Financial panic, that is. With the stock market going up and down like a yoyo, many people are giving in to panic. The irony is that while some panic over the effects of the Covid-19 virus is understandable if not entirely rational, the frenzy over the financial markets is completely irrational. People appear to be confusing the secondary stock market with the primary productive market.
Here’s a surprising fact. The “financial panic” is a fairly recent thing in human history and has an identifiable cause: manipulation of the money supply combined with issuing money not linked to or backed by something of value.
|John Law and the Mississippi Scheme|
The first financial panic of note in modern times was the so-called “Mississippi Scheme” of John Law sponsored by the government of France in the early eighteenth century. The idea was that the development of the Mississippi Valley, then owned by France, could be financed by issuing shares and money backed by the future profits of development.
Two things went wrong. One, instead of concentrating on the potential for trade and agriculture, it was believed that there were significant deposits of gold, silver, and gemstones such as the Spanish had found in their colonies. There weren’t. Two, the speculative frenzy that seized France caused many people to think that the shares in Law’s company and the banknotes backed by the shares, were somehow valuable in and of themselves.
The Regent, duc d’Orleans (after whom New Orleans is named), took over the project and — going directly contrary to the advice of Law — cranked up the printing presses, flooding the country with fiat money. The economy crashed, and France took years to recover.
|The South Sea Bubble|
The English South Sea Bubble was a little different. This time it was not the government, but the private sector that went wild. On the strength of an ephemeral claim to be able to secure a license to trade with the Spanish colonies in the Caribbean and along the Atlantic coast of South America, the “South Sea Company” sold shares that almost immediately started rising in price before any license had been secured.
People went insane for stock speculation, thinking it the easy road to endless wealth. Companies formed for every conceivable reason (even none), floated shares, and collected immense amounts in capitalization to (in one instance and this is not made up) generate sunlight from cucumbers. Everybody and his brother was buying and selling shares in corporations. When the crash came, tens of thousands of people were wiped out — and also found themselves personally liable for the debts of the corporations in which they had invested when the “projectors” who floated the companies took their loot and headed for the continent beyond the writ of English law. (Limited liability was not generally available for English corporations prior to the late nineteenth century except by special act of parliament.)
|The Bubbles of 1825, including the Republic of Poyais|
How about the modern business cycle, which most authorities concede began with the Panic of 1825? The main culprit was (again) government having issued massive debt to finance the Napoleonic Wars instead of borrowing from existing savings. The new “paper pound” was backed by government bills of credit instead of private sector hard assets.
At the same time, there were some shady private sector doings, such as the “Republic of Poyais” organized by the Cacique and Knight of the Green Cross, Sir Gregor MacGregor. The presumed country issued currency and emitted debt that traded on the London Exchange. With both the government and the private sector issuing unbacked paper, the value of shares on the London Exchange plunged when the public lost confidence in the government and in the financial system.
|Hard Times of the 1830s and 1840s|
As for the Panic of 1837, that resulted from the “War on the Bank” when Andrew Jackson got mad at the Second Bank of the United States for not giving a job to a friend of his. Then Nathan Biddle used unethical, possibly illegal means to lock in the Bank’s recharter ahead of schedule to forestall Jackson, whereupon Jackson used unethical, possibly illegal means to remove federal deposits from the Bank and prevent the Bank’s recharter.
Jackson then issued “the Specie Circular,” prohibiting receipt of anything except gold or silver in payment of taxes or for purchases of land from the federal government. As banknotes and credit instruments accounted for 99% or so of the U.S. money supply at the time (and land sales were the single largest source of revenue for the federal government), credit dried up, a depression immediately ensued and lasted until the mid-1840s, capital formation virtually halted, and several states that had heavily invested in infrastructure declared bankruptcy.
|The Panic of 1893|
The Panic of 1873? Banks overextended credit to railroads that went on a building frenzy, temporarily outstripping the market demand for rail transport. Most farmers, ranchers, and western businessmen couldn’t get credit for development the way the railroads and eastern manufacturers could, and demand for transport lagged far behind supply. Railroads couldn’t make debt service payments and failures had a ripple effect throughout the economy. A serious drop in the price of silver due to falling demand also sent shock waves through the economy. This caused the Great Depression of 1873-1878.
The Panic of 1893? The price of silver fell drastically, European investors liquidated their U.S. holdings, demanding payment in gold. Commercial bank gold reserves were depleted as foreign investors refused to accept the inelastic, debt-backed National Bank Note reserve currency. With reserves depleted and no central bank to supply additional reserves combined with an inelastic reserve currency backed only by government debt, commercial bank reserves became inadequate, and the banks began cutting off credit to businesses and calling loans. This caused the Great Depression of 1893 -1898.
|They do start to look a bit alike, don't they?|
The Panic of 1907? J.P. Morgan took the opportunity to shut down a competing bank that had gotten into trouble speculating in copper. He cut off clearinghouse privileges and refused to extend an emergency loan. As panic spread after the rival bank closed its doors, Morgan offered to take over the rival bank’s assets and make good on all its deposits and other obligations, bringing the panic to a halt. He then took credit for stopping the panic he created.
The Panic of 1907, “the Bankers’ Panic,” resulted in the Pujo Commission, the 1913 report of which, Concentration of Control of Money and Credit, was instrumental in the passage of the Federal Reserve Act of 1913. Key goals of the Act were to oversee clearinghouse operations, provide adequate liquidity for agriculture, industry, and commerce, establish and maintain an elastic, stable, uniform, asset-backed reserve currency, and retire the federal debt. (Today’s Federal Reserve still oversees clearinghouse operations and provides an elastic reserve currency.)
|Yeah. 1929. You can tell by the neat vintage cars.|
The Crash of 1929. “The Big One” according to most people. Massive money creation by private sector banks for stock market speculation grossly inflated the value of shares on the secondary market. When speculators panicked, shares plunged in value. This began a monumental sell-off, made worse by the need to meet margin calls on speculative share purchases.
Based primarily on the mistaken belief that commercial loans are made out of reserves, banks immediately stopped extending all new credit for any reason, and were cautious about renewing existing loans to business. Instead of renegotiating loans for a missed interest payment or extending time, banks were forced to “call” loans, i.e., loans became due and payable in full as the result of a single missed payment. The fall in the value of assets used for collateral contributed to the increase in called loans when borrowers couldn’t meet the required ratio of debt to equity.
|Harold Glenn Moulton|
In the opinion of Dr. Harold G. Moulton, president of the Brookings Institution, the Great Depression of 1930-1940 was greatly exacerbated by the Keynesian New Deal intervention and the massive issue of inflationary fiat money backed only by government debt. In Moulton’s opinion, the real economic problem was a temporary overstock of certain consumer durables, coupled with banks cutting off credit to productive businesses as well as to the speculators. The real answer, as he maintained in The Formation of Capital (1935) was to restore a sound money supply, and limit new money creation by the commercial banks to productive business purposes.
Instead, under the influence of Fabian socialism and Keynesian economics, what the U.S. got was a currency backed exclusively by government debt, inflation, growth of government at the expense of the private sector, reliance on past savings to finance growth ossified into political and economic dogma, and the “Depression Within the Depression” of 1936-1937. Instead of a Great Depression lasting five years like the previous ones, it lasted more than a decade, and it took World War II, not Keynesian economics, to end it.
The Housing Bubble. In an old story, massive money creation for home mortgages and a few shady practices among lenders and other financial institutions led to a crash in the housing market that spread to other sectors of the economy and resulted in “the Great Recession.” After nearly two-hundred years of currency manipulation, and the powers-that-be still haven’t figured out that you don’t solve economic problems by making them worse.
Anyway, that’s a very brief summary of financial panics and their aftermath over the past two centuries. In the next posting on this subject we will look at the current panic and discuss what might be done about it.