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Does This Happen Often?

Monday, October 6, 2008

A look back at the financial crisis of 1836, which triggered America’s first protracted depression.

On September 16, 1920, shortly before noon, a horse and wagon pulled up in front of the Morgan Bank at the corner of Wall and Broad streets and exploded. Five hundred pounds of cut-up sash weights turned into shrapnel. Thirty people on the street were killed instantly; ten more died later from their wounds. All that was left of the wretched horse were his two front hooves, found a block away on the steps of Trinity Church.

The windows of the Morgan Bank were shattered and the limestone facade was scarred by the sash-weight pieces. (The scars were left unrepaired and can still be seen.) But because the windows had recently been screened on the inside, only two men in the bank were killed.

A French general who had been talking with some Morgan partners in an ornate conference room was stunned into silence by the explosion. But as the noise of the blast faded away and the tinkling of glass was replaced by the moans of the wounded, he looked around and asked, “Does this happen often?”

The same question might well be asked about the current financial crisis. The answer is: yes, roughly once a generation.

While each Wall Street crisis is unique, human nature remains constant. It is often said that there are only two emotions on Wall Street, greed and fear, and that when the mood changes suddenly from the former to the latter the result is panic. There were major panics on Wall Street in 1792, 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987, and now 2008.

Much like the 2008 meltdown, the 1836 crisis occurred after a huge real estate crash.

In each case, Wall Street forgot that the laws of economics are as ineluctable as Newton’s law of universal gravity. (It seems politicians will never learn this.) Prices do not rise forever, risk must always equal reward, and supply and demand must balance each other over the long term. Our current crisis emerged after Wall Street acted as though housing prices would continue rising inexorably, and after the government-backed housing giants Fannie Mae and Freddie Mac created trillions of dollars worth of an economic oxymoron: a high-yield, no-risk investment called mortgage-backed securities.

Much like the 2008 meltdown, the 1836 crisis occurred after a huge real estate crash. In the early 1830s, settlers were pouring into the West and buying land from the Government Land Office (GLO), as were increasing numbers of speculators. Land prices rose swiftly. The speculators borrowed from local banks to maximize their leverage, counting on the rising prices to guarantee them a profit despite the interest costs.

The GLO had sold $2.5 million worth of land in all of 1829, but by the summer of 1836 it was selling $5 million worth of land each month. Local banks, many of them woefully undercapitalized and poorly regulated, proliferated. President Andrew Jackson was partly responsible for this: his destruction of the Second Bank of the United States (BUS) had removed the primary source of discipline in the banking system, and his transfer of federal deposits from the BUS to state banks (which were dubbed “pet banks”) had allowed those banks to greatly increase their lending to speculators.

But Jackson was a good Jeffersonian, and he hated speculation, paper money, and banks. Probably unaware of his own role in fueling the real estate boom, he wanted to end it. Jackson faced stiff opposition both from U.S. lawmakers and from members of his own cabinet, many of whom were profiting handsomely from speculation. But as soon as Congress adjourned for the year in July 1836, Jackson issued an executive order requiring the GLO to accept only specie (gold and silver), not bank notes, as payment for land.

If the federal government acts with dispatch and wisdom—two commodities that can be hard to come by in Washington—the current crisis should have only moderate macroeconomic consequences.

The Specie Circular, as it was called, brought the speculation to a screeching halt; unfortunately, it also triggered an economic disaster. As Americans exchanged their bank notes for gold and silver, western banks had to call in loans to stay liquid. In a vicious cycle, the western banks drained specie out of the larger eastern banks, forcing the latter to call in their loans, too. Interest rates, which had hovered around 7 percent a year, rose to 2 percent and 3 percent a month. The weaker banks began to collapse, and the credit crunch caused manufacturing to falter.

The boom had turned to bust. By April 1837, New York City diarist (and former mayor) Philip Hone wrote in his journal that “the immense fortunes which we heard so much about in the days of speculation, have melted likes the snows before an April sun.” Government revenues in 1837 were half of what they had been the previous year. Several state governments were forced into default when they were unable to roll over their bonds. The country entered its first protracted depression.

Will the same thing happen this time? Probably not. If the federal government acts with dispatch and wisdom—two commodities that can be hard to come by in Washington—the current crisis should have only moderate macroeconomic consequences. Individual people and corporations have been and will be badly burned. But our economic fundamentals—including agriculture, exports, and employment—remain strong. And history tells us that, over the long term, nobody has ever made money selling the U.S. economy short.

John Steele Gordon is the author of An Empire of Wealth: The Epic History of American Economic Power (HarperCollins).


Image by Getty Images/The Bergman Group/Darren Wamboldt.


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