“Imperial Finance: A History of Empires”
It’s finally here. The second Investor Amnesia course has launched… and wow is it exciting. This course offers more than eight hours of world class lectures taught by an incredible lineup of speakers. Highlights include:
- Marc Andreessen on anti-trust, Robber Barons & Golden Age of Piracy.
- Niall Ferguson reveals which financial innovations produce empires.
- Tracy Alloway explains how political chaos impacts investors.
- Mike Green uncovers episodes of monetary debasement and inflation.
Enroll in Course for $99
From the Archives
Report on a National Bank (1790)
Today’s post is going to be a bit different! The “Panic Series” is a new series that goes in-depth on one “Panic” from history each week. For both myself, and you the reader, I think this will be a great way to learn what the hell really happened in those panics that sound familiar, but we actually know very little about. The goal of this series is for every reader to finish the post with a working knowledge and understanding of what happened in a given panic.
With the launch of this new initiative, if you enjoy today’s post I’d greatly appreciate you sharing on social media to spread the word! No sense in delaying this any further, so let’s dive into America’s first “panic”: The Panic of 1792.
America’s First Panic: 1792
The Panic of 1792 is a fascinating episode in America’s financial history for many reasons. Not only did this period witness the first attempted ‘corner’ in America, the creation of a quasi central bank, and an insider trading scandal involving former Treasury department officials… it also occurred at the very founding of America. This meant that unlike today, where economists can leverage prior experiences and lessons to guide their decision-making process, Alexander Hamilton and his team were navigating crises on the fly. To understand the eventual Panic in 1792, however, we must first understand the conditions that preceded it.
Before getting into the panic, let me transport you back to your high school US History class by briefly recapping the significant events surrounding America’s founding. The Revolutionary War ended with the Treaty of Paris in September 1783, but you may recall that America had another constitution and form of government before the Constitution we know today was ratified in 1787: The Articles of Confederation (AOC). (Funnily enough, I actually wrote one of my dissertations on the AOC, so blew the cobwebs off that bad boy for this post)
The AOC were adopted by Congress in 1777, but only ratified by the states in 1781. The main problems with the AOC related to how little power it granted the federal government, and how much it gave the states. The substantial restrictions on the federal government’s authority was in response to colonists’ fears that a strong executive authority would lead to tyranny. Again, given this was written during a war against Britain’s “tyrannical monarchy”, this focus on restricting executive power is not surprising.
To illustrate this point, the progression of AOC drafts in the late 1770s reveals a clear pattern of reducing the federal government’s power. For example, between the first and second drafts of the Articles, 28 total changes were made to the original document, and eighteen of those were revisions that weakened the power of Congress. Then, in the third draft, a further eleven changes were made reducing the central government’s power.
So, why is this relevant? Due to this resulting imbalance of power, the federal government struggled to enforce its rulings upon the states. In such a weak federal system, the states quickly began abusing the system for their benefit, which was most clearly demonstrated in the sphere of public finance.
For instance, the Articles did not grant Congress the authority to tax, rather the federal government could only request funds from states. The rights of regulating commerce and taxation was left to the states. Making matters worse:
“State officials tended to print money rather than resort to increased taxation in order to raise war revenue. As a consequence, most state currencies depreciated quickly and severely. The Continental Congress relied on loans from the French, Dutch, and wealthy Americans at first, but soon turned to the printing press as well, with similar results.” (Tax History)
Therefore, even though the Federal Constitution passed in 1787 remedied these issues, when Alexander Hamilton became the first Treasury Secretary in 1789, the country’s financial situation was dire:
“Before 1790, the government was effectively bankrupt. Without tax revenues until late in 1789—after the newly created Treasury Department opened in September of that year, it managed to collect by year end a grand total of $162,200 in custom duties—the U.S. government was in default on almost all of its large domestic debts left over from the Revolution, as well as on most of its foreign debts incurred in the struggle. The new nation lacked a national currency, a national bank, a banking system, and regularly functioning securities markets.” (Sylla, 2010)
Suffice it to say that as the incoming Treasury Secretary, Alexander Hamilton had his work cut out for him.
Hamilton’s Report on Public Credit: January 1790
Within just 10 days of assuming his new role, the House of Representatives asked Hamilton to draw up a plan “for the support of the public credit, as a matter of high importance to the national honor and prosperity”. In January 1790, Hamilton presented his famous “Report on Public Credit”, which shared his bold vision for America’s public finances.
Hamilton’s Debt Restructuring Plan
In relation to the Panic of 1792, the first key component of the report was a restructuring of US debt:
“Hamilton estimated the debts of the United States, including arrears of interest, at $54.1 million, of which $11.7 million was owed to foreign governments and investors, and $42.1 was owed to domestic creditors… state debts incurred mostly during the War of Independence, including arrears of interest, were $25 million. Because they had been incurred in the common cause, Hamilton argued that the state debts ought to be assumed by the federal government. The grand total of the national debt estimated by Hamilton amounted to $79.1 million, about 40 percent of the estimated gross domestic product.” (Sylla, 2010)
With this large amount of debt, in essence an ’empty’ treasury coffer, and little-to-no government revenues to cover interest payments, Hamilton’s report put forth a bold plan. Hamilton proposed asking current US creditors to accept a reduced yield on their bonds (from 6% to 4%). Importantly, this would not involve a similar write down of their principal, just a lower interest rate. This reduction in interest rate would lower the government’s annual interest expenses on public debt by some $1.3 Million. Hamilton’s pitch to existing debt holders was that the government could not currently pay their 6% interest, and the only way it could make those payments was by raising taxes (an option he correctly assumed these debt holders would oppose).
Logistically, this debt conversion scheme manifested in US debt holders exchanging their old debt for “packages of new Treasury debt consisting of 6% bonds, 6% “deferred” bonds (interest at 6% would commence in 1801, so for ten years these were “zeros”), and for 3% bonds”. By September 1791, 50% of the US debt had been converted, and by 1794 that figure stood at 98%. The emergence of these new bonds in Fall 1790 produced an active secondary trading market in Boston, Philadelphia & New York. More on that later.
The Sinking Fund
Historian Richard Sylla wrote that within Hamilton’s Report on Public Credit, the Sinking Fund was “a seemingly minor feature of Hamilton’s plan… [that] in fact played an important role in managing financial crises in 1791 and 1792.” However, this “minor” feature turned out to be anything but that… This Sinking Fund would:
“apply surplus revenues and money borrowed at home or abroad to open-market purchases of public debt ‘until the whole of the debt shall be discharged’. Investors thus could count on the government not merely to pay interest on its debt, but ultimately to redeem it. And, the government gained the ability to conduct open-market purchases to support debt prices.” (Sylla, 2010)
A lot to unpack here. First, this fund was important for re-assuring investors that the government was committed to paying its debts. While we don’t worry about the US government paying its debt today, at that time America was still a nation in its infancy. Second, this fund allowed the government to make open-market purchases of its debt in order to provide liquidity and “support debt prices”. It was this feature that made the Sinking Fund so crucial during the 1792 crisis.
Hamilton’s work in shaping American finance was just beginning. His next plan focused on creating a national bank.
Hamilton’s Report on a National Bank: December 1790
Hamilton’s interest in a national bank stretched back many years. In a letter to fellow financier Robert Morris on April 30, 1781, Hamilton wrote:
“The tendency of a National Bank is to increase public and private credit. The former gives power to the state for the protection of its rights and interests, and the latter facilitates and extends the operations of commerce among individuals. Industry is increased, commodities are multiplied, agriculture and manufactures flourish, and herein consists of the true wealth and prosperity of a state.”
In his report to Congress calling for the creation of a national bank, Hamilton focuses on three key advantages said bank could offer:
- “It would deepen financial markets encouraging commercial activity and economic growth.
- It would provide loans to the government, especially in emergencies.
- It would facilitate the payment of taxes because Bank notes and deposits would increase money in circulation.”
Congress approves Hamilton’s “Bank of the United States” (BUS) and President George Washington signs the bill on February 25, 1791. The BUS had a $10 Million capitalization and 25,000 shares with a $400 par value. In terms of ownership, private investors owned 80% and the U.S. government owned 20%.
You may have noticed in the figure above that there were some unique features of the BUS IPO, particularly in how shares were paid for. For investors interesting in buying BUS shares, they would have to pay 25% of the share price in specie (gold, silver, bullion or plate) and 75% in Hamilton’s new US debt securities (specifically, the main bond of Hamilton’s restructured debt: the 6% bonds known as ‘Sixes’). If this type of government debt-for-equity swap concept sounds familiar, it’s because John Law implemented a similar idea in France that led to the Mississippi Bubble of 1720. Referencing Law’s scheme, Hamilton wrote:
“It will be our wisdom to select what is good in [Law’s] plan and in any others that have gone before us, avoiding their defects and excesses.”
In other words, Hamilton realized that the concept of allowing investors to buy stock using government bonds was beneficial to the state, as it increased demand for its debt. This is demonstrated by the rally in prices of ‘Sixes’ after Hamilton’s Bank Report was issued in December 1790.
And so on July 4th (when else, right?) of 1791 the Bank of the United States went public.
The Bank Scrip Bubble & ‘Mini-Panic’ of 1791
The IPO proved to be a wildly speculative affair, with the IPO heavily oversubscribed. Part of the reason for this speculation stemmed from the issuance itself. Rather than issuing fully paid-up shares, the IPO was an issuance of “subscription rights” (“Scrips”) for buying full shares of BUS stock. These BUS ‘Scrips’ were issued for $25 at the IPO. The scrip holder would then have to make additional purchases of $100, $100, $100 and $75 at pre-determined dates in the future. This “buy now, pay later” element fueled heavy speculation in BUS scrips, which quickly doubled to $50 in July. In New York, BUS scrips soared to $264 on August 11th, before plummeting to $154 on August 16th, and then rallying again.
Again, because investors knew US ‘Sixes’ could be used to buy scrips / shares of BUS, there was a simultaneous rally (and then crash) in the price of ‘Sixes’. The chart below shows the price of US ‘Sixes’ rallying from 90% of par on July 4 (BUS IPO) to 1112.5% on August 13, and then dropping to 100% on August 17.
One person not enjoying these wild market swings was the Treasury Secretary, Alexander Hamilton. All of his programs and plans were designed to build construct a stable and reliable system of public finance. Volatile swings in the price of US Debt like those of August 1791 were not in line with that vision. Hamilton wrote to US Senator and Bank of New York (BONY) Director Rufus King that “a bubble connected with my operations is of all the enemies I have to fear, in my judgment the most formidable.”
That said, Hamilton organized the Commissioners of the Sinking Fund to authorize $300-$400 thousand in open-market purchases of US debt in Philadelphia and New York. The purchase prices could not go higher than par for ‘Sixes’, 60 (% of par) for ‘Threes’ and 62.5 for the deferred ‘Sixes’. However, because the Bank of the United States branch in New York had not opened yet, Hamilton had to rely on a private institution to execute his open-market purchases: The Bank of New York (BONY).
In a letter to BONY Cashier William Seton on August 16th concerning the open-market purchases, Hamilton makes a very interesting point regarding the messaging around government purchases of US debt. Hamilton wrote to Seton:
“You recollect that the [Sinking Fund] act requires that the purchase should be made openly. This has been construed to mean by a known agent for the public.
When you make a purchase therefore, it will be proper that it should be understood that it is on account of the United States but this need not precede the purchase, and it will be best that there should be no unnecessary demonstration lest it should raise hopes beyond what will be realized.“
Hamilton was very cognizant of the thin line he must tread with these purchases, as he wanted the market to know the Treasury was stepping in to support prices, but also wanted to avoid investors expecting the Treasury to step in and support the market every time prices fell (in Richard Sylla’s words, a “Hamilton Put”). Seton had completed the $150,000 in open-market purchases by September 5th, but informed Hamilton that while these purchases had helped improve the situation, he felt that additional purchases would be needed to fully quell this panic. Hamilton obliged and authorized an additional $50,000 in open-market purchases for Seton to execute on behalf of the Treasury. Seton wrote back on September 12th that the panic had officially subsided.
In total, the Treasury had authorized some $560,000 open-market purchases of US debt in just one month. At the time, this equated to 2% of the outstanding ‘Sixes’, ‘Threes’ and deferred ‘Sixes’. In modern terms, this equates to roughly $270 billion of open-market purchases in one month. This successful experience with open-market purchases and handling financial crises was critical for navigating the Panic of 1792 just a few months later.
The Panic of 1792
The Panic of 1792 has two key components that we’ll explore individually, but they are closely related. The first component is the rapid expansion in credit fueled by the BUS in New York and Philadelphia. As with any investment mania, this large expansion of credit promoted speculative activity as individuals were able to borrow money easily to fund trades in the market. This brings us to the second component: William Duer & his merry band of speculators.
Most historical accounts of the 1792 Panic focus on William Duer’s speculative and nefarious actions. Duer was not only a degenerate speculator, however, he was also the former Assistant Secretary of the Treasury, personal friend of Alexander Hamilton, and former Continental Congress representative. Despite all of these distinctions and respected titles, Duer’s morals were more suspect. For example, despite working in the Treasury department, Duer continued to actively trade in government securities for his personal account, which was expressly forbidden.
Upon leaving the Treasury department in 1790, Duer began a speculative journey that would end with him sitting in debtor’s prison:
“Forming a partnership with Alexander McComb, a New York businessman and land speculator, he [Duer] set out to corner the market in government 6 percents (‘Sixes’). Duer soon drew in many of the leading Society for the Establishment of Useful Manufactures (SUM) investors forming what later would be called the “6 percent club.” They hoped to achieve a corner by July 1792, when the next installment on stock in the Bank of the United States was due.
They also bought “on time” as many shares in the bank as they could find. If they brought off the corner, Duer and McComb planned to sell the 6 percents at huge markups to European investors eager to buy American securities. With revolutionary France on the brink of exploding, United States looked far more stable than any country on their continent. With this wealth, Duer and McComb hoped to buy enough shares to take control of the Bank of the United States.
Another part of the Duer-McComb strategy called for winning early control of the Bank of New York, a private institution Hamilton had helped to found. The partners spread a rumor that the Bank of New York would soon combine with the local branch of the Bank of the United States. To depress the price of the Bank of New York’s shares, they launched a bogus entity, the Million Bank, which they capitalized at $1.8 million. Duer and McComb soon had contracts to buy 400 of the Bank of New York’s outstanding shares.”
Word spread quickly about Duer’s schemes, and many speculators gave Duer money to invest on their behalf. Even one of the women at a notorious brothel in New York is said to have given Duer the money she kept hidden under her well-used mattress. Eventually, however, Duer’s scheme collapsed in March of 1792 when the BUS and other banks around the country began to sharply contract their credit. Since Duer had borrowed heavily from the banks to speculate, when credit tightened and stocks declined, Duer was suddenly unable to repay his debtors.
On March 9, 1792, Duer wrote to Hamilton informing him that he was unable to pay off his debts. Duer spent the rest of his life in debtor’s prison, where he died on May 7, 1799.
The Credit Boom
As I alluded to earlier, there was another key component of the 1792 crisis, and that was the explosion in credit provided by the BUS.
“Speculative bubbles typically require a lot of newly created credit to be launched and sustained… The BUS opened its headquarters in Philadelphia in December 1791. It started accepting deposits on the 12th of that month, and to make discounts [loans] on the 20th. By December 29, the BUS had issued $1.10 million of monetary liabilities in the form of notes and deposits, and had discounted bills [loans] to an amount of $0.96 million. This was largely new money and credit. But that was only a start. A month later, on January 31, 1792, BUS monetary liabilities had nearly doubled to $2.17 million and discounts had nearly trebled to $2.68 million. For perspective, the open market purchases that had stopped the mini-panic a few months earlier involved the far smaller sum of not quite $0.35 million.”
It was this explosion in credit fueled by BUS branches that facilitated speculative activities. It did not take long for Hamilton to make this connection, and begin urging both the BONY and BUS to contract their credit and loan making operations. Hamilton wrote to Seton at BONY:
“The state of things however requires unusual circumspection. Every existing bank ought within prudent limits to abridge its operations. The superstructure of Credit is now too vast for the foundation. It must be gradually brought within more reasonable dimensions or it will tumble.“
The problem, however, was that the banks did not gradually contract credit, they did so quickly. This sharp contraction in credit was what led to Duer’s downfall, but also scores of other speculators, which threatened to bring down Hamilton’s system.
“By February the BUS was suffering the consequences of that credit over-expansion as its liabilities were being returned for conversion to specie… the BUS sharply (not gradually) contracted its discounts, which declined from $2.68 million on January 31 to 2.05 million on March 9…
Still, the contraction of BUS discounts by $0.62 million from January 31 to March 9 did severe damage to speculators such as Duer and ‘company,’ who were longs in the public debt market, attempting to corner US 6s. The BUS credit expansion had fueled their speculations in January, but then the tables were turned. The BUS was saved, but the speculators and others went down in flames. U.S. 6s in New York fell from 125.83 on March 5 to 116.25 on March 8, the day before Duer stopped paying his debts. Duer’s default caused a contagion of further defaults as well as panic selling of securities.” (Sylla, 2010)
Hamilton’s approach to the 1792 crisis was similar to how he handled the ‘mini-panic’ of 1791. Using the BONY, Hamilton repeatedly authorized Seton to make open-market purchases on behalf of the Treasury in order to provide liquidity and support prices. However, he also encouraged the BONY to act as a “lender of last resort” in order to make sure that there was not widespread failure in the financial system:
“Hamilton and the Sinking Fund Commission authorized the government to buy up government bonds to support their price and slow the collapse in prices. On March 26, and with only Jefferson dissenting, the commission authorized $100,000 in open-market purchases of securities to offset the credit crunch that was occurring.To get out of the financial crisis, Hamilton had the Bank of New York take several measures. Hamilton encouraged the bank to take loans collateralized by government securities, but to lend at seven percent instead of six.
Hamilton promised that the government would buy from the bank up to $500,000 of securities should the Bank of New York be stuck with excess collateral. Hamilton also supported lending by the Bank of Maryland and Hamilton authorized an additional $150,000 of open-market purchases by the Bank of New York. In essence, Hamilton followed Bagehot’s dictum, given eighty years later in his book Lombard Street to “lend freely, against good collateral, at a penalty rate,” acting as the lender of last resort for other banks.”
And that, ladies and gentlemen, is the Panic of 1792! If you’d like to read up further, check out the articles below! If you enjoyed this post, share it with others, and come back next week for another installment of the Panic Series!
The U.S. Panic of 1792: Financial Crisis Management and the Lender of Last Resort
The Panic of 1792
Wall Street’s First Collapse
MISS LAST WEEK’S SUNDAY READS? CATCH UP HERE