Topic 1. Part 5.

The Political-Economy of Financial Panics and Bankruptcy 1789-1819

Financial Panics or Crises -- Include a variety

of situations in which some financial assets

suddenly lose a large part of their nominal

value. Main Types:

1)Banking Crisis

2)Speculative Bubbles

3)International Crises

Bank Run

With Fractional Reserve Banking in the 18th and 19th

Centuries, if too many depositors showed up and

demanded their deposits back in specie, then banks with

insufficient reserves and few liquid assets could not

pay all their depositors and they collapsed.

Banking panic

A banking panic is a financial crisis that occurs

when many banks suffer runs at the same time, as

a cascading failure (USA 1933).

Speculative Bubbles

A speculative bubble exists in the event of large,

sustained overpricing of some class of assets. One

factor that frequently contributes to a bubble is

the presence of buyers who purchase an asset based

solely on the expectation that they can later resell it

at a higher price, rather than calculating its Expected

Value (the income it will generate in the future) (USA

Stock market 1927-29; Housing 2001-2007).

International CrisesExamples: A country that maintains a fixed exchange rate is forced to devalue its currency due to a speculative attack (this is how George Soros made a lot of money when he shorted the English Pound – That is, Soros bet that the £ would fall in value against other currencies.)

A country fails to pay back its sovereign debt and defaults (this is pretty common – Argentina is in default now).

The Panic of 1791-1792

Hamilton’s debt securities were so successful that the

market price for the bonds kept going up. In late 1791

William Duer (a friend of Hamilton’s) raised large sums of

money from friends and investors to buy up as many of the

6% Government Bonds as possible and also to start new

banks.

By late January of 1792 the US Government and Private Bank

securities peaked and began to fall precipitately. This

bankrupted Duer and he ended up in Prison.

Hamilton shrewdly had brokers quietly buy up the

Government Securities at reasonable prices and thereby

stopped the panic and stabilized the markets.

For his trouble Hamilton was relentlessly attacked by

Madison and Jefferson.

The Panic of 1797 and The Bankruptcy Act of 1800

USA: Land Speculation Schemes. Investors would issue Private

Securities based on Western Land Claims (the Land was the

collateral). They sold the securities for specie. The idea was

to sell the land at a price high enough to pay off the securities

and make a profit.

Britain: Specie Outflow due to endless Wars. Result was the

Bank Restriction Act of 1797 that halted specie payments. This

caused a severe commercial downturn in the port cities of the USA

and bankrupted most of the Land Speculators.

The Bankruptcy Act of 1800 was the first federal

legislation governing bankruptcy procedures. A result of

the depression of 1797, the act provided only for

1) creditor-initiated proceedings and

2) applied only to traders, merchants, and brokers.

3) After receiving petitions from two creditors

concerning debts of $1,000, a district court judge

could appoint a commission to decide the case.

4) The main provisions of the act allowed the sale of the

bankrupt's assets to satisfy creditors, permitted the

bankrupt to keep a percentage of his assets, and

established that the consent of two-thirds of the

creditors could discharge the bankrupt from any

unsatisfied indebtedness.

Though enacted as a 5-year measure, prosperity

and public dissatisfaction with the act prompted

its repeal in 1803.

The Panic of 1819A Land Bubble and Bank Runs

William Jones, First President of the Second Bank of the United States, 1816-1819

The first major American depression, the Panic of 1819 was

rooted to some extent in economic problems reaching back

to the war of 1812.

1) The Demise of the First Bank of the United States

caused an explosion of State Banks many of whom engaged

in uncontrolled land speculation.

2) During the War of 1812 the Federal Government was

forced to turn to these banks for loans. This had the

effect of adding to the proliferation of paper money

(State Bank notes).

3) This practice tended to shift specie into the more

conservative New England banks, depleting the newer

“Wildcat” State banks of their hard money reserves.

4) The Federal government had to agree to a suspension of

specie payments from state banks in order to prolong the

wartime lending.

5) Politically, it was simply not possible to resume

specie payments in the war’s aftermath, allowing old and

new banks to profitably lend without regard to their

metallic currency reserves. The economy was booming with

large increases in the population of the “Western” States.

6) Because of the economic difficulties revealed by the

War of 1812 – lack of transportation infrastructure,

manufacturing, uncontrolled banking – leading merchants

and financiers, Stephen Girard, John Jacob Astor, David

Parish – along with major Jeffersonian political leaders

John C. Calhoun, Henry Clay, and James Monroe advocated

re-establishing the Bank of the United States. A bill was

proposed in January 1816 and signed by President Madison

in April 1816.

7) Under its charter guidelines, the BUS was expected to

acquire species totaling $28 million by the time it opened

for business; but with only $2 million secured when it

commenced operations, the Bank was compelled to purchase

species at usurious rates from the London financial

markets in 1817 and 1818, overburdening BUS credit. In

addition by 20 February 1817 the Bank was supposed to

resume Convertibility – that is a return to specie banking

of BUS notes. This was delayed for political reasons.

8) The 18 branch offices of the BUS in 1817 operated with

little oversight from the Philadelphia headquarters, nor

from the US Treasury. Indeed, they poured gasoline on the

fire by flooding the West with BUS issued notes. This had

the effect of draining even more specie from the well run

State Banks and some of the BUS branches in the Northeast.

By July 1818, the Second Bank of the United States had

demand liabilities exceeding $22.4 million, whereas its

species fund stood at $2.4 million. This was simply

unsustainable.

9) The Dam broke in August 1818 when William Jones ordered

BUS branch offices to reject all state-chartered bank

notes, with the exception of those used as revenue

payments to the US Treasury. In October 1818, The US

Treasury demanded a transfer of $2 million in species from

the BUS to redeem bonds on the Louisiana Purchase.

10) State banks in the West and South, unable to provide

the required specie, began to call in their loans on the

heavily mortgaged lands they had financed. Cash poor

farmers and speculators found their land values dropping

50% to 75%. Banks began foreclosing on the properties and

transferring them to their creditor: the Second Bank of

the United States. Adding to the problem was the fall in

the price of Cotton on the London exchanges. The

combination of these events produced the Panic of 1819 and

plunged the USA into a Depression.

11) In 1819 Langdon Cheves was elected President of the

BUS, and during the next three years succeeded in

restoring its credit through a rigorous tight money

policy. The problem is that it deepened the Depression.

Through public land debt relief legislation, Cheves

managed to reduce the Bank’s land debt by $6 million

within a year of assuming his position as BUS President.

By 1821 specie reserves had risen to $8 million by 1821

and bank notes in circulation were reduced by about $23

million within a span of four years from 1816 – 1820.

Langdon Cheves: President of the Second Bank of the United States from

1819-1822

Table 1a. The Inclusion of New States

State Admitted Slavery

Status Total Free

States

Total Slave States

Population at Entry

US Population at Previous

Census Original 13 1787-1790 See

Notes 7 6 3-4,000,000

Vermont 1791 Free 8 6 92,329 3,929,214 Kentucky 1792 Slave 8 7 103,133 3,929,214 Tennessee 1796 Slave 8 8 77,638 3,929,214 Ohio 1803 Free 9 8 100,984 5,308,483 Louisiana 1812 Slave 9 9 91,926 7,239,881 Indiana 1816 Free 10 9 98,115 7,239,881 Mississippi 1817 Slave 10 10 62,205 7,239,881 Illinois 1818 Free 11 10 46,625 7,239,881 Alabama 1819 Slave 11 11 116,016 7,239,881 Maine 1820 Free 12 11 298,335 9,638,459 Missouri 1821 Slave 12 12 73,973 9,638,459

Arkansas 1836 Slave 12 13 70,700 12,886,020 Michigan 1837 Free 13 13 158,079 12,886,020 Florida 1845 Slave 13 14 70,961 17,069,453 Texas 1845 Slave 13 15 212,592 17,069,453 Iowa 1846 Free 14 15 132,573 17,069,453 Wisconsin 1848 Free 15 15 360,577 17,069,453 California 1850 Free 16 15 92,597 23,191,876 Minnesota 1858 Free 17 15 138,834 23,191,876 Oregon 1859 Free 18 15 48,428 23,191,876 Kansas 1861 Free 19 15 132,925 31,443,321 West Virginia 1863 Free 20 15 296,286 31,443,321 Nevada 1864 Free 36 0 21,111 31,443,321 Nebraska 1867 Free 37 0 94,747 31,443,321 Colorado 1876 Free 38 0 132,542 39,818,449 North Dakota 1889 Free 39 0 175,576 50,155,783 South Dakota 1889 Free 40 0 323,567 50,155,783 Montana 1889 Free 41 0 132,548 50,155,783 Washington 1889 Free 42 0 329,020 50,155,783 Idaho 1890 Free 43 0 88,548 62,947,714 Wyoming 1890 Free 44 0 62,555 62,947,714 Utah 1896 Free 45 0 250,361 62,947,714 Oklahoma 1907 Free 46 0 1,396,900 75,994,575 Arizona 1912 Free 47 0 230,000 91,972,266 New Mexico 1912 Free 48 0 333,600 91,972,266 Alaska 1960 Free 49 0 226,000 178,464,236 Hawaii 1960 Free 50 0 633,000 178,464,236 Notes: In 1776, slavery had been abolished in only 2 of the original 13 states. By 1849, it had been abolished in all of the 7 “free” states among the original 13. However, abolition was often restricted only to those born after a certain date. In 1860, 18 slaves remained in New Jersey, a “free” state. (Freehling, 1990, pp. 133, 480). Slavery also existed in the form of “black apprentices” in the “free” states. Apprentices continued in Illinois until 1824 (Freehling, 1990, p. 149). President Lincoln’s Emancipation Proclamation of 1863 freed slaves only in Confederate states but, for simplicity, all states are treated as “Free” beginning in 1864. Slavery was ended in all of the United States by the 13th amendment, ratified 18 December 1865. Source for population figures, Stewart and Weingast, 1992, p. 256, Morison and Commager, 1950, p. 790.