The Crash Of 1854 In 5 (Relatively) Simple Graphs

In late 1854, an economic panic of cataclysmic proportions struck the Midwest. The early 1850s had seen rapid change in monetary regimes in the region, as more states adapted to stagnant growth in the money supply by throwing the doors open to private banks, known as free banks, printing their own currencies backed by state bonds. However, when combined with complex regulatory differences among states and the radical anti-bank politics of the time, this upswell in currency led to disaster.

1. 1836 was a disaster for the United States monetary supply, as President Jackson’s Species Circular and destruction of the Second Bank of the United States crashed the value of paper banknotes. As previously only groups individually chartered by the legislature could enter banking, one attempt to rehabilitate the currency supply was known as Free Banking, a system under which private bankers could open banks as long as they possessed sufficient capital, backed their own banknotes with state bonds, and kept a certain amount of gold on hand. As you can see below, free banking flourished, particularly in the Midwest:


2. Not all free banking systems operated precisely the same. By 1852 Ohio had a large number of free banks, and a growing local currency. That year it passed a tax bill which sharply increased taxes on the banks, a tax preponderantly larger than those in its neighboring states. In the same year, Indiana passed a free banking act allowing for the creation of new banks. So Ohio bankers, and those who saw the opportunity to lend to Ohioans without paying Ohio taxes, swarmed into Indiana to create money. Meanwhile, Ohio banks pulled back to avoid the tax burden:


It’s clear that this didn’t last very long. We’ll get to why it failed so spectacularly shortly.

3. By early 1854, Indiana money was pouring into Ohio. It’s important to understand how much of Indiana’s currency wound up in Ohio. Importation was important, but more critical was regulatory arbitrage: that is, Indiana banks supplying the currency Ohio banks would have in the absence of Ohio’s crushing bank tax. In short, merchants in New York purchased Ohio goods using a loan called a bill of exchange, which promised to pay for the goods at a later time at a New York bank (think of it as a paper credit card charge). The New York merchant would give the bill of exchange to an Ohio merchant, who would then take it to a local bank. The local Ohio bank would pay for the bill in banknotes – frequently most of them were Indiana banknotes – with a discount for the service. The Ohio banker would then sell the bill to an Indianan bank for banknotes, charging a premium because New York bills of exchange were highly valued. This is the relationship in visual form:


4. Because, to merchants, Indiana notes and bills of exchange were both transferable at face value, and bills of exchange were worth more elsewhere, either bills of exchange would steeply drop in supply or they would begin to gain in value relative to banknotes. Both began to happen, which created inflation among noteholders and forced Ohioans to hold more Indiana currency, which they deemed dangerous, and fewer bills of exchange, which they valued for their security. In response to these fears the Ohio legislature in May 1854 passed a law banning all non-Ohio currency less than $10 in value. This ban went into into effect in October. In August, bankers in Cincinnati organized an expulsion of Indiana currency. As banknotes swept back into Indiana, Indiana banks ran out of gold and began to sell off the bonds held as collateral for their notes. However, as banks held a large percentage of all Indiana state bonds, their sudden sell-off quickly turned into a fire-sale and prices collapsed. Other Midwestern states’ bond values declined during the panic, but only Indiana bonds stayed consistently low due to the glut of bonds sold as banks failed.


5. This quickly became a vicious cycle. Banknotes arrived without gold to pay for them, bonds were sold, depressing the market, noteholders knew that the notes were backed by bonds and so rushed to redeem them before they became worthless. By mid-1855, 53 of Indiana’s 89 banks had stopped redeeming banknotes for coin, and the discount on the average Indiana banknote was over 20%. The whole sorry saga can be seen by looking at banknote discounts (the y-axis is percent discount from a $100 par)

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Central Banking in Middle-Earth, or: The Much-Maligned King Thror


Watch out there, Bilbo, you’re about to slip into some Dutch Disease!

This is not a post about the inflation of Hollywood movie length, although The Hobbit (part 1 of 3, mind you) surely fits that trend (and some unfortunate others). If you want that, there are some reviews I can point you to. Instead, this is a necessary corrective to the flawed monetary theories embodied in The Hobbit.

The film opens with a compact 20-minute history of the Dwarvish kingdom of Erebor, a mining city sunk deep into the mountains. The narrator helpfully explains that the city and its neighbors exploded in wealth and prosperity as gold poured bountifully from the ground; beautiful sweeping shots show us implausible mining efforts quarrying deep into the heart of Middle Earth. But then the music, Law-and-Order-like, turns somber as we learn that King Thror grew perniciously greedy, hoarding the gold and refusing to distribute it equally. Naturally, karma, the gods, and the plot of The Hobbit demanded vengeance, and it came in the fiery computer-generated form of the dragon Smaug. The kingdom was shattered, the Elves refused to aid the Dwarves, and the basic dramatic tension of the book was set in place.

Sadly, this is all so very wrong. The supposed villain of this piece, Thror the hoarder, should be hailed as its hero. His economic policy, while on the surface avaricious, was in fact brilliantly advanced. He was the Paul Volcker of Middle Earth, and it’s time to clear the record.


Fed chair Ben Bernanke may have the whole Central Banking thing down…


… but he has a ways to go until he achieves Dwarfish beard magnificence

As gold poured into the Dwarvish economy it faced a dual threat: Dutch disease and hyperinflation. In the former case, the gains from trade Erebor would achieve by selling gold would lead to a stagnation of its famed metal-smithing and beard-braiding sectors as labor shifted from manufacturing into mining. Ereborian currency would surge in value abroad as international demand for the currency increased to purchase gold. Concurrently inflation would explode at home as the value of gold disappeared. At some point these two effects would be about a wash, but in the presumably illiquid international markets of Middle Earth these forces would clash dangerously, destabilizing the Ereborian economy even as it entrenched itself further into the unsustainable mining industry.


When I have the time, I’ll add a caption here that explains how this graph helps illustrate what I’m saying (Corden, 1984)

Fortunately, King Thror had a solution: a sovereign wealth fund, a la Norway’s. To fight inflation and Dutch Disease simultaneously, Thror pulled a Volcker and tightly controlled the gold and precious jewel supply by hoarding it. This fiat ceiling on private gold supply would help fend off mining’s monopoly of labor, thereby preserving industry, and preserve the value of the Ereborian Dollar. One monetary policy to rule them all, if you will.

Of course, the hoard of gold did lead to the whole dragon coming and engulfing everything the dwarves cherished in flame, but you can’t really blame Thror for not implementing NGDP targeting, can you?

We can’t all be as foresighted as ibn Khaldun.

Correction: A previous version of this post referred to an ibn Khardun rather than the illustrious historiographer, historian, sociologist, economist, theologian and historical personality of ibn Khaldun. We present our sincerest apologies to his ghost.

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Where do ideologies come from? The thought of Pericles, Cicero and Paul in context

Great thinkers do not live in a vacuum. When they enter their writing chambers, or perch upon some grand vista to compose a foundational treatise they don’t throw off the fetters of their reality. In fact, it’s that dominating, driving force of history which often dictates a great deal of what they argue. I tried to show how that interaction works in an essay I wrote about Pericles, Cicero and Paul. You can read the whole thing here; excerpt:

Pericles, Marcus Cicero, and Paul the apostle, three of the great thinkers of the ancient world, through their writings and speeches helped frame their civilizations and ideals. Set side by side, the most glaring difference among these thinkers was that between the classical thought of Pericles and Cicero and the Christian philosophy of Paul. Where Pericles saw a state whose good citizens would seek its glory above all, and Cicero saw Rome’s greatest citizens as those who harnessed the state to improve the welfare of its subjects, Paul judged a Christian good not because of his or her relationship to the state but because of his or her unquestioning faith in Jesus Christ, expressed in belief and action.

Continue reading

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Don’t Bail Out the Banks, Bail Out the Economy

The Capitol

It’s recently been argued that central banks working as a lender of last resort makes no sense under a fiat money system. Being insolvent and being illiquid is virtually the same thing when the central bank can just print money. It’s not exactly clear why this should be the case. There is a finite number of dollars out there in the world, manipulatable by the Fed. When a banking panic sets in, and the value of assets is completely confused, credit lines seize up and illiquidity sets in — no one will lend to anyone else. That said, there are still institutions which, if given credit, can apply it to good use and pay their creditor back. As Felix Salmon points out, this is exactly what happened to Morgan Stanley in 2008. At one point, they owed the Fed $107 billion! Though they did pay this back, due to the extremely cheap rate at which the Fed was lending, MS made over $76 million dollars on the deal. This is acting as a lender of last resort, shooting huge amounts of money into the system to bolster banks and prevent complete collapse of the financial system and credit markets.

There are two questions that emerge from this. First, is there any real distinction between an illiquid and an insolvent company? After all, you just need to invest in US Treasuries to make an income, and in fact given that Morgan was loaned $107 billion at near-zero rates and only made about $76 million shows a tiny rate of return — hardly great evidence of solvency. At a certain point, if leant money at ~0% interest and given an investing opportunity that returns more (say, a US T bill) it’s essentially impossible not to make money. If the US govt leant me $100 billion dollars and charged me almost no interest, I could make some money too. Of course, the Fed could’ve listened to the founder of central banking Bagehot’s famous words, “lend freely, at a penalty rate.” But given that the banks were barely able to eke out a profit even at the absurdly cheap rates the Fed gave, it’s entirely possible that penalty rates would have wrecked the banking system completely. As Stephen Williams points out, lending freely and charging a penalty rate is kind of a contradiction in terms.

If that’s the case, the second question is: how can we solve general liquidity crises without rewarding the same bankers who in part created it? How can we avoid moral hazard? The real issue here is that we treat the banks as the only medium for solving liquidity crises. This makes a kind of sense, as they seize up and don’t lend to each other or anyone else. However, what the Fed is often doing when solving liquidity crises is managing expectations — will the money supply shrink? Will assets that we thought were safe stay valuable? Will NGDP grow? But expectations can be managed by means other than safeguarding banks. Because it’s the entire economy that’s uncertain, more direct means would be preferable.

For example, the U.S. might institute a minimum guaranteed income for all citizens as its form of welfare, subject to certain conditions (seeking work, scaling up when finding a job, etc). Even Hayek was in favor of minimum income! And to avoid bailing out the banks, the Fed could have control over the amount given every month. When a recession hits, the Fed would target NGDP by raising minimum income, directly raising the monetary supply and roughly fixing the liquidity crisis. Debt overhang is avoided; aggregate demand can stay roughly stable. And because liquidity crises raise the value of the dollar (by increasing demand for cash), this wouldn’t have to cause inflation if it’s aimed at propping up the growth in NGDP. In one fell swoop you can stabilize AD and avoid bailing out the banks.

Update: As Felix Salmon points out, Bloomberg’s assertion that the Fed leant these loans at below market rates is actually pretty unsubstantiated. The Fed claims that it usually leant at above market rates — a penalty rate. The point is that there’s a huge amount that just isn’t disclosed, and Bloomberg read things as being pretty bad. This doesn’t discount from the main argument here though, that giving money to the bank might not be the best way to solve a liquidity crisis while also avoiding moral hazard.

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Captured in Passing: 10,000 Feet over New York, New York

Captured in Passing: 10,000 Feet over New York, New York

My picture, taken while flying back to Chicago on 11/27

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Something is Rotten in the Corporation of Apple

Gold mine

Imagine you and a bunch of friends got together and started a gold mine. You had a plot of land with a lot of gold in it, and everyone in the group chipped in some money to hire people to build the mine, mine the gold out, etc. In return, all of your friends got a share of the company. Some other people, seeing that the gold mine was going to be super valuable, wanted to buy some shares in the company. People start trading shares. Soon the company starts turning a profit, and as it got better at mining gold and the price of gold shoot up, it made a killing.

But then you noticed that something weird was going on. All of this profit wasn’t going anywhere. It wasn’t being given out to the owners of the company (the shareholders). It wasn’t going to growth. In fact, it was just sitting there. So of course, the shareholders got together and demand that the money be handed out or invested or they’ll fire all the managers.

Or do they? Right now Apple (in the thought experiment, the gold mine) is sitting on $82 billion in liquid assets. To put that in some perspective, that’s $14 billion more than the combined annual GDP of Costa Rica and Ghana.  Matt Yglesias and Karl Smith argue that this is why Apple’s P/E ratio has been steadily declining — shareholders are realizing that Apple doesn’t treat them like owners. Really, they’re being treated like gamblers on the future profits of Apple. And that smacks of the total failure of public ownership in the case of Apple, maybe American corporations in general.

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Law of the Day

Law of the Day

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