Panic Series (Pt. II) - 1819 — Investor Amnesia

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Sunday Reads

America’s First Depression: 1819

Welcome back to another installment of The Panic Series, where the goal is to leave readers well educated and knowledgeable on notable panics from history. While you do not need to read the series chronologically, I would certainly suggest taking the time to read about America’s first financial panic in 1792, which I covered last week.

If 1792 was the nation’s first financial panic, the Panic of 1819 is considered America’s first Depression. Those that read last week’s post will recognize some familiar themes and players like the role of a national Bank of the United States, it’s over expansion / sharp contraction of credit, and specie flows influenced by speculation. With that, let’s all become experts on the Panic of 1819.

Background

The asset class at the heart of the Panic of 1819 was not equities, but real estate. The impetus for America’s first speculative real estate boom had a few culprits, some of which are familiar from the Panic of 1792. You may remember that in 1812, America waged another war with Great Britain (it was in this war that the White House was torched by British soldiers). Well, as with the Revolutionary War, America had borrowed heavily to finance the costs of this conflict, and found herself heavily indebted when the conflict drew to a close. Making matters worse, the large debts Jefferson had issued to execute his famed 1803 Louisiana Purchase from France were coming due to 1818.

In short, the American government needed a substantial revenue stream – and fast – to meet all of its payments associated with the War of 1812 & Louisiana Purchase.

Western Land Boom

The government’s preferred avenue for raising funds was via federal land sales in western territories, which helped ignite a speculative land boom. Historian Murray Rothbard wrote:

“The initial seller of land was the Federal government, which ―facilitated large-scale speculation in public lands by opening up for sale large tracts in the Southwest and Northwest, and granting liberal credit terms to purchasers.”

The federal government’s need to raise funds for paying off debt provided the supply of land, but what was driving the demand for this land? The first source of western land purchases stemmed from the Land Act of 1800, which provided liberal credit and installment measures for prospective land buyers; fueling demand.

“The most important credit policy during the boom was the 1800 Land Act, which enabled purchasers of public land to put up one-twentieth of the price immediately, and then bring the payment up to one-fourth within forty days. The remainder was to be paid in annual installments, beginning two years after the purchase date. The nominal interest rate was six percent, but there were added discounts for early payment, so the effective discount rate was higher… the existence of these policies may still have helped prices rise.“ (Glaeser, 2013)

The second driver of demand stemmed from American farmers. In this period, the importance of Europe and Britain in particular for American exports cannot be overstated.

“Britain emerged from nearly a quarter century of war with France ready to supply the world with manufactured goods, it needed cotton to supply the mills, and all of Europe needed wheat to supplement a series of poor harvests. The United States met that demand for cotton and wheat by expanding agricultural production…

While some cotton and wool was used for domestic mills in the Northeast, the majority was produced for export, with Boston, New York, and Philadelphia serving largely in an export/trade capacity.“

The importance of European demand for American exports is highlighted in the chart below. As you can see, in 1818 Europe accounted for 73.1% of American exports, and the UK alone accounted for 40.9% of that figure.

But how does this relate to the land boom? Simply put, this insatiable demand for American staples (cotton, wheat, etc.) in Europe meant land that could grow such crops became increasingly valuable.

“British textile mills voraciously consumed American cotton, and the devastation of the Napoleonic Wars made Europe reliant on other American agricultural commodities such as wheat. This drove up both the price of American agricultural products and the value of the land on which staples such as cotton, wheat, corn, and tobacco were grown.

Many Americans were struck with “land fever.” Farmers strove to expand their acreage, and those who lived in areas where unoccupied land was scarce sought holdings in the West. They needed money to purchase this land, however.”

To summarize, the booming demand for American staples meant that farmers found ample reason to move westward in search of untapped / arable land to harvest more crops for exporting to Europe.

The State-Chartered Banking Boom

However, the important question here is how did these farmers afford to move their operations westward? This brings us to another key component of the Panic of 1819: the boom in state-chartered banks. As the chart below shows, the number of state-chartered banks exploded from just 29 in 1800, to 300 in 1820.

The reason for this proliferation of state-chartered banks was two-fold. First, Alexander Hamilton’s first Bank of the United States had only enjoyed a 20-year charter, which was not renewed at expiration in 1811. From 1811 to 1816 there was no national bank, and it was state banks that rushed in to fill this void. However, many of these state-banks had questionable lending practices, and were far from disciplined.

Part of this “wildcat” banking style was due to the government’s suspension of specie (gold, etc.) convertibility during the War of 1812. Since banks did not have to worry about customers demanding payment in specie at a moment’s notice, state banks were very loose with their credit and loan policies, particularly in the western lands experiencing land booms.

“During the War of 1812, the Bank of the United States had suspended payments in specie, “hard money” usually in the form of gold and silver coins. When the war ended, the bank continued to issue only paper banknotes and to redeem notes issued by state banks with paper only.

The newly chartered banks also adopted this practice, issuing banknotes in excess of the amount of specie in their vaults. This shaky economic scheme worked only so long as people were content to conduct business with paper money and refrain from demanding that banks instead give them the gold and silver that was supposed to back it. If large numbers of people, or banks that had loaned money to other banks, began to demand specie payments, the banking system would collapse, because there was no longer enough specie to support the amount of paper money the banks had put into circulation.“

The second reason for growth in state-chartered banks was the land boom covered in the last section.

“Farmers strove to expand their acreage, and those who lived in areas where unoccupied land was scarce sought holdings in the West. They needed money to purchase this land, however. Small merchants and factory owners, hoping to take advantage of this boom time, also sought to borrow money to expand their businesses.

When existing banks refused to lend money to small farmers and others without a credit history, state legislatures chartered new banks to meet the demand. In one legislative session, Kentucky chartered forty-six.”

As long as cotton and other crop prices were high and European demand continued to be strong, this system would work. You can probably tell where this is going, but we still have a few key points to cover first.

The Second Bank of the United States (SBUS)

As mentioned, the first Bank of the United States’ charter was not renewed upon expiration in 1811. However, after 5 years without a national bank, the federal government realized that such an institution had its advantages. More specifically, the government felt that a national bank acting as America’s “fiscal agent” would be critical for overseeing the repayment of debts used for financing the War of 1812, but also the bonds used to fund the Louisiana Purchase in 1803 that were coming due in 1818.

In addition, the boom in state-chartered banks had created a currency issue, since each state-chartered bank was often printing its own bank notes. This was an issue for the banking system as a whole, as a conservative bank in New England would be wary of accepting bank notes from a distant “wildcat” bank in the west that it had never heard of. Thus, bank notes of different banks traded at different values, creating headaches. So, in 1816, Congress chartered the Second Bank of the United States.

The creation of this national bank had an almost immediate affect on America’s financial system:

“When the [BUS] was incorporated in 1816, its charter required that its notes be redeemable in specie…. [The BUS’s] cashiers were understandably reluctant to accept deposits in the form of unfamiliar, distant banks’ notes when withdrawals could then be made in gold or silver, especially when overextended local banks began refusing to redeem their notes in specie.”

The fact that the SBUS notes were redeemable in specie by law created an issue with the state banks that had lent recklessly without concern for specie convertibility. This was an issue because the SBUS’s deposits largely consisted of state-chartered banks’ paper banknotes, that were not fully backed by specie. This was a serious risk for the SBUS, because if the national bank needed to pay out large sums in specie, but could not redeem state-chartered bank’s banknotes for specie, the SBUS could not meet its payments. Thus, in 1817, the SBUS persuaded state-chartered banks to resume specie-convertibility. However, this did not fully address the issue…

The Panic of 1819

Rather than one specific trigger, the Panic of 1819 was the result of multiple triggers from the areas we’ve covered so far: land values, federal debt payments, state-chartered “wildcat” banks, American staples exports, etc. While separate, many of these triggers are very much related to one another.

For example, a key driver of this panic was declining prices of American staples like cotton and wheat, which also coincided with falling demand for American exports in Europe. The price of cotton in particular fell dramatically due to over supply in America and India. Demand fell because of strong harvests in Europe, which reduced the need to import crops from America. Between 1818 and 1819, British importations of American grains fell 74.6%.

This had significant knock-on effects as it meant that the value of farmland for harvesting cotton and other crops with declining prices plummeted. This, in turn, meant that the loans “wildcat” state-chartered banks made to individuals buying such farmland were in jeopardy. Many of the people fueling this land boom by buying up plots of farmland did so with the belief that crop prices and demand would remain high for years to come. Their repayment of loans to state-chartered banks was predicated on the fact that their newly purchased land would be valuable and harvest crops that sold at high prices.

Even founding father Thomas Jefferson was a victim:

“Many people know that Thomas Jefferson died in dire financial straits, but they may not know the role the Panic of 1819 played in that. In an apparent quid pro quo for Jefferson’s personal loans, the BUS’s Richmond branch president asked Jefferson to cosign $20,000 of the bank president’s own notes for speculative land purchases. Those notes then turned sour:

[Jefferson’s] mounting debts and the unexpected failure of a friend whose notes he cosigned would force his heirs to sell his beloved mountaintop plantation…. Jefferson had begun borrowing from the BUS as soon as it opened an office in Richmond. Already chronically in debt to creditors, … in June 1817 he borrowed $3,000 from the BUS, adding another $3,000 the following spring…. [By 1819, with the BUS tightening,] Jefferson tried to sell land to pay the Bank but was shaken to discover how low the price of land had now sunk and how little demand there was at any price.“

The fact that state-chartered banks had made so many speculative loans to people for buying farmland out west was now an issue. Like Jefferson, many of these people could now no longer meet their payments as the prices of cotton plummeted alongside the value of their farmland.

This issue was exacerbated by the issue of debt repayments, specifically the Louisiana Purchase bonds that were due in 1818 and 1819.

“Over $4 million in Louisiana bonds would come due in 1818 and 1819— most owed to foreign creditors, and all promised in specie…. The [BUS] saw no choice but to demand some of the millions of dollars owed to it—in specie—by the hundreds of state banks whose notes made up the bulk of its deposits. About the time the BUS began restricting credit, the private banks began failing at an alarming rate, first suspending specie conversion and then closing their doors.”

According to some estimates, upwards of 40% of state banks failed in this period. Another issue with these debt repayments was that a large portion of the payments were being sent in specie to foreign creditors. In October 1818, $3.5 Million of the $4.5 Million Louisiana bonds retired were payments to foreign creditors. While this may seem unimportant, it meant that at a time when the economy was faltering and in need of support, there was a drain of specie out of America. It also potentially reduced domestic spending that would’ve aided the economy since specie was not being paid from the government back into the hands of American creditors.

Impact and Conclusion

The impact of the 1819 Panic was severe, and marked America’s first true “depression”. In Virginia, the number of merchant licenses issued between 1818-1819 dropped 40%. In Philadelphia, the number of people employed across 30 industries dropped 78% between 1816-1819:

What made this episode so severe was the widespread nature of the depression.

“dramatic decrease in the value of agricultural goods left farmers unable to pay their debts. As they defaulted on their loans, banks seized their property. However, because the drastic fall in agricultural prices had greatly reduced the value of land, the banks were left with farms they were unable to sell. Land speculators lost the value of their investments. As the countryside suffered, hard-hit farmers ceased to purchase manufactured goods. Factories responded by cutting wages or firing employees…

In states with imprisonment for debt, the prison population swelled. As a result, many states drafted laws to provide relief for debtors.“

It is easy to forget that we used to have debtor’s prisons, but their dissolution was a lasting impact of the 1819 Panic. With a nation of indebted Americans and farmers unable to pay their debts or keep businesses open, the federal government was forced to step in with relief. At the time, this was a meaningful decision as the government had largely kept out of such affairs prior to the Panic of 1819:

“Following much debate, the final relief legislation for federal land purchasers passed Congress early in 1821. The act allowed debtors to give back the proportion of the land yet to be paid for in exchange for a clear title to what remained and forgave back interest.

For those wanting to keep all their land, the act extended payment of the full debt to eight annual installments, without interest charges, and gave a large discount to those who would pay promptly. While Congress had enacted postponement laws frequently in the decade following 1810, this level of federal government involvement into debtor-creditor relations was unusual for a time when state laws governed such relationships.”

Another lasting effect of the 1819 Panic, and the one that we will conclude on, is that it set the stage for Jackson’s Bank War just a few years later. The nation’s experience in 1819 tainted public view of the national bank in a way that is similar to devout “anti-Fed” followers today.

I hope you enjoyed this post, and please share with others! Until next week…