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)