Crisis Chronicles: Defensive Suspension and the Panic of 1857

Crisis Chronicles: Defensive Suspension and the Panic of 1857
Thomas Klitgaard and James Narron
Liberty Street Economics October 02, 2015




Sometimes the world loses its bearings and the best alternative is a timeout. Such was the case during the Panic of 1857, which started when a prestigious bank in New York City collapsed, making all banks suddenly suspect. Banks, fearing a run on their gold reserves, started calling in loans from commercial firms and brokers, leading to asset sales at fire-sale prices and bankruptcies. By mid-October, banks in Philadelphia and New York suspended convertibility, meaning they would not allow gold to be withdrawn from their vaults even while all other banking services continued. Suspension then swept the nation as part of a defensive strategy, supported by local business interests, to prevent the Panic from spreading. While the suspensions appeared successful and few banks ended up failing, President Buchanan was outraged by what he viewed as yet another corrupt banking practice. He proposed making suspension a “death sentence” for banks as a draconian incentive to encourage safer banking practices. In this edition of Crisis Chronicles, we describe the Panic of 1857 and explain why businesses pushed for national suspension to save themselves.

Paper Bubbles and Premonitory Symptoms
The outpouring of gold from California starting in 1849 fostered a period of prosperity in the 1850s. Spurred by migrations to the West, the decade saw a massive expansion of the railroads and the accompanying financial speculation by bankers and British investors. Robert C. Kennedy notes that “railroads were the backbone of the economic growth, with the construction of over 20,000 miles of track during the 1850s. They were aided by state land grants and financed by government bonds, stock sales on Wall Street, and foreign, particularly British, investments. . . . The number of banks almost doubled from 1850 to 1857. . . . Particularly important was New York City, the nation’s financial center and home to the Stock Exchange.”

The mood of the nation, however, turned a bit darker in the summer of 1857. Van Vleck (The Panic of 1857, page 60) quotes the New York Heraldin June of that year: “What can be the end of all this but another general collapse like that of 1837, only upon a much grander scale? The same premonitory symptoms that prevailed in 1835-36 prevail in 1857 in a tenfold degree. Paper bubbles of all descriptions, a general scramble for western lands. . . . The worst of all these evils is the moral pestilence of luxurious exemption from honest labor which is infecting all classes of society.”

Like a Cannon Shot
The start of the Panic of 1857 is attributed to the closing of a New York City bank owned by the Ohio Life Insurance and Trust Company on August 24th. The announcement of the bank failure

“struck on the public mind like a cannon shot. An intense excitement was manifested in all financial circles, in which bank officers participated with unusual sensitiveness and want of self-possession. Flying rumors were exaggerated at every corner. The holders of stock and commercial paper hurried to the broker and were eager to make what a week before they would have shunned as a ruinous sacrifice. Several stock and money dealers failed. . . . Every individual misfortune was announced on the news bulletins in large letters.” (J.S. Gibbons 1858)

It did not help that bonds and stocks issued by railroads had been heading down over the course of the summer and that this decline had contributed to the bank’s failure. The question then was what other banks were vulnerable to dropping railroad securities prices.

Fears of runs on their gold compelled banks to call in their loans to brokers and commercial firms and withdraw their deposits in other banks in hopes of building their gold holdings. Commercial firms were forced to sell assets at such deep discounts that many ended in bankruptcy, which in turn made banks more aggressive in calling loans. The telegraph meant that the panic swept quickly across the country.

By September 26th, banks in Philadelphia suspended the right to withdraw gold. New York banks held on until October 13th, when a large run that day caused all but one bank to suspend. Most other banks in the country soon followed. Countrywide suspension would last two months, with New York City banks not resuming payment in gold until December 14th.

Banks Go Defensive
Calomiris and Schweikart note that the suspensions in Philadelphia and New York led to defensive suspensions in the rest of the country that were encouraged by commercial interests. Firms gave up the right to pull out their gold in order to eliminate the need for banks to call in loans, which would “cause customers to go bankrupt or to sell off merchandise at ‘fire sale’ prices, which can result in bank losses as well. Suspension did not force banks to shut down; it allowed banks to choose which deposits and notes to redeem and permitted them to accumulate reserves gradually without calling in loans en masse.” Suspension forced the country’s banking system to work through paper-based transactions for two months and the fact that few banks failed suggests it was a good strategy.

Indeed, Calomiris and Schweikart argue that the rest of the country’s response was a lesson for New York City banks. Had they suspended earlier, “they might have been able to extend the necessary loans to keep the securities market afloat. Focusing on their banks’ reputations, rather than the health of the markets as a whole, the bankers chose the path of tight credit, falling prices, and commercial failures.”

Not Everyone Agreed
But the use of defensive suspensions to quell the panic wasn’t approved of by all. In December of that year, President James Buchanan focused on the Panic in his State of the Union. He argued for states to “require that the banks shall at all times keep on hand at least one dollar of gold and silver for every three dollars of their circulation and deposits, and if they will provide by a self-executing enactment, which nothing can arrest, that the moment they suspend they shall go into liquidation. I believe that such provisions, with a weekly publication by each bank of a statement of its condition, would go far to secure us against future suspensions of specie payments.” He then pushed this point by saying that the remedy might be done at the national level. “Congress, in my opinion, possesses the power to pass a uniform bankrupt law applicable to all banking institutions throughout the United States, and I strongly recommend its exercise. This would make it the irreversible organic law of each bank’s existence that a suspension of specie payments shall produce its civil death. The instinct of self-preservation would then compel it to perform its duties in such a manner as to escape the penalty and preserve its life.”

So, would Buchanan’s bank death-sentence for suspending convertibility have altered bank practices enough to make them less vulnerable to the Panic of 1857 or would the inability to suspend have caused much more economic damage throughout the country from the initial loss of confidence in New York City? Let us know what you think.

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

James Narron is a senior vice president in the Federal Reserve Bank of San Francisco’s Cash Product Office.

Klitgaard_thomasThomas Klitgaard is a vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Posted by Blog

Category: Think Tank

X-Files Special

The X-Files “The Truth Is Still Out There”     The next mind-bending chapter of THE X-FILES debuts with a special two-night event beginning Sunday, Jan. 24 (10:00-11:00 PM ET/7:00-8:00 PM PT), and continuing with its time period premiere on Monday, Jan. 25 (8:00-9:00 PM ET/PT). The thrilling, six-episode event series, helmed by creator/executive producer…Read More

Category: Film, Weekend

‘Never Buy a Boat’ and Other Misguided Financial Advice

‘Never buy a boat’ and other rash financial advice Barry Ritholtz Washington Post, September 27, 2015       “A boat is a hole in the water you throw money into.” “The two happiest days in a sailor’s life are the day he buys a boat and the day he sells it.”   I have…Read More

Category: Apprenticed Investor, Consumer Spending, Really, really bad calls

MiB: Gary Shilling

This week in our Masters in Business interview, we speak with with economist Gary Shilling, author of The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. In the 1960s, Shilling helped to create Merrill Lynches economics department; at the time, firms that focused on equities like ML never felt the need for staff economists,…Read More

Category: Podcast

10 Weekend Reads

Welcome to the weekend! Pour yourself a hot mug of Jamaican Blue Mountain, and settle in for our longer form weekend reads: • Sneaker Wars: Inside the Battle Between Nike and Adidas (GQ) • Children of the Yuan Percent: Everyone Hates China’s Rich Kids (Bloomberg) • How Prescription Drugs Get So Wildly Expensive (Wired) • A Brief History of the Corporation: 1600 to 2100…Read More

Category: Financial Press

Charles Evans: Thoughts on Leadership and Monetary Policy

Thoughts on Leadership and Monetary Policy Charles Evans Marquette Leadership Forum in Milwaukee, WI., September 28, 2015       Thank you, President Lovell for that kind introduction. Before I begin, I should note that my commentary reflects my own views and does not necessarily represent those of my colleagues on the Federal Open Market Committee (FOMC) or…Read More

Category: Federal Reserve, Think Tank

Succinct Summations of Week’s Events 10.02.15

Succinct Summations for the week ending October 2nd, 2015 Positives: Motor vehicle sales came in at 18.2mm, well above the 17.6mm expected. Consumer spending rose 0.4%, in line with forecasts. Core inflation rose 0.1%, in line with expectations. Case-Shiller home prices rose 5% y/o/y, slightly above the 4/9% expected rise. ADP employment came in at…Read More

Category: Markets

Firing a Researcher on Fiduciaries for Breaching A Fiduciary Duty

Over the years, I have written and spoken positively about the fiduciary standard (see e.g., this or this or this). Simply stated, a fiduciary is obligated to put the client’s interest first. Period. It is higher duty of care owed to clients than the traditional broker “suitability standard.” I’ll say more another time about why the new Department of Labor…Read More

Category: 401(k), Investing, Regulation

Meet with Ben and Josh in Arizona in December!

    My colleagues Ben Carlson and Josh Brown will both be speaking at the IMN Global Indexing and ETF Conference at the Hyatt Regency Scottsdale Resort & Spa at Gainey Ranch from December 6-8, 2015. We will be meeting with clients and prospective clients in area who want to learn about our approach to investing, and how we can help them…Read More

Category: Asset Allocation, Investing

10 Friday AM Reads

My shade grown, organic morning train reads: • Inside Steve Cohen’s groundbreaking ‘Academy’ poaching young talent from Wall Street (Business Insider) • Google’s Cute Cars And The Ugly End Of Driving (Buzzfeed) see also A Car That Knows What the Driver Will Do Next (MIT Technology Review) • Munger’s Advice on Shamans, Humility, and Attention Spans (Motley Fool) • How Steve Jobs…Read More

Category: Financial Press