We are nearly finished with our series covering each of the financial panics in the US prior to the Great Depression. We’ve identified, through our look at history, what I believe to be a string of repeated, identifiable events. Before we get into today’s topic, let’s recap.
The US government has a political imperative to spend more than it has, and thus issues bonds. Bonds are bought up by private and state banks and then held as collateral (given that they are technically positive yielding financial instruments with a “guarantee” of zero risk of default). This collateral is then borrowed against as a way for banks to expand credit and bank note issuance. Monetary expansion than brings about artificial financial booms, encouraging rampant speculation, much of this speculation is mal-investment.
Expansion of credit and bank notes falters and/or black swan economic events occur, putting severe deflationary pressure on credit and asset markets. Large scale economic bust occurs at the tail end of the inflationary cycle, deflationary credit contractions and mass liquidations (redemption of specie) occurs as individuals fear bank insolvencies. The US government (nearly every-time) suspends redemption of specie to keep banks solvent and draw out liquidation process. Thus, my theory is that Executive Order 6102 and the creation of the Federal Reserve were financial engineering methodologies specifically intended to permanently curb liquidation (redemption of specie) pressure on banks which the Federal government was using to expand its access to credit and ability to increase spending. Recall that the last time the US government did not have outstanding debts was under Jackson.
We’ve actually already touched on some of the history surrounding today’s topic. The phrase, “not worth a continental” draws its origin from the massive amounts of unbacked paper currencies which were issued by the Continental Congress in order to pay for debts incurred during the American Revolution.
The First National Bank of the United States was signed into Charter by Washington (under the direction of Alexander Hamilton) which set in motion a massive inflationary speculative boom. Private investors were allowed to purchase stock in the national bank, however only 1/4 of the cost had to be paid in specie (gold and silver), the other 3/4 of the cost were to be paid in government debt securities. Of course, this led to rampant speculation surrounding National Bank stock, and it was ultimately unsustainable, the speculation would’ve liquidated itself had it been allowed to run its course.
However, Alexander Hamilton worked closely with a New York Financier (William Seton) to authorize the purchase of $150,000 of public debt with government revenue. A first great step in the marriage of government and private enterprise. By 1792 the expansion of credit made available to speculators by the Bank of the United States (in excess of $2.17 million) nearly bankrupted the Bank of New York, from December 29 to March 9, cash reserves for the Bank of the United States decreased by 34%, prompting the bank to not renew nearly 25% of its outstanding debt.
Speculators were then forced to sell off securities in order to satisfy outstanding debts and the deflationary contraction began. Hamilton then authorized an additional $100,000, in march, in open-market purchases of securities and heavily encouraged the bank of New York to continue offering loans collateralized by US debt securities. Hamilton also promised the Treasury would buy up to $500,000 of securities from the Bank of New York. Thus staving off the liquidation for a short time.
The following few years were characterized by rampant speculation and malinvestment in bank stock, government debt securities, and paper land claims (corresponding to west ward expansion). As is typical, new credit and capital dried up (these inflationary schemes never do seem to last) as a war torn Europe grew weary of American speculative instruments and paper land claims began to depreciate in value rapidly.
In 1797, British Parliament suspended redemption of specie (which lasted until 1821!) and the complete undoing of the speculative credit expansion and paper financial instrument bubble followed.
A major commercial downturn occurred in the American port cities as international trade slowed to a crawl. And I wish I could say everyone learned from their mistakes, but I suppose I’ve already spoiled that particular literary device by telling this story backwards. Oops.
-CollinThe Road to Serfdom by F A Hayek
-“There can be no doubt that the promise of greater freedom has become one of the most effective weapons of socialist propaganda and that the belief that socialism would bring freedom is genuine and sincere. But this would only heighten the tragedy if it should prove that what was promised to us as the Road to Freedom was in fact the High Road to Servitude. Unquestionably, the promise of more freedom was responsible for luring more and more liberals along the socialist road, for blinding them to the conflict which exists between the basic principles of socialism and liberalism, and for often enabling socialists to usurp the very name of the old party of freedom. Socialism was embraced by the greater part of the intelligentsia as the apparent heir of the liberal tradition: therefore it is not surprising that to them the idea of socialism’s leading to the opposite of liberty should appear inconceivable.”
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