every bit as large, and often larger. A map of the Illinois Central Railroad, the largest railroad when established in 1851, shows the two main track branches (Figure 5.1). The darker areas alongside them are the land grants provided by the government to help finance the company. Two-thirds of the closely spaced towns along these tracks were br
and-new, started by the company to provide buyers for its land and thus funds for its operations and to bring in the people and crops that it would transport. From 1851 through 1856, the number of inhabitants in these towns grew from 13,400 to more than 70,000. In 1856 alone, 3,392 farms were purchased within the land grant area, again largely with debt, bringing the total area under cultivation to more than 1.6 million acres.

  Figure 5.1. Railroad map of Illinois, 1864

  This sprawling, chaotic, debt-financed expansion of hundreds of railroads throughout the industrial world powered global GDP to miraculous heights. In fact, GDP in the United States grew almost sixfold, Britain’s GDP more than tripled, Germany’s grew more than fourfold, and France’s GDP more than doubled during the last half of the nineteenth century. But devastating financial crises followed railroad expansion from the late 1840s to 1907. The reason was simple. In the race to expand, railroads would inevitably build too much, too fast. They created far more capacity than needed and incurred far more costs than projected. Land prices alongside their tracks would skyrocket and then bust, apace. The townspeople along the way would build far too many homes and buildings, and the farmers would start too many farms. Across these countries, there were few constraints and only rare efforts to curb this pell-mell rush. And when the railroads, farmers, businesspeople, and homeowners then found themselves unable to service their debt, lenders and financial markets would collapse. Those markets would only recover as debts were written off and as enough time passed for demand to grow to absorb the overcapacity. As nineteenth-century observer and sociologist E. V. Grabill wrote in regard to the period leading up to the 1873 crisis, “[Rail]roads were constructed in enormous excess of any possible use that the population of the West, though growing rapidly, could make of them for years to come.”6

 

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