The following post analyzes the ambient risk attitudes, outcomes and differing governmental responses to two of our country’s largest financial panics: 1792 and 1837.
The financial panics of 1792 and 1837, and the respective governmental reactions to each, stand in stark contrast to one another. The panic of 1837 was marked by a confluence of factors – including crop shortages, a dry-up of British credit and the subsequent drop in British import of US cotton – but the biggest factor may be attributed to acts of the U.S. government. Although President Jackson inherited a large surplus when he took office, his specific choices in handling the aforementioned surplus coupled with his particular dislikes in the realm of monetary policy may have directly spurred the crisis.
Because Jackson was staunchly opposed to the Second Bank of the United States (akin to a US central bank at the time) he chose not to renew its charter and, instead, instructed that the federal government deposit funds in the many state-charted banks throughout the country. These state-chartered banks, now flush with fresh federal cash deposits, began lending more freely to customers and, as a result, real estate speculation boomed. As a natural consequence of this increased speculation, land prices skyrocketed. Jackson also preferred the use of specie (gold/silver) to bank notes. So when Jackson saw the increased speculative activity in real estate (a direct result of his choice to close the Second Bank) he attempted to curb the speculation by issuing a “specie circular” which barred the federal government from accepting bank notes. The crisis was triggered when New York banks refused to pay specie for bank notes and began recalling loans – resulting in the crashing of financial markets and, ultimately, a 6-year recession. Jackson’s successor, Martin Van Buren, also had a conceivably negative impact on the situation by not injecting capital into the failing system or taking on some other expansionary policy like incurring debt. For these many reasons, the 1837crisis is regarded as having been both triggered, and prolonged, by acts of government regulation.
The 1792 crisis stands in stark contrast to 1837 by showing how government can take steps to assist the economy in times of crisis, even when prior governmental actions may have contributed to the crisis at hand. In 1791, President Hamilton called for State debts to be converted into Federal debt via one of two sinking fund options: a 3% bond or a 6% zero coupon (10yr). The “sinking fund” features on these bonds are crucial in that Hamilton foresaw the potential for a crisis and created these sinking funds as a means to inject the liquidity he knew he would eventually need. When Hamilton’s friend, William Duer, attempted to corner the market on government bonds, prices began to crash and Hamilton responded by injecting liquidity; a tactic that is now regarded to be a staple of economic crisis policy management. He also authorized open market purchases of bonds to slow down prices and spread news of loans from Dutch banks. Furthermore, Hamilton personally encouraged local lenders to extend credit liberally so that, within the year, they had contained the crisis and, incidentally, helped create what would become the NYSE. By working with financial institutions to implement plans for liquidity injection, Hamilton created the model of modern financial crisis management (which dubiously was not utilized by Jackson in 1837). However, in doing so, he may have also created the moral hazard known pejoratively as the “Bailout”.
Hamilton’s lightning quick injection of liquidity stands in marked distinction to the government inaction of 1837. While the differences in government reaction are abundantly clear, what is less clear (but equally as important) is the level of government foresight prior each crisis. This is more commonly referred to as ambient risk attitude. Whereas Hamilton was keenly aware of potential risks (as evidenced by his utilization of the sinking funds) Jackson did not pay attention to ambient risk as the crisis of 1837 was pending. Even if Jackson was not able to recognize that his injection of federal capital into state banks would result in freer lending policies (and therefore, speculation) he should have been more aware of the ambient risk when he issued the specie circular amidst a clear real estate bubble. Its easy to do the math on these two crises: Different ambient risk attitudes + different economic policy reactions = far different results for our economy in times of crisis.