Sunday, March 19, 2017

New York Fed: "Crisis Chronicles: The Long Depression and the Panic of 1873"

From the Federal Reserve Bank of New York's Liberty Street Economics blog, February 5, 2016:
It always seemed to come down to railroads in the 1800s. Railroads fueled much of the economic growth in the United States at that time, but they required that a great deal of upfront capital be devoted to risky projects. The panics of 1837 and 1857 can both be pinned on railroad investments that went awry, creating enough doubt about the banking system to cause pervasive bank runs. The fatal spark for the Panic of 1873 was also tied to railroad investments—a major bank financing a railroad venture announced that it would suspend withdrawals. As other banks started failing, consumers and businesses pulled back and America entered what is recorded as the country’s longest depression.

Westward Ho!
Formed in 1861, Jay Cooke & Co. was a bank that achieved fame and fortune by aggressively marketing government bonds during the Civil War. By 1869, it had expanded into financing railroads, specifically the Northern Pacific Railway that would link Duluth to Seattle. The line would be part of a transcontinental system that would carry goods from the Pacific Coast to the Great Lakes and then to Europe. Unfortunately, the project was plagued by mismanagement and construction challenges, and a growing funding gap made more challenging by the Credit Mobilier scandal.

In that case, the Union Pacific Railroad got caught using a shell company, Credit Mobilier, to inflate costs to maximize government subsidies for building the line. The revelation of this deception in 1872 damaged investor confidence in railroads and made Congress much less willing to support new railroad construction, including by the Northern Pacific.

Jay Cooke & Co. knew it was sinking at least a year before it suspended payments. “In the fall of 1872, the London partner Fahnestock observed that it was cruel to the depositors to use their money to support Northern Pacific bonds, and that the railroad should go to the market to borrow at any prices. The near panic in September 1872 made this impossible.” (Kindleburger in Crashes and Panics, p. 80)

The firm kept bleeding money and on September 18, 1873, suspended deposit withdrawals from its New York and Philadelphia offices (houses) with the following announcement: “The immediate cause of suspension of Jay Cooke & Co. was the large drawing upon them by the Philadelphia house and their own depositors during the last fortnight. Both houses had suffered a large draw upon their deposits in consequence of the uneasy feeling which has recently prevailed, and which has affected, more or less, all houses closely identified with new railroad enterprises.”

The announcement caused pandemonium on Wall Street:

The first intimation which came into the Stock Exchange of any change in the programme was contained in a brief notice, which said authoritatively that Jay Cooke & Co. had suspended payment. To say that the street became excited would only give a feeble view of the expressions of feeling. The brokers stood perfectly thunderstruck for a moment, and then there was a general run to notify the different houses in Wall street of the failure. . . . The members of the firms who were surprised by this announcement had no time to deliberate. The bear clique was already selling the market down in the Exchange, and prices were declining frightfully. . . . Some of the men who were ruined swore, some of them wept, some went out of the street without saying a word; others talked of the trouble in a jovial way and went about trying to borrow money from friends. . . (New York Times, September 19, 1873)
The Fallout
The panic led to bank runs and bank failures, followed by commercial bankruptcies and unemployment so severe that the downturn was called the Great Depression at the time. It lasted so long, more than five years, that it is now known as the Long Depression. Those were miserable years for many, including veterans....MORE