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posted on 11 October 2015

Crisis Chronicles: Defensive Suspension And The Panic Of 1857

from Liberty Street Economics

-- this post authored by Thomas Klitgaard and James Narron

Sometimes the world loses its bearings and the best alternative is a timeout. Such was the case during the Panic of 1857, which started when a prestigious bank in New York City collapsed, making all banks suddenly suspect. Banks, fearing a run on their gold reserves, started calling in loans from commercial firms and brokers, leading to asset sales at fire-sale prices and bankruptcies. By mid-October, banks in Philadelphia and New York suspended convertibility, meaning they would not allow gold to be withdrawn from their vaults even while all other banking services continued.

Suspension then swept the nation as part of a defensive strategy, supported by local business interests, to prevent the Panic from spreading. While the suspensions appeared successful and few banks ended up failing, President Buchanan was outraged by what he viewed as yet another corrupt banking practice. He proposed making suspension a "death sentence" for banks as a draconian incentive to encourage safer banking practices. In this edition of Crisis Chronicles, we describe the Panic of 1857 and explain why businesses pushed for national suspension to save themselves.

Paper Bubbles and Premonitory Symptoms

The outpouring of gold from California starting in 1849 fostered a period of prosperity in the 1850s. Spurred by migrations to the West, the decade saw a massive expansion of the railroads and the accompanying financial speculation by bankers and British investors. Robert C. Kennedy notes that "railroads were the backbone of the economic growth, with the construction of over 20,000 miles of track during the 1850s. They were aided by state land grants and financed by government bonds, stock sales on Wall Street, and foreign, particularly British, investments. . . . The number of banks almost doubled from 1850 to 1857. . . . Particularly important was New York City, the nation's financial center and home to the Stock Exchange."

The mood of the nation, however, turned a bit darker in the summer of 1857. Van Vleck (The Panic of 1857, page 60) quotes the New York Heraldin June of that year: "What can be the end of all this but another general collapse like that of 1837, only upon a much grander scale? The same premonitory symptoms that prevailed in 1835-36 prevail in 1857 in a tenfold degree. Paper bubbles of all descriptions, a general scramble for western lands. . . . The worst of all these evils is the moral pestilence of luxurious exemption from honest labor which is infecting all classes of society."

Like a Cannon Shot

The start of the Panic of 1857 is attributed to the closing of a New York City bank owned by the Ohio Life Insurance and Trust Company on August 24th. The announcement of the bank failure

"struck on the public mind like a cannon shot. An intense excitement was manifested in all financial circles, in which bank officers participated with unusual sensitiveness and want of self-possession. Flying rumors were exaggerated at every corner. The holders of stock and commercial paper hurried to the broker and were eager to make what a week before they would have shunned as a ruinous sacrifice. Several stock and money dealers failed. . . . Every individual misfortune was announced on the news bulletins in large letters." (J.S. Gibbons 1858)

It did not help that bonds and stocks issued by railroads had been heading down over the course of the summer and that this decline had contributed to the bank's failure. The question then was what other banks were vulnerable to dropping railroad securities prices.

Fears of runs on their gold compelled banks to call in their loans to brokers and commercial firms and withdraw their deposits in other banks in hopes of building their gold holdings. Commercial firms were forced to sell assets at such deep discounts that many ended in bankruptcy, which in turn made banks more aggressive in calling loans. The telegraph meant that the panic swept quickly across the country.

By September 26th, banks in Philadelphia suspended the right to withdraw gold. New York banks held on until October 13th, when a large run that day caused all but one bank to suspend. Most other banks in the country soon followed. Countrywide suspension would last two months, with New York City banks not resuming payment in gold until December 14th.

Banks Go Defensive

Calomiris and Schweikart note that the suspensions in Philadelphia and New York led to defensive suspensions in the rest of the country that were encouraged by commercial interests. Firms gave up the right to pull out their gold in order to eliminate the need for banks to call in loans, which would "cause customers to go bankrupt or to sell off merchandise at 'fire sale' prices, which can result in bank losses as well. Suspension did not force banks to shut down; it allowed banks to choose which deposits and notes to redeem and permitted them to accumulate reserves gradually without calling in loans en masse." Suspension forced the country's banking system to work through paper-based transactions for two months and the fact that few banks failed suggests it was a good strategy.

Indeed, Calomiris and Schweikart argue that the rest of the country's response was a lesson for New York City banks. Had they suspended earlier, "they might have been able to extend the necessary loans to keep the securities market afloat. Focusing on their banks' reputations, rather than the health of the markets as a whole, the bankers chose the path of tight credit, falling prices, and commercial failures."

Not Everyone Agreed

But the use of defensive suspensions to quell the panic wasn't approved of by all. In December of that year, President James Buchanan focused on the Panic in his State of the Union. He argued for states to "require that the banks shall at all times keep on hand at least one dollar of gold and silver for every three dollars of their circulation and deposits, and if they will provide by a self-executing enactment, which nothing can arrest, that the moment they suspend they shall go into liquidation. I believe that such provisions, with a weekly publication by each bank of a statement of its condition, would go far to secure us against future suspensions of specie payments." He then pushed this point by saying that the remedy might be done at the national level. "Congress, in my opinion, possesses the power to pass a uniform bankrupt law applicable to all banking institutions throughout the United States, and I strongly recommend its exercise. This would make it the irreversible organic law of each bank's existence that a suspension of specie payments shall produce its civil death. The instinct of self-preservation would then compel it to perform its duties in such a manner as to escape the penalty and preserve its life."

So, would Buchanan's bank death-sentence for suspending convertibility have altered bank practices enough to make them less vulnerable to the Panic of 1857 or would the inability to suspend have caused much more economic damage throughout the country from the initial loss of confidence in New York City? Let us know what you think.

Disclaimer

The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

Source

http://libertystreeteconomics.newyorkfed.org/2015/10/crisis-chronicles-defensive-suspension-and-the-panic-of-1857.html#.Vg5n53pViko


About the Authors

James Narron is a senior vice president in the Federal Reserve Bank of San Francisco's Cash Product Office.

Klitgaard_thomasThomas Klitgaard is a vice president in the Federal Reserve Bank of New York's Research and Statistics Group.

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