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April 22, 2008

Eternal Recurrence, American Style

Friedrich von Blowhard writes:

Dear Blowhards,

I’ve been reading Sean Wilentz’s “The Rise of American Democracy,” a political and social history of antebellum America. I’m enjoying it immensely. I’m not done with it – I’m only up to Jackson or so – but I can make two observations:

(1) American political and economic life seems to have certain patterns that repeat over and over again. It’s as though America is an instrument that only vibrates at certain pre-set frequencies. Sometimes we vibrate on one frequency, sometimes on another, but there’s a very small fixed number of notes that we can sustain for any length of time.

(2) The way these apparently fixed patterns played out a couple centuries ago was, by and large, more entertaining than in our contemporary America.

To see an example of this American ‘eternal recurrence’, take a look at the similiarities between our current economic impasse and the Panic of 1819. According to Wilentz:

Under the financial stresses of [the War of 1812], state-chartered banks had suspended specie payments, which meant they could issue the equivalent of paper money in bank notes to borrowers without regard to the amount of gold or silver coin the banks actually held in their vaults. The suspension continued after peace returned, allowing established banks to make large dividends by extending loans and note issues far in excess of their specie reserves, and permitting new private banks to open with only tiny amounts of borrowed specie on hand and indulge in profligate lending of their own notes.

Gee, it sounds a lot like modern day financial innovation to me! For the last decade or so, banks in modern-day America have made record profits by using tricks -- oops, I mean sophisticated financial techniques -- like securitization and off-balance sheet entities that allow them to do much more lending with much less capital. (And those new banks starting up in the latter 1810s and jumping into the game are clearly the forerunners of today's hedge funds.) In the 1810s, banks kept their capital in the form of gold and silver (i.e., 'specie'), and made their loans in the form of bank notes, essentially paper money. Today's banks no longer need to worry about keeping enough gold or silver in the vault but via financial innovation they've gotten us to exactly the same place -- an excessive expansion of lending which has escaped any prudent relationship with the bank's underlying capital, leading inevitably to borrowers indulging in wild speculative buying and selling of assets at ever increasing prices. Just like in 1817:

With so much bank paper of dubious value forced into general circulation, the nation’s economic health was threatened by a large and growing bubble of speculation.

Hey, it sounds like sub-prime mortgages and CDOs all over again! Wait a minute, I guess it's the other way around. Anyway, this orgy of speculation took place against the increasing global trade that sprang up at the end of the Napoleonic Wars:

Britain’s warehouses [in 1815] were bulging with manufactured goods, which, with the coming of peace, the British dumped on the American market, overwhelming the protectionist tariff measures enacted by Congress in 1816 and threatening American manufacturers...These difficulties were masked by a dizzying climb in agricultural export prices, sparked by European crop failures and by a seemingly limitless British demand for American short-staple cotton, now easily grown throughout the American south. A speculative boom in American land and cotton ensued, fueled by the riotous proliferation of state-chartered banks...

An American manufacturing crisis! Covered up by an American real estate boom! (Hmmm...who ever heard of that exact combination before?) But not to worry, everything was under control, because the antebellum USA had its own version of the Fed:

[The Bank of the United States], however...could curb the inflation by reinstating specie payments -- that is, by regularly presenting the state bank notes it received back to the state banks and demanding specie in return, thereby compelling the banks to reduce their vastly inflated loans and note issues. Acting as a financial balance-wheel, the national bank would, in principle, keep currency values and capital markets stable, and prevent national economic expansion from turning into an orgy of overspeculation and runaway inflation.

Unfortunately, the Fed of the 1810s, the Bank of the United States, was apparently run by a previous incarnation of Easy Al Greenspan, known in his former life as William Jones. Even two centuries ago, this guy was a pretty lame regulator of banks:

Rather than force state banks to curtail their inflated emissions of notes and loans, Jones approved lavish lending, especially by [the Bank of the United States’] new branches on the western urban frontier. By putting so many BUS notes into circulation, Jones abdicated the leverage he had had over the states banks early in 1817 -- for no longer could the national bank demand specie payments without being pressed for such payments in return.


Alan Greenspan in a Former Life, a.k.a William Jones

Sadly, even with Jones…or Greenspan…in charge, pumping out credit like there was no tomorrow, things couldn’t go on their merry way forever:

Unnoticed at the time, however, was a growing shortage in available specie due to political unrest in Mexico and Peru...which in turn put a downward pressure on commodity prices. That pressure, coupled with the recovery of European agriculture and increased British imports of East Indian cotton, sent prices of American goods tumbling in 1818, and burst the speculative bubble. American staple prices and land values dropped by anwhere from 50 to 75 percent, and backward the dominos fell, from ruined speculator to merchant to farmer.

Darn, and that nice Jones/Greenspan guy had been so sure that cotton prices in the 1810s, like home prices in the 2000s, couldn’t go anywhere but up. Bummer. But I seem to remember something about people who refuse to learn from history being doomed to repeat it...

As for my second observation (about how things were more entertaining back a couple of centuries), I will use as an example the legal developments in Kentucky after the Panic. Per Mr. Wilentz:

Kentucky, once the richest state west of the Alleghenies, had been hit hard by the panic and rendered a virtual creditor’s protectorate. The downturn’s effects lingered into the early 1820s. A so-called Relief Party, after winning a commanding legislative majority in 1819, enacted several pro-debtor measures: abolition of imprisonment for debt, laws greatly extending the time granted to repay creditors, and, above all, replacement of the...Bank of Kentucky with a special relief bank, The Bank of the Commonwealth, empowered to issue massive amounts of inflationary paper money. Creditor interests, aghast, appealed to the state judiciary, which, after the hard times lifted in 1823, declared the laws unconstitutional -- moves that the aroused legislature denounced as both economic ruinous and an attack on the electorate...[When] another pro-relief majority was returned to the legislature [in 1824, it] passed a reorganization bill that created an entirely new court of appeals, friendlier to the state's hard-pressed small farmers. But the members of the established court refused to stand down...creating a constitutional crisis of the first order.

This sparked a huge and fight, which the 'old court'-banker party ultimately won because they had greater financial resources. Still, the spectacle of two branches of government going head to head in this fashion is pretty entertaining. I say, let's get the differences out in the open! The wild-and-wooly tone of the whole affair is well encapsulated by a choice tidbit about the Relief-Party legislative leader who pushed the new court system:

The new [post-1824 Kentucky] legislature [was] led by a rugged, self-made ex-congressman named John Rowan -- who had once killed a man in a duel over who was the greater master of classical languages...

Well, I guess in those days, at least one thing was different from today: they certainly took their classical languages more seriously!



posted by Friedrich at April 22, 2008


I appreciate the time and thought you put into your posts, but here's one of my problem with economics.

Why is a gold-backed dollar any more stable than mere paper money? Let's say that I'm the government and I say that a $1 dollar bill is equivalent to one gram of gold. But isn't the valuation of one gram of gold ultimately arbitrary? I could say it's worth 1, 5, or ten dollars.

To me even fundamentals like this seem arbitrary and abstract.

Posted by: Peter L. Winkler on April 23, 2008 3:53 AM

Mr. Winkler:

In the case of your example, you can set the ratio between your unit of money and your unit of gold any way you like. However, once you've set it at one level, I think you'd find people would draw conclusions if you changed that ratio.

In any event, the purpose of this post wasn't to argue for a return to the gold standard or some other metallic standard. (Although historically your are correct, there was a strong push for a hard money regime and a revulsion against banks in the aftermath of the Panic of 1819.) It was to point out that when there is an explosion of lending relative to bank capital, the result is usually to encourage speculative trading in non-monetary assets, such as land. Because such speculative frenzies feed on themselves (people see other people making a fortune and want to get in on the game), eventually such speculation becomes unsustainable and crashes. The high asset values collapse, but the debt taken out to buy them remains, sadly.

It's sad that we're suffering a hangover from yet another bout of such easy credit-induced speculation, nearly two centuries after the Panic of 1819.

Posted by: Friedrich von Blowhard on April 23, 2008 9:09 AM

"Under the financial stresses of [the War of 1812]": which, to continue the analogy, was an American war of aggression launched under a pretext that was deeply dishonest.

Posted by: dearieme on April 23, 2008 12:09 PM

I don't know a damned thing about this subject!

Wouldn't it be a much better world if people would admit, from time to time, that they just don't know shit about certain subjects?

I'm completely ignorant of almost all large scale financial subjects... and I admit it.

Posted by: Shouting Thomas on April 24, 2008 11:44 AM

I couldn't help noticing the parallels, also. Nice job!

Posted by: Jason Pappas on April 28, 2008 8:30 PM

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