#66 The Panic of 1857

As we continue to work our way back in time, understanding the nature of banking and its historical changes grows more complex. For a deep dive, I suggest Murray Rothbard’s A History of Money and Banking in the US, which I will draw from heavily here.

By the 1850s, nearly half of the states in the Union had transitioned to what was called “free banking”. An important distinction here is that “free banking” in the context of the political rhetoric, was not what was traditionally considered free banking by economists at the time.

The system of free banking that existed during this time period allowed the government to afford banks the “general suspension of specie payments whenever the banks overexpanded and got into trouble.” As pointed out by Rothbard.

This means that during times of crisis, banks were no longer liable to redeem their outstanding paper money certificates for the underlying metals. Free banking brought “a myriad of regulations, including edicts by state banking commissioners and high minimum capital requirements that greatly restricted entry into the banking business.”

In this way, competition in banking was heavily stifled by government intervention and normally where overextended banks would fail during a time of liquidation, this liquidation was halted as well.

But even more concerning: “the expansion of bank notes and deposits was directly tied to the amount of state government securities that the bank had invested in and posted as bond with the state. In effect, then, state government bonds became the reserve base upon which banks were allowed to pyramid a multiple expansion of bank notes and deposits. Not only did this system provide explicitly or implicitly fractional reserve banking, but the pyramid was tied rigidly to the amount of government bonds purchased by the bank.”

The effectively meant that a banks ability to expand its credit and monetary base was directly tied to public debt. The more debt it purchased from the government, the more new money it could create and in tandem, the more banks expanded this financial trickery, the more governments could expand their debt as well. This ability to expand credit and essentially soft default on that debt when it came due through the suspension of specie redemption is very important for what came next.

Returning to the panic of 1857, starting in 1848 the American Gold rush was in full swing. A huge supply of new gold was introduced to the market creating strong inflationary signals. Seemingly, economic conditions were good and investors and speculators engaged in rampant over leveraging.

By the mid 1850’s the supply of new gold began to dry up and additionally a large shipment of gold aboard the SS Central America was lost in the midst of a heavy storm. She was carrying approximately 30,000 lbs of gold to the shores of Eastern America at the time!

In the midst of these two deflationary events, the railroad companies booming around the growing westward expansion experienced a speculative stock bubble. Thanks to the abundance of cheap credit (and latent malinvestment) many of these companies were worth considerable amounts of money on paper but had no physical assets with which to run their business. Railroad stock values peaked in July of 1857 and a slow market sell off began.

The subsequent fall out from these events lasted up until the Civil war at which point virtually all specie redemption was stopped. The National Bank Act of 1863 forbade the issuance of any new state bank notes, finally giving a full monopoly of monetary expansion to the federal government.

Book of the Month:

The Road to Serfdom by F A Hayek

-“It is one of the saddest spectacles of our time to see a great democratic movement support a policy which must lead to the destruction of democracy and which meanwhile can benefit only a minority of the masses who support it. Yet it is this support from the Left of the tendencies toward monopoly which make them so irresistible and the prospects of the future so dark.”

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