Lessons from the Panic of 1873

The U.S. suffered a severe economic depression in 1873. Like today’s recession, the 1873 crisis was mainly caused by unsound banking policies and the overexpansion of government-backed businesses. Did politicians then try the same remedies that are being tried today? No!

The panic’s roots were in the Civil War, which had ended just eight years before. Along with the vast changes in society, culture, and politics that took place during the war came immense changes in banking and finance. These economic changes have produced consequences that led to a depression in the 1870s and are still felt today.

During the war, a nationalized banking system was created, in which state and private banks were required to join the national system or else pay heavy taxes. This system, the forerunner of today’s Federal Reserve, enabled politicians to centralize banking power in Washington. This also allowed Wall Street to exert greater influence on the economy.

A nationalized paper currency was also introduced. Before the war, state banks issued their own currencies and the currency value was guaranteed by the specie (i.e., gold or silver) those banks had on reserve. The new paper money was not backed by specie, which allowed the U.S. Treasury to print as much as was needed to fight the war. However, the massive influx of new money into the economy led to rampant price inflation.

Also during the war, the federal government began granting large amounts of taxpayer money (known today as “pork barrel spending”) to businesses for the first time. Railroads were the main recipients, as rail companies were given land and subsidies to build new rail networks, including an historic transcontinental route. Like most “pork barrel spending,” allocations were based on politics rather than business, which largely resulted in waste, inefficiency, and corruption.

When the Bubble Bursts…

The railroad industry boomed after the war. In fact, government subsidies and land grants made the boom much larger than it should have been. Investors, speculators, and banks hurried to join in by investing hundreds of millions of dollars in the industry, which further increased the false prosperity. Within a decade, railroad supply had far exceeded consumer demand. The bubble caused by the railroad boom was bound to bust.

The bust happened in September 1873. Jay Cooke & Company, one of the largest national banks in the U.S., declared bankruptcy when its heavy railroad overinvestment crashed. In the decentralized banking era before the Civil War, this bank’s failure would not have had such a large impact on fellow banks. However, under the new nationalized banking system, in which most of the nation’s major banks were financially linked, Cooke’s failure caused a chain reaction of bank failures throughout the country.

The banking failures caused a stock market crash, forcing the New York Stock Exchange to close for 10 days. As stocks became worthless, businesses were forced to close down. This led to drastic increases in unemployment and poverty.

Inflation is the Cure?

By the end of 1873, over 5,000 businesses worth over $200 million had failed. Wages were cut by over 25 percent and nearly one million industrial workers lost their jobs. Of the nation’s 364 railroads, 89 declared bankruptcy. This was known as the “Great Depression” for many years until a bigger one happened in the 1930s.

Like today, heated debate ensued in Washington over how to address the crisis. This debate produced the Inflation Bill, under which $18 million in paper money would be printed to stimulate the economy. This was similar to the “stimulus” signed by President Obama in 2009, which pumped nearly $1 trillion into the economy. However in 1873, President Ulysses S. Grant knew what Obama has not yet learned—printing money out of thin air cannot stimulate an economy; it can only spread misery more evenly. Grant vetoed the Inflation Bill.

Grant was harshly criticized for failing to provide help for those most in need. But while inflation may have helped in the short term, it is highly damaging in the long term because it increases the cost of living through higher prices. The veto actually kept the crisis from getting worse. This differs from Obama’s “stimulus,” under which unemployment has actually risen since its enactment.

In 1875, Grant further angered stimulus supporters by signing a bill into law stopping the further printing of paper money and backing the paper money in circulation with gold. Opponents argued that more money needed to circulate to restore prosperity. However, this argument fails to acknowledge that government, which had mismanaged the economy into a depression in the first place, should not be empowered to print and potentially mismanage even more money.

In the 1870s, Grant’s efforts to curb inflation and stabilize the currency with gold were painful but necessary corrections in an economy that had been poisoned by bad investments, excessive paper money with little worth, and crony capitalism between government and business. The pain caused by these corrections reduced the long-term pain, which is primarily why this severe depression lasted only six years.

Lessons for Today

Government-backed railroad expansion, unbridled Wall Street speculation, and the nationalization of finance led to a depression in 1873. Government-backed housing expansion, unbridled Wall Street speculation, and the Fed’s control over interest rates and the money supply led to a crash in 2007 that could very well become a depression.

Today, banking is centralized in the Federal Reserve, which has consistently kept interest rates below market levels to encourage economic growth. However, artificially low interest rates often encourage businesses to borrow too much and save too little.

The Fed has also introduced Quantitative Easing 1 and 2, which were programs to buy toxic assets, bail out favored businesses on the verge of failure, and print more money. The price inflation caused by these schemes has already begun, and could very well get worse in the coming years.

Like the railroads in the 1870s, the housing market boomed in the early 21st century thanks to government-backed companies such as Fannie Mae and Freddie Mac that are required to offer subprime mortgage loans. This led to a housing bubble that burst in 2007, just as the railroad bubble burst in 1873.

Like 1873, the bust of 2007 led to a banking crisis. However, while big banks were forced to either cut back or go under in the 1870s, today’s big banks were bailed out by taxpayers under TARP (Troubled Asset Relief Program) because they were “too big to fail.” Thus, an economic crisis caused by crony capitalism between government and business was addressed by increasing the crony capitalism.

To restore the U.S. economy today, individuals and corporations must do as they did in the 1870s: work harder, spend less, and save more. This applies to government as well—Washington must reduce borrowing and spending, pay down debt with incoming revenue, and eliminate as many programs and departments as possible. If this is not done, then any perceived “recovery” will only be another bubble just waiting to burst once more.