23 March 2009

Historical American and Asian Financial Panics

Prior to the Great Depression, the customary name for a financially crisis or sudden severe economic downturn was a panic. These have been the norm, rather than the exception in U.S. history. A brief guide to them, cribbed from Wikipedia (citations within the text omitted), follows:

The Panic of 1819 was the first major financial crisis in the United States. The new nation faced a depression in the late 1780s (which led directly to the establishment of the dollar and, perhaps indirectly, to the calls for a Constitutional Convention), and another severe economic downturn in the late 1790s following the Panic of 1797. In those earlier crises, however, the primary cause of economic turmoil originated in the broader Atlantic economy. In contrast, the causes of the Panic of 1819 largely originated within the U.S. economy. The resulting crisis caused widespread foreclosures, bank failures, unemployment, and a slump in agriculture and manufacturing. It marked the end of the economic expansion that had followed the War of 1812. However, things would change for the US economy after the Second Bank of the United States was founded in 1816, in response to the spread of bank notes across United States from private banks, due to inflation brought on by the debt following the war.

Explanations from economists range from "boom-bust cycles happen," to "a failure of the banking system following the War of 1812 because it was not rechartered. Combined with the issue of the depression and overspeculation," the notion that

Government borrowed heavily to finance the War of 1812, which caused tremendous strain on the banks’ reserves of specie and led inevitably to a suspension of specie payments in 1814 during war & again in 1819-1821 during recession, violating contractual rights of depositors. The suspension of the obligation to redeem greatly spurred the establishment of new banks and the expansion of bank note issues. This inflation of money encouraged unsustainable investments to take place. It soon became clear the monetary situation was bad, and the Second Bank of the United States was forced to call a halt to its expansion and launch a painful process of contraction. There was a wave of bankruptcies, bank failures, and bank runs; prices dropped and wide-scale urban unemployment began. By 1819, land measures in the U.S. had also reached 3,500,000 acres, and many Americans did not have enough money to pay off to their loans.

The Panic was also partially due to international events. European demand for American foodstuffs was decreased because agriculture in Europe was recovering from the Napoleonic Wars, which had decimated European agriculture. War and revolution in the New World destroyed the supply line of precious metals from Mexico and Peru to Europe. Without the base of the international money supply, poor Europeans and governments hoarded all the available specie. This caused American bankers and businessmen to start issuing false banknotes and expand credit. American bankers, who had little experience with corporate charters, promissory notes, bills of exchange, or stocks and bonds, encouraged the speculated boom during the first years of the market revolution. By the end of 1819, the bank would call these loans [to disasterous effect].

Other notable historical panics in the U.S. are the Panic of 1873 and Panic of 1893, together sometimes known as the Long Depression.

Wikipedia describes the events leading up to the Panic of 1873 as follows:

It was precipitated by the bankruptcy of the Philadelphia banking firm Jay Cooke & Company on September 18, 1873, following the crash on May 9, 1873 of the Vienna Stock Exchange in Austria (the so-called Gr√ľnderkrach or “founders' crash”). . . . In September 1873, the American economy entered a crisis. This followed a period of post Civil War economic overexpansion that arose from the Northern railroad boom. It came at the end of a series of economic setbacks: the Black Friday panic of 1869, the Chicago fire of 1871, the outbreak of equine influenza in 1872, and the demonetization of silver in 1873.

The Black Friday panic was caused by the attempt of Jay Gould and Jim Fisk to corner the gold market in 1869. They were prevented from doing so by the decision of the administration of President Ulysses S. Grant to release government gold for sale. The collapse of gold premiums culminated in a day of panic when thousands of overleveraged speculators were ruined - Friday, September 24, 1869, popularly called Black Friday. There was great indignation against the perpetrators.

Coming at the height of an extremely dry period, the Chicago fire of October 8-9, 1871, caused a loss of nearly $200 million in property in a blaze that overran four square miles. . . .

The outbreak of equine influenza in 1872 had a pervasive effect on the economy. Called the "Great Epizoötic", it had an effect on every aspect of American transportation. The whole street railway industry ground to a halt. Locomotives came to a halt as coal or wood could not be delivered to power them. Even the United States Army Cavalry was reduced to fighting the Western tribes on foot; their adversaries likewise found their mounts too sick to do battle. The outbreak forced men to pull wagons by hand, while trains and ships full of cargo sat unloaded, tram cars stood idle and deliveries of basic community essentials were no longer being made.

The Coinage Act of 1873 changed the United States policy with respect to silver. Before the Act, the United States had backed its currency with both gold and silver, and it minted both types of coins. The Act moved the United States to the gold standard, which meant it would no longer buy silver at a statutory price or convert silver from the public into silver coins (and stopped minting silver dollars altogether.)

The Act had the immediate effect of depressing silver prices. This hurt Western mining interests, who labeled the Act "The Crime of '73." Its effect was offset somewhat by the introduction of a silver trade dollar for use in the Orient, and by the discovery of new silver deposits at Virginia City, Nevada, resulting in new investment in mining activity. But the coinage law also reduced the domestic money supply, which hurt farmers and anyone else who carried heavy debt loads. The resulting outcry raised serious questions about how long the new policy would last. This perception of instability in United States monetary policy caused investors to shy away from long-term obligations, particularly long-term bonds. The problem was compounded by the railroad boom, which was in its later stages at the time.

The conventional wisdom concerning the Panic of 1893, according to Wikipedia is that it "was caused by railroad overbuilding and shaky railroad financing; which set off a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value."

Since then, as measured by the stock market, the most notable economic downturns were the Great Depression, the 1973 oil crisis from January 1973 to October 1974, and the tech bust from March 2000 to October 2002, and of course, the current financial crisis which reached its pre-collapse stock market peak in October 2007.

Abroad, there are two frequently examined recent economic crisis precedents frequently compared to the U.S. financial crisis that we are in now.

One is the Japanese real estate bust. This started when a housing bubble in Japanese real estate collapsed in 1989 and produced a profound economic slump and deflation, followed by a brief recovery in the stock markets, at least, from April 2003 to June 2007, but, Japanese stock markets fell approximately 50% (between June 2007 and December 2008), and Japanese economy remains less than thriving now, in part due to the global impact of the American led financial crisis which is similar in many respects to the one we are in now.

The other is the Asian Financial Crisis of 1997 takes a bit of explaining to make sense of:

The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt.

Though there has been general agreement on the existence of a crisis and its consequences, what is less clear is the causes of the crisis, as well as its scope and resolution. Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong Kong, Malaysia, Laos and the Philippines were also hurt by the slump. The People's Republic of China, India, Taiwan, Singapore, Brunei and Vietnam were less affected, although all suffered from a loss of demand and confidence throughout the region.

Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in 1993-96, then shot up beyond 180% during the worst of the crisis. In Korea, the ratios rose from 13-21% and then as high as 40%, while the other Northern NICs (Newly Industrialized Countries) fared much better. Only in Thailand and Korea did debt service-to-exports ratios rise.

Although most of the governments of Asia had seemingly sound fiscal policies, the International Monetary Fund (IMF) stepped in to initiate a $40 billion program to stabilize the currencies of South Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis. The efforts to stem a global economic crisis did little to stabilize the domestic situation in Indonesia, however. After 30 years in power, President Suharto was forced to step down in May 1998 in the wake of widespread rioting that followed sharp price increases caused by a drastic devaluation of the rupiah. The effects of the crisis lingered through 1998. In the Philippines growth dropped to virtually zero in 1998. Only Singapore and Taiwan proved relatively insulated from the shock, but both suffered serious hits in passing, the former more so due to its size and geographical location between Malaysia and Indonesia. By 1999, however, analysts saw signs that the economies of Asia were beginning to recover.

Deeper analysis of what was behind these panics presented in thumbnail, economic history 101 sketches from Wikipedia above (to save me the trouble of rewriting well written prose there) will have to be saved for my uncoming paper on the financial crisis at the Law and Society Conference in Denve this May, but these tidbits of research are topic and useful, so they deserve and early release.


Michael Malak said...

The way to avoid boom-and-bust is a combination of a gold standard with no fractional reserve banking. The Bank of England brought fractional reserve banking into practice at the end of the seventeenth century, and we've been stuck with it ever since.

Andrew Oh-Willeke said...

I don't agree. A gold standard does have important impacts on monetary policy (and the 1873 and 1893 panics had important elements that related to the role of a silver standard in the U.S. currency), but a gold standard is no silver bullet to the problem of boom-bust cycles, which have more to do with the corporate structure of banking and an inability to interrupt bubbles promptly.

Fractional reserve banking is also far more of a "natural" and far less of an intentionally structured legal arrangement, than it might seem. There is an argument that the multiplier effect of fractional reserve banking makes booms more robust and busts more severe, but there is an equally good argument that this flows inherently from rapid changes in collective market opinion about creditworthiness, independent of the "back office" technicalities of the banking system.