10.17
Our analysis of booms, busts and panics in the time before the Federal Reserve must begin with the Panic of 1819. That’s where Murray Rothbard started, so that’s where we’ll start as well. He describes this episode as “America’s first great economic crisis and depression.” He explains the idea further by saying that it “was a crisis marked with strong hints of modern depressions; it appeared to come mysteriously from within the economic system itself. Without obvious reasons, processes of production and exchange went awry.” In short, it was a thoroughly modern depression in every sense.
To understand the Panic of 1819 properly, it must be viewed in it’s proper context as being inextricably linked to the war of 1812. War’s are among the most powerful inflationary forces that exist and the war of 1812 was no exception. Governments love to wage war, and to wage a proper war it’s almost always necessary to fire up the printing press and inflate the currency. This is exactly what happened starting in 1811. Banks outside of New England were buying government bonds like mad to finance the war. When it became obvious in 1814 that the outstanding bank notes could not be covered by gold reserves, the Federal government issued a declaration for the suspension of specie payment. This simply meant that, by law, the banks weren’t required to redeem their notes in gold.
CJ Maloney lays it out like this:
Now freed from having to actually raise money (gold) prior to issuing paper promises for it, the banking system’s highly inflationary printing binge went into overdrive. During the war’s three years, domestic prices rose by 25% and import prices by 70%.
From 1811 to 1815, banks multiplied like mushrooms on a dung heap, lending out credit they didn’t have as if it were manna from heaven. Where actual money in bank vaults had decreased by 9.4% during that period, paper bank notes and deposits, all with claims on that money, had increased by 87.2%. Keynes himself would have been proud (Rothbard 2002, p. 73).
All of this led to a, now classic, easy credit consumption binge(sound familiar?) where imports severely outpaced exports. Trade imbalances are a classic symptom of currency debasement. As a country inflates it’s currency, it’s citizens begin to import goods from other countries who haven’t inflated because prices in the non-inflated country are cheaper(again, sound familiar?). People in 1815 were buying everything they could get their hands on, fueled by the moral hazard that the government injected into the system by buying paper debt and suspending gold redemption. There was no central bank yet, but all of the classic checks and balances on free banking that the market imposes had been legislatively removed by Washington. What we got next would just add more fuel to the fire: the second Bank of the United States.
The second Bank of the United States was chartered in 1816 under the auspices of bringing inflation under control. But, of course that’s not what they did:
Instead, the men who ran the new central bank promised not to demand redemption of any state bank paper notes until over one year later. And they bailed out the insolvent state banks with $6 million in taxpayer money. The more things change, the more they stay the same.
To add injury to insult, the men who ran the central bank “jumped on the inflationary bandwagon” themselves (Dupre 2006, p. 271). Printing paper and promises with Bernanke-like abandon, within two years of its creation they had loaned $41 million worth of gold promises and issued paper bank notes redeemable in gold worth $23 million, all on top of just $2.5 million worth of gold (Dupre 2006, p. 270), a level of leverage insane enough to make a Lehman Brothers risk manager feel right at home.
You can, of course see where all of this is heading. A bubble was forming by rampant money printing with no real money(gold) to back it. What began with an attempt to deal with war-time debt blossomed into a full blown credit expansion bubble. What were the effects of this? The same kinds we see today. Exorbitant real estate/land prices, ridiculously low interest rates, rampant speculation into all kinds of wierd business schemes. Easy credit makes people do things they would never ordinarily do. And it was as true then as it is now.
The whole thing came to a head in 1819 when foreign debtors, specifically England and France, were demanding payment in gold from the Bank of the United States. This meant the bank had to call in loans from smaller state banks in order to raise enough specie to pay these foreign debts. But, of course, the smaller banks didn’t have nearly enough gold to cover the amount of paper it had printed either. When this was publicly realized the whole thing collapsed:
When it was realized that many paper bank notes were just that, their values began to collapse, many to zero (the same amount of gold you could get for it), and the money supply contracted at a ferocious rate. From the fall of 1818 to the beginning of 1819, demand liabilities at the central bank fell from $22 million to $12 million (Dupre 2006, p. 272) and the total money supply fell about 28% (Rothbard 2007, p. 89).
Insolvent banks and overextended debtors alike collapsed, while prices, no longer pumped up by the bubble, raced downward to their equilibrium. As the money supply cleansed itself of the bad apples, time and effort had to be paid so that the flow of funds could adjust back to their best uses, following prices as their guideposts. It was a massive, countrywide downturn, and introduced a slowly industrializing America to a new experience — mass unemployment.
So, as you can see, the first true economic disaster of the 19th century was completely enabled by government intrusion into the monetary system and by central banking. Suspension of specie payment led to defacto inflation since banks no longer had to redeem what they printed. This created a scenario of basically hundreds of little federal reserves that were able to inflate like mad. And when the Bank of the United States came into the fray it just accelerated the whole process.
Next time we’ll look at the Panic of 1837.
