The Real Great Depression (Panic of 1873)

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Submitted by greekfire on October 6, 2008 - 7:45pm

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The depression of 1929 is the wrong model for the current economic crisis

By SCOTT REYNOLDS NELSON

Editor's Note: I caught up with Professor Scott Nelson at his office at the College of William and Mary in Williamsburg, Virginia last week. As I write my book on the economy and where it's headed I'm always glad to talk to a historian to get a professional's perspective and share notes. I assert in my book that as serious consumer demand and financial crisis led depressions go, the one that is developing will be epic. However, our current period is unlike the pre-1930s depression era. That depression was triggered by the crash of 1929 but primarily caused by bad monetary policy that exacerbated the debt deflation that followed from consumer over-indebtedness. Weakly structured consumer lending and manufacturing sectors led a sudden decline in consumer purchasing power. Demand crashed. The US depression was then quickly transmitted throughout the world via financial markets, then more slowly through disturbances in trade, which were multiplied by politically motivated disastrous trade policies, and finally war.

Our current episode has more in common with the 1870s depression which, as Nelson notes, was considerably worse. It was primarily caused by over-indebtedness in the commercial real estate sector, which mortgages were based on new forms of financing which were intermingled on the balance sheets of commercial banks with less rarefied assets that the banks added by making business loans. The era, as the poster to the left depicts, was one of broad based public participation in credit financed asset price inflation and speculation. When the commercial real estate market crashed, it took down the banks and caused the market for commercial credit to seize up, much as we are seeing today. Small businesses were hit especially hard. Unemployment spiked and a severe and lengthy depression ensued as financial markets throughout the world suffered, followed by international trade. The crisis emanated from Europe. It was the beginning of the end of Europe's dominance as the center of global economic power. Read on for the full story. Sign up here to be notified when my book is published. - Eric Janszen

As a historian who works on the 19th century, I have been reading my newspaper with a considerable sense of dread. While many commentators on the recent mortgage and banking crisis have drawn parallels to the Great Depression of 1929, that comparison is not particularly apt. Two years ago, I began research on the Panic of 1873, an event of some interest to my colleagues in American business and labor history but probably unknown to everyone else. But as I turn the crank on the microfilm reader, I have been hearing weird echoes of recent events.

When commentators invoke 1929, I am dubious. According to most historians and economists, that depression had more to do with overlarge factory inventories, a stock-market crash, and Germany's inability to pay back war debts, which then led to continuing strain on British gold reserves. None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines; our current stock-market dip followed bank problems that emerged more than a year ago; and there are no serious international problems with gold reserves, simply because banks no longer peg their lending to them.

In fact, the current economic woes look a lot like what my 96-year-old grandmother still calls "the real Great Depression." She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral. The most marvelous spots for sightseers in the three cities today are the magisterial buildings erected in the so-called founder period.

But the economic fundamentals were shaky. Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export train loads of wheat to abroad. Britain, the biggest importer of wheat, shifted to the cheap stuff quite suddenly around 1871. By 1872 kerosene and manufactured food were rocketing out of America's heartland, undermining rapeseed, flour, and beef prices. The crash came in Central Europe in May 1873, as it became clear that the region's assumptions about continual economic growth were too optimistic. Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

As continental banks tumbled, British banks held back their capital, unsure of which institutions were most involved in the mortgage crisis. The cost to borrow money from another bank — the interbank lending rate — reached impossibly high rates. This banking crisis hit the United States in the fall of 1873. Railroad companies tumbled first. They had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.

The long-term effects of the Panic of 1873 were perverse. For the largest manufacturing companies in the United States — those with guaranteed contracts and the ability to make rebate deals with the railroads — the Panic years were golden. Andrew Carnegie, Cyrus McCormick, and John D. Rockefeller had enough capital reserves to finance their own continuing growth. For smaller industrial firms that relied on seasonal demand and outside capital, the situation was dire. As capital reserves dried up, so did their industries. Carnegie and Rockefeller bought out their competitors at fire-sale prices. The Gilded Age in the United States, as far as industrial concentration was concerned, had begun.

As the panic deepened, ordinary Americans suffered terribly. A cigar maker named Samuel Gompers who was young in 1873 later recalled that with the panic, "economic organization crumbled with some primeval upheaval." Between 1873 and 1877, as many smaller factories and workshops shuttered their doors, tens of thousands of workers — many former Civil War soldiers — became transients. The terms "tramp" and "bum," both indirect references to former soldiers, became commonplace American terms. Relief rolls exploded in major cities, with 25-percent unemployment (100,000 workers) in New York City alone. Unemployed workers demonstrated in Boston, Chicago, and New York in the winter of 1873-74 demanding public work. In New York's Tompkins Square in 1874, police entered the crowd with clubs and beat up thousands of men and women. The most violent strikes in American history followed the panic, including by the secret labor group known as the Molly Maguires in Pennsylvania's coal fields in 1875, when masked workmen exchanged gunfire with the "Coal and Iron Police," a private force commissioned by the state. A nationwide railroad strike followed in 1877, in which mobs destroyed railway hubs in Pittsburgh, Chicago, and Cumberland, Md.

In Central and Eastern Europe, times were even harder. Many political analysts blamed the crisis on a combination of foreign banks and Jews. Nationalistic political leaders (or agents of the Russian czar) embraced a new, sophisticated brand of anti-Semitism that proved appealing to thousands who had lost their livelihoods in the panic. Anti-Jewish pogroms followed in the 1880s, particularly in Russia and Ukraine. Heartland communities large and small had found a scapegoat: aliens in their own midst.

The echoes of the past in the current problems with residential mortgages trouble me. Loans after about 2001 were issued to first-time home buyers who signed up for adjustable rate mortgages they could likely never pay off, even in the best of times. Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing. Those debts were wrapped in complex securities that mortgage companies and other entrepreneurial banks then sold to other banks; concerned about the stability of those securities, banks then bought a kind of insurance policy called a credit-derivative swap, which risk managers imagined would protect their investments. More than two million foreclosure filings — default notices, auction-sale notices, and bank repossessions — were reported in 2007. By then trillions of dollars were already invested in this credit-derivative market. Were those new financial instruments resilient enough to cover all the risk? (Answer: no.) As in 1873, a complex financial pyramid rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans. Businesses large and small now face a potential dearth of short-term credit to buy raw materials, ship their products, and keep goods on shelves.

If there are lessons from 1873, they are different from those of 1929. Most important, when banks fall on Wall Street, they stop all the traffic on Main Street — for a very long time. The protracted reconstruction of banks in the United States and Europe created widespread unemployment. Unions (previously illegal in much of the world) flourished but were then destroyed by corporate institutions that learned to operate on the edge of the law. In Europe, politicians found their scapegoats in Jews, on the fringes of the economy. (Americans, on the other hand, mostly blamed themselves; many began to embrace what would later be called fundamentalist religion.)

The post-panic winners, even after the bailout, might be those firms — financial and otherwise — that have substantial cash reserves. A widespread consolidation of industries may be on the horizon, along with a nationalistic response of high tariff barriers, a decline in international trade, and scapegoating of immigrant competitors for scarce jobs. The failure in July of the World Trade Organization talks begun in Doha seven years ago suggests a new wave of protectionism may be on the way.

In the end, the Panic of 1873 demonstrated that the center of gravity for the world's credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess. I still have microfilm to read.

Scott Reynolds Nelson is a professor of history at the College of William and Mary. Among his books is Steel Drivin' Man: John Henry, the Untold Story of an American legend (Oxford University Press, 2006).

Submitted by underdose on October 6, 2008 - 11:30pm.

Thank you for posting this. Just responding to keep it near the top so others may read.

I wonder what investment strategies were successful for capital preservation back then. Still, I assume the one big difference between now and then is the gold standard. There was no Fed in the 1870's, and no opportunity to print one's way out of the crisis. I'll still wager we are in completely uncharted waters now.

Submitted by CA renter on October 7, 2008 - 12:43am.

Yes, thank you for posting that article.

The only thing I would question is the claim that the Great Depression wasn't related to a credit bubble. There was sharply rising debt and increased wealth disparity just before the Depression. Just like we have now.

With this dramatic increase in the instalment selling of automobiles came the expansion of this technique into the markets for other major durable goods. According to credit expert Rolf Nugent, the success of automobile instalment plans "tended to remove the stigma which instalment selling had acquired at the hands of low-grade instalment merchants in the 1890s."20 In fact, credit was used in the purchases of up to 90% of major durable goods by the end of the 1920s.21 Average purchases of major durable goods rose from 3.7% of disposable income between 1898 and 1916 to 7.2% between 1922 and 1929. Accompanying this rise in purchases of durables was a drop in the personal savings rate, from 6.4% of disposable income in the former period to 3.8% in the latter.22

http://etext.virginia.edu/journals/EH/EH...

IMHO, all depressions occur when the greatest number of people have the greatest amount of debt, and the wealth disparity is the greatest (tends to happen concurrently because credit shifts money away from the working class/labor to the capitalists/lenders).

Basically, all the future demand has been exhausted (because everyone brings their purchases forward when using credit, and they now have to use current/future income to service that debt), which leads to deflation as the debt is destroyed via rolling bankruptcies and foreclosures.

Submitted by EconProf on October 7, 2008 - 6:59am.

One factor that will make this downturn worse than previous ones is peoples' current use of credit cards as a substitute for savings accounts to cushion for emergencies.
A generation or two ago, people regularly saved about 8% of their paychecks, on average. This fraction was fairly constant for many decades until about the mid-1990s. Families tended to have a "rainy day" fund for emergencies: medical, car breakdowns, etc., as well as a growing fund for planned vacations, car and house downpayments, and retirement. As a result, people learned to budget, defer gratification, plan their future, and watch proudly as their nest egg grew.
Rampant consumerism encouraged by marketers and lenders changed all that. It was abetted by schools and parents that abandoned teaching the values of thrift, saving, and any other old-fashioned values.
Nowadays, emergencies are met by credit, as are vacations, vehicles, holidays, etc. So as deleveraging hits our big financial institutions with such pain, the same process will confront individuals now deeply in debt.
The ratcheting up of CC interest rates for missed payments, or the yanking of allowable limits is the whack upside the head many people need. Its going to hurt, but its time to sober up.

Submitted by Aecetia on October 7, 2008 - 9:48am.

How Taxes Reduce Savings
by Daniel J. Mitchell, Ph.D.

"The fact that Americans save very little today should come as no surprise. Federal taxes--which are at an all-time high--significantly lower the income that Americans could save and use for capital formation. Even worse, the tax burden on savings and investment is much heavier than the tax burden on consumption."

http://www.heritage.org/Research/Taxes/B...

Submitted by yooklid on October 7, 2008 - 10:20am.

While I agree with the point about the tax burden on consumption v saving, are you honestly suggesting that if people had more of their pay check, they WOULDN'T spend it?

What's truly changed is people's attitude to debt. It's no longer shameful

Submitted by kewp on October 7, 2008 - 10:32am.

What's truly changed is people's attitude to debt. It's no longer shameful

I wouldn't say that.

I would say its the attitude of *defaulting* on debt that's no longer shameful.

People have absolutely no qualms about maxing out their HELOC's and CC's, then tossing the keys and declaring bankruptcy.

This is why the downturn is going to be much longer and the credit squeeze much tighter than most think. Nobody is going to get second jobs or stretch their budgets to repay debt. They will just default, en masse'.

Declaring bankruptcy due to excessive consumer consumption is the most shameful I can imagine, personally. I have no problem with throwing these deadbeats in debtor prisons for the rest of their lives.

Submitted by aldante on October 7, 2008 - 11:43am.

Thank you for this post

Submitted by scaredyclassic on October 7, 2008 - 3:51pm.

debtor's prison? wow. good for business in the criminal justice system. could start a whole new bull market in criminal defense. i expect jury nullification to be not too difficult to obtain on heloc defense cases involving life sentences.

i think the reformed bankruptcy laws should inflict quite enough pain. funny how that law got passed well in advance for the big crash, isn't it...

Submitted by sdduuuude on October 7, 2008 - 10:10pm.

This really is an excellent post. Thanks. Bump.

Submitted by DaCounselor on October 8, 2008 - 2:30pm.

"What's truly changed is people's attitude to debt. It's no longer shameful

I wouldn't say that.

I would say its the attitude of *defaulting* on debt that's no longer shameful."
__________________________

I would say it's both.

I would also say that we are very likely to see a shift back toward an anti-debt sentiment.

Submitted by greekfire on October 8, 2008 - 11:39pm.

I have been searching for answers to our current problems quite a bit in the past couple years or so. I am convinced now, more than ever, that unless we know our history we are doomed to repeat it. I used to think this was a tired cliche, but it has won me over now. Nearly all of the problems that we are facing today have been faced before in our nation's history in one form or another. We'd be wise to study our own history better because we are well into the process of repeating it all over again.

Submitted by EconProf on October 9, 2008 - 6:50am.

Greekfire: your are sooo right.
And it wasn't even very long ago. What is remarkable is how this crisis resembles the Long Term Capital Management moment of, I believe 1998. Then LTCM used extremely high leverage, a complicated and flawed economic model with innovative new tools, and even a Nobel-prize winning economist in their highest management. The whole structure was based on an assumption that success was nearly inevitable--only a 1 in 1000 probability of failure. Well, a black swan flew by, and they blew up.
I think their top guy was named Merriweather, and he recently was in control of a hedge fund that just collapsed. Basing this all on my flawed memory of news events, so if anyone can fill in the blanks please do.

Submitted by Beets on January 6, 2009 - 8:03am.

Hello Greekfire.
Is this what you are talking about?
http://www.sjsu.edu/faculty/watkins/ltcm...

Also the PBS program cover LTCM in the program Command Heights, it is very well done.
http://www.pbs.org/wgbh/commandingheights/

Submitted by Carl Veritas on January 6, 2009 - 7:21pm.

Great info, Greek.
There is a common thread however: Bank credit by way of fractional reserve banking. Banks are technically insolvent and this is where booms, financial panics and depressions originate. Even when paper notes were required to have backing of specie, bankers routinely issued in excess of their reserves, causing bank runs. Picture a wagon full of specie being delivered to bank after bank, ahead of the bank examiner. It may be a blip on the screen today but it's the same unstable, leveraged banking system that allows for all the subsequent abuse to occur.

What appeared to be prosperity from 1813-1818 was nothing but a bubble that resulted from inflationary war finance. It was unsustainable. And the panic of 1819 was the result. The Second Bank of the United States, authorized to issue note, had fueled land speculation. (from Panic of 1819 by Rothbard)

The panic of 1837 was also a culmination of expanding banks and bank credit and bank runs. The bankers were expanding credit with or without a central bank, which only served to coordinate the credit expansion and to a wider area. So was the bank panic of the 1920s that turned into a great depression by Hoover's economic policies.

Submitted by stockstradr on January 6, 2009 - 7:42pm.

Thanks to the EconProf for remarking about LTCM

http://en.wikipedia.org/wiki/LTCM

..and its connection to:

http://online.wsj.com/article/SB12300081...

I was obviously aware of the LTCM story, but not aware of how John Meriwether had later set up a hedge fund (to mimic LTCM strategies only with "less leverage") and how that fund is also now in serious trouble.

If that story alone isn't sufficient grounds for greater regulation of hedge funds, I don't know what is!

Submitted by Allan from Fallbrook on January 6, 2009 - 8:34pm.

EconProf: Excellent book on LTCM out there called "When Genius Failed" by Daniel Lowenstein. It not only chronicles the how and why of LTCM's implosion, but the ensuing "rescue" attempt by the Fed and several investment banks. That rescue attempt is nearly as interesting as the failure itself.

Submitted by carlsbadworker on January 6, 2009 - 9:33pm.

Dec 23 (Reuters) - John Meriwether's JWM Partners LLC hedge fund will lose four of its seven active partners and cut 10 of 35 staff after the weak performance of its flagship fund this year, the Wall Street Journal reported.

The Greenwich, Connecticut firm expects to lose four partners next year, including Lawrence Hilibrand and John Tsai, the paper said, citing a letter sent to investors on December 17.

According to the paper, the letter said Arjun Krishnamachar is expected to leave by March 31 and Chief Financial Officer Andrew Geisert after March 31.

JWM's flagship fund, the Relative Value Opportunity Portfolio, fell 42.78 percent in the first 11 months of this year, the paper said.

Meriwether's previous hedge fund, Long-Term Capital Management, had to accept a $3.6 billion bailout by U.S. banks in 1998 after it ran aground with leveraged trading strategies.

JWM could not immediately be reached for comment. (Reporting by Eric Yep in Bangalore; editing by John Stonestreet)

Submitted by carlsbadworker on January 6, 2009 - 9:48pm.

I think it is unfair to criticize the fractional reserve system. The banking industry has turned into a commodity business and it is tough to make money in such kind of industry. As HLS points out recently, "I don't know of any other business that sells something for $400,000 and only makes $1080 gross". Without fractional reserve system, the banks will all die because they really have no profit margin at all.
I don't think there is a solution to that. Risk takers in the banking industry will always get awarded for the short term. The government can regulate the hell out of it but there will always be loopholes.
The same will gradually apply to all businesses that turns into commodity business. They make up their margin by quantity... which is essentially excessive inventory that will kill them in times of economy trouble. The only way is for business and the country to innovate itself out of the poor industries (and let the Asian countries deal with it), but American has become too stupid and lazy to make steady innovations.

Submitted by peterb on January 6, 2009 - 10:33pm.

I think fractional reserve is mostly a good thing. But it's like a friendly pit bull. It's all great until it turns on you, then it's a world of hurt. When any business is allowed to operate at a ratio of 30 to 1 for cash outlays, it needs to be very highly and closely regulated. Because if it goes off the tracks, it's a huge train wreck. And here we are. 5 solid years of highly unregulated fractional reserve lending. Ka BOOM!!!!

Submitted by patb on January 6, 2009 - 10:43pm.

Aecetia wrote:
How Taxes Reduce Savings
by Daniel J. Mitchell, Ph.D.

"The fact that Americans save very little today should come as no surprise. Federal taxes--which are at an all-time high--significantly lower the income that Americans could save and use for capital formation. Even worse, the tax burden on savings and investment is much heavier than the tax burden on consumption."

http://www.heritage.org/Research/Taxes/B...

nothing personal but the heritage guys are all cocksuckers.
not one of them was worth a damn intellectually

Submitted by paramount on January 6, 2009 - 10:51pm.

Very good post, of course the question of the day is are we going into a wide spread depression in the US?

Are you currently stocking up on water, canned and dry goods?

Submitted by SD Realtor on January 7, 2009 - 12:40am.

Counselor I would hope that what you posted would come to fruition but I honestly do not see it happen with either the present and the incoming administration. In fact from where I sit it, appears that we will be force fed more of the same deficit spending mentality. However at some point in the future I do agree with conventional posts that the world will eventually stop feeding our addiction. Thus we will forced to gravitate towards a future like you have envisioned.

Submitted by Aecetia on January 14, 2009 - 6:09pm.

"The ultimate result of shielding men from the
effects of folly, is to fill the world with fools."

[Herbert Spencer, Essays, vol. 3, "State
Tamperings with Money and Banks" (1891).
from The Columbia Dictionary of Quotations]

Submitted by Arraya on January 14, 2009 - 7:09pm.

Owners of capital will stimulate the working class to buy more
and more expensive goods, houses and technology, pushing them
to take more and more expensive credits, until their debt
becomes unbearable. The unpaid debt will lead to bankruptcy of
the banks, which will have to be nationalized, and the State
will have to take the road which will eventually lead to
Communism.”
Karl Marx 1867

Submitted by Blogstar on January 14, 2009 - 7:40pm.

I was thinking today about this very idea that you quoted Arraya.

What happens to the proletariat who have not taken the bait and who became solvent land owners instead? I sort of hope we never really have to worry about the answer to that question.

Submitted by barnaby33 on January 14, 2009 - 7:44pm.

Without fractional reserve system, the banks will all die because they really have no profit margin at all.

Not true at all. Banks just have to learn to charge interest commensurate with risk. Those that do prosper, those that don't die. What turned lending into a commodity business was the govt regulating who could get a loan and by what criteria. As soon as that happened, then yes banks are just brokers working off very thin margins. They aren't taking any risk, so why a broker be an extremely profitable business?
Josh

Submitted by DriveByLurker on January 17, 2009 - 7:30pm.

arraya wrote:
Owners of capital will stimulate the working class to buy more
and more expensive goods, houses and technology, pushing them
to take more and more expensive credits, until their debt
becomes unbearable. The unpaid debt will lead to bankruptcy of
the banks, which will have to be nationalized, and the State
will have to take the road which will eventually lead to
Communism.”
Karl Marx 1867

That quote is cool, but suspect...

http://meganmcardle.theatlantic.com/arch...

http://imgs.xkcd.com/comics/duty_calls.png

Submitted by Arraya on January 17, 2009 - 8:19pm.

DriveByLurker wrote:
arraya wrote:
Owners of capital will stimulate the working class to buy more
and more expensive goods, houses and technology, pushing them
to take more and more expensive credits, until their debt
becomes unbearable. The unpaid debt will lead to bankruptcy of
the banks, which will have to be nationalized, and the State
will have to take the road which will eventually lead to
Communism.”
Karl Marx 1867

That quote is cool, but suspect...

http://meganmcardle.theatlantic.com/arch...

http://imgs.xkcd.com/comics/duty_calls.png

Huh, interesting. It does seem a little made up in retrospect. That comic is hilarious!

Submitted by Aecetia on September 1, 2009 - 12:24pm.

A Tale of Two Depressions

This is an update of the authors' 4 June and 6 April 2009 columns comparing today's global crisis to the Great Depression. World industrial production, trade, and stock markets are now showing signs of recovery. Still – today's crisis remains dramatic by the standards of the Great Depression.

http://www.voxeu.org/index.php?q=node/3421

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