Drozda Near

DRAFT

2015-16 JOHN NEAR GRANT Recipient Learned Lessons: Financial Innovation and the Panic of 1873 Zarek Drozda, Class of 2016

LEARNED LESSONS: FINANCIAL INNOVATION AND THE PANIC OF 1873

Zarek Drozda 2016 John Near Scholar Mentors: Mrs. Meredith Cranston, Mr. Sam Lepler April 6, 2016

Drozda 2 The Panic of 1873 set off one of the worst economic depressions witnessed in the United States, second only to that of 1929 in terms of “damage done to the economy and social fabric of the nation.”1 Lasting six years, the “long depression” caused a 32% decline in business, led to 5100 bankruptcies in 1873 alone, and created an unemployment level of reportedly up to fourteen percent.2 Moreover, the political, cultural, and social ramifications were also significant. The overall decline shook business confidence, which translated into wage cuts and poor working conditions that sparked numerous labor strikes.3 The unrest left over one hundred dead and many more injured, forcing President Rutherford B. Hayes to dispatch troops to over a half dozen states.4 The terms “bum” and “tramp” became commonplace in American vocabulary as unemployed Civil War veterans rode the rails looking for work.5 As conditions further deteriorated, the North turned its political efforts away from Reconstruction policies in the South, allowing white supremacists to regain elected offices and the violent Ku Klux Klan to expand its membership, rolling back progress made for recently liberated African Americans.6 Yet instead of focusing on the impacts, this paper will attempt to explain the cause of this historically significant economic crisis. Moreover, a distinction will be made between the proximate trigger of a railroad failure and the underlying changes in the economy. Rather than a result of railroad overbuilding, the Panic of 1873 instead may have been caused by financial innovations, namely the opening of rival exchanges, the introduction of around-the-clock trading, the invention of faster trading technology, and the construction of new financial institutions, all localized to New York City. These innovations created the potential for a small or average disturbance to reek disastrous

Drozda 3 consequences primarily through 1) the ability for news of a failure to quickly spread and react within New York City markets, and additionally through the side-effects of 2) the development of a riskier and interconnected investment community and finally 3) the development of a new, but somewhat isolated monetary system within the larger country, which meant little relief was available should a panic occur.

Current Theories on the Panic of 1873 Current work on the Panic and innovation falls into three categories. The largest category is comprised of studies that examine the political consequences caused by the Panic. Particularly notable works include Jay Cooke’s Gamble: The Northern Pacific Railroad, the Sioux, and the Panic of 1873, which examines in detail Cooke’s role in conflict with the Native Americans and how that contributed to his company’s failure, and Charles Cashdollar’s Ruin and Revival: The Attitude of the Presbyterian Churches Toward the Panic of 1873, which argues that the panic created a desire for national purity, the panic being a part of God’s punishment for amoral behavior.7 A second relatively small category comprises papers that analyze certain aspects of the Panic, but do not examine financial innovation. Such examples include the work of Dove, Mixon, and Nelson, which analyze the impact of the resulting municipal debt, the risk associated with the actual railroad bonds sold before the panic, and the influence of European investment (which is also discussed later in this paper), respectively.8 Finally, there are some works that compile general financial innovation theories, such as William Silber’s Financial Innovation, or Henry Cavanna’s Financial Innovation (which focuses solely on the 1980s to present time), but don’t attribute those theories to causing a specific panic in the Gilded Age. 9 In contrast, this paper will focus very specifically on financial

Drozda 4 innovation in the context of 1873 by correlating economic history presented by Robert Sobel, business historian of Hofstra University, in A History of America’s Financial Disasters, in combination with data from Milton Friedman’s A Monetary History of the United States and other sources to infer its impact. 10 An additional claim prevalent in most reference articles is that over-construction of railroads was the culprit of the Panic, but a reexamination of the data refutes this correlation. Such introductory materials can be found in the Historical Encyclopedia of American Business and Micklethwait’s The Company, and other encyclopedias.11 Many works claim that lines overlapped, that too much track was built overall, and that the “if you build it, they will come” attitude the railroad industry held resulted in overproduction and promoted too much speculation.12 First, from a purely theoretical level, this argument seems unlikely due to basic supply and demand. With more lines, the supply curve would shift right, lowering prices, eventually making companies unprofitable, and causing market exit. Yet railroad companies continued to exist and further expand into the next decade, meaning the rapid increase in supply via track building was likely justified by the demand. Second, census data from the period confirms high demand. In the years leading to 1873, track mileage (operated) per year increased by about four to six thousand miles each year, and then after the Panic, mileage decreased to approximately two thousand more miles operated per year.13 However, total revenue across railroad companies continued to increase through 1875, suggesting the decline in building was simply due to lowered business confidence while actual usage remained strong for a full two years into the Panic.14

Drozda 5 Additionally, both passenger and freight revenue increased by 26% (108,889 to 137,384; 1= $1000) and 32% (294,430 to 389,036; 1= $1000) respectively from 1871 to 1873, yielding an average 29% increase.15 This rise compares to a 37% (51,445 to 70,651) increase in total mileage (owned) over the same period.16 While the difference between revenue and mileage may have led some to believe that track was overbuilt, it must be remembered that the nature of railroad construction requires building slightly ahead of demand: the line must be fully completed before operation can begin.

Additionally, track outpaced revenue by less than ten percent, so the difference is not significant. Thus, if not simply a result of overbuilding through an investment bubble, what caused the Panic of 1873?

Economic Background & Panic History To establish the potential alternate causes for the Panic, we must review the economic context and the specific events that led to the Panic. The economy at large was doing well, yet showed signs of potential weakness. Between the 1860s and early 1870s, industry was booming. Grain, foodstuffs, and other raw materials (much from mining) were transported east, where they were processed into manufactured goods that either went back west, or were shipped abroad.17 Farmers, miners, and industrialists all benefitted, as well as the railroaders in-between. This cycle helped push aggregate demand (AD) further to the right as the country industrialized.18 Yet there were also weaknesses, which carried with them the ability to amplify a crisis should one occur. Startup costs for both railroad companies and farmers alike were on the rise – with industrialization, capital became larger and more advanced, pushing infrastructure expenses further upwards.19 Debt held by both groups subsequently rose,

Drozda 6 creating a situation in which, according to Sobel, “each was in constant danger of bankruptcy should the monetary noose tighten,” as real debt burdens grew with deflation.20 Moreover, much of this debt was highly leveraged via bank loans, making the situation even more precarious.21 The metaphorical cherry on top was the (mostly) gold standard, which the United States still operated on during the period, meaning the national money supply could not quickly be altered.22 A secondary characteristic of the 1860s and 70s was the need for continued capital investment to continue industrial expansion. Sobel identifies four potential options for companies: reinvestment, inflation, diversion of funds from other sectors, and foreign borrowing.23 Reinvestment wasn’t possible because private citizens or other interests had already purchased and borrowed against much of the property in the west.24 Inflation was politically unlikely because merchants and their firms on the east coast protested monetary policy that created inflation.25 Diversion of funds from other sectors was not economically feasible, given that the transfer itself would be complicated, other sectors also held debt because of industrialization, and there was little willingness to do so.26 Thus foreign borrowing was the only available strategy, of which Europe appeared most promising due to its earlier industrial boom.27 In particular, London had the ability to invest in American infrastructure due to the capital inflow the Suez Canal brought to the market.28 The same calculus was made by Jay Cooke, the man who created the company that most immediately caused the Panic, Jay Cooke and Co. Once applauded as the “savior of the nation” after helping finance Union efforts during the Civil War, Cooke lost that reputation when he later (and ironically) bankrupted the country.29 Cooke was

Drozda 7 attempting to build a second transcontinental rail line, dubbed the Northern Pacific Railroad.30 Given the tight monetary conditions, Cooke innovated to aggressively procure investment. He hired marketing specialists, such as the celebrity “newspaperman” Sam Wilkerson, to advertise the potential profits, which helped to raise over $100 million in bonds for the line still waiting to be built.31 Eventually Cooke was forced to look to Europe (as Sobel notes), encouraging settlement along the yet-constructed line.32 One proposed city was to even to be named “Bismark” to attract German peoples.33 Though following storms, poorly constructed track, flimsy bridges, and even an entire section of rail line sinking into a lake, Cooke’s line was overdrawn by $1.6 million in February of 1873.34 Cooke would have had little reluctance to simply borrow more, yet that was not possible due to the concurrent situation in Europe. A combination of market crashes, such as in Vienna (where banks overextended on forecasted profits from a World’s Fair), postWar busts, and central bank actions (both in Austria-Hungary and England) caused sudden frigidity in European capital movement beginning in May of 1873.35 The lack of foreign capital inflow, combined with the already-low reserves as money rested out west during the harvest season (as farmers used cash to pay workers and rent equipment), meant there was nowhere else for Cooke to borrow.36 On September 8th, the New York Warehouse & Security Company “admitted to be insolvent” because railroad construction companies stopped paying on their debts (because they were not being paid by Cooke).37 Ten days later, Cooke closed his offices in both New York and Philadelphia, followed by the First National Bank of Washington and other institutions linked with Cooke’s company.38 As news of Cooke’s closure spread like wild fire, bank runs flooded Wall

Drozda 8 Street, panicked investors were trampled in the streets, sending some to the hospital, and the N.Y.S.E. suspended operations for the first time in its existence “for an indefinite period” (yet notably a full week after the Panic had begun).39 Proximate v. Underlying Causation While many blame Cooke for directly causing the Panic and subsequent “Long Depression,” it must be noted that any young, relatively risky investor or entrepreneur could have easily filled Cooke’s void, or at least replicated similar actions. In the same light, any company, whether building a railroad, canal, or factory, could have overextended and declared bankruptcy at that time. The real answer then, to what caused the panic, must lie in the creation of the conditions that allowed for these potential “bad apples” to have such a large influence on the whole economy.

In earlier U.S. economic crises, much of the declines were caused by either natural or tangible events. The first category of previous causes is agricultural based: bad harvests (often related to simple bad weather) caused grain prices or other commodities to skyrocket, causing subsequent contractions from the inflation. The second is governmental actions that ruin monetary confidence, such as during the Jacksonian bank wars, or during the Civil War, when both the Union and Confederacy issued eventually worthless paper money to pay for troops and supplies. While some of these phenomena were present in 1873, the Panic is unique because its main causes were more related to financing issues in the private business sector.

A small exception is the Coinage Act of 1873, passed in April, later known as the “Crime of ’73,” which removed silver minting from the monetary system.40 Though seemingly a significant government action ruining monetary confidence, Freidman notes

Drozda 9 in his article, “The Crime of 1873,” that the law did not have a deflationary effect until 1875, two years after the Panic.41 Moreover, there was no political recognition of the supposed problem until 1876, in which rural dissatisfaction led to the creation of the Greenback Party, meaning there was no monetary confidence loss, or at least until 1876.42 In fact, the law did not earn the “Crime of ‘73” nickname until later elections in the 1880s, when representatives who had originally voted for the legislation flipped to vehemently criticize the law following the public outcry.43 Thus a change of the underlying economic framework must have occurred in order to alter the market so drastically, which this paper argues is through new innovations that changed the way the market functioned.

The Role of Financial Innovation in the Panic This section will identify and discuss four particular financial innovations in the decades preceding the panic, namely rival exchanges, around-the-clock trading, faster trading technology, and new financial institutions and services. The subsequent development created the conditions in which velocity of money could fall quickly, which was seen following the Panic. The velocity decrease will be estimated in the following section using the monetarist equation of exchange. This decrease, in tandem with interconnected debt and a separated monetary system that were also created by the same innovations, turned a small failure into a significant collapse.

Rival exchanges, and later all-day trading, were the two results of changing power-relations between classes of investors in New York City. The early and mid 1850s marked the conservative era of Wall Street. The New York Stock and Exchange Board, later to become the N.Y.S.E., served as the “legitimate” financial sector, its doors

Drozda 10 separating the elite brokers from individuals who operated on curb markets, where shares of companies quite literally were exchanged on the streets.44 Outside, according to Sobel, “clearings were still cumbersome, petty thievery the rule, and three-day weekends in the summer normal.”45 In stark contrast, the Board was “dull, conservative, and secure,” dominated by elder white males who “frowned on the newcomer and forced them to curb trading.”46 As backlash against this financial elitism, those “newcomers,” both young in age and in their practices, began to open rival exchanges in hopes of competing with the Board, creating the first “innovation.” By the time the Civil War had ended, over twodozen separate, rival exchanges had been established.47 One such example only charged a $50 admit fee and outlined very few rules.48 On the floor, investors interested in certain shares would simply aggregate in its usual trading “spot;” for example, those interested in shares of Eerie would navigate to the “Eerie crowd” to shout out their trades and hope to catch the ear of a seller.49 With this sort of democratization of trading, more shares could now move simultaneously instead of just through one exchange, thereby increasing the ability for higher volumes. To fit into the monetarist equation, this increase in capacity translates to a similar ability in velocity: more (or in the case of the Panic, less) investment affects companies ability to buy capital, and thus changes the rate at which those goods and services are produced and purchased within the economy.

The Board was conservative in practice as well, but with the power of younger investors, new practices such as all-day trading would eventually win-out. Whereas 40,000 shares per day were flaunted and exchanged outside, only a measly 7,000 shares were available to be traded by the Board’s members during the 1850s.50 The Board also

Drozda 11 instituted strict methods of exchange through an auction system.51 Twice a day, members would meet at 10:30am and 2:45pm to deposit slips with the exchange president.52 Buyers would then proceed to bid on these slips in a very procedural fashion, starting with bonds, banks, canals, and eventually ending with railroads.53 However, this conservatism would not last.

The Panic of 1857 soon upset the local politics of the Street. Attributed to a decreased demand for American crops as Russian troops returned to their farms after the Crimean War ended, the crisis also wiped out much of the wealth held by the conservative Board members, effectively forcing many of them to an early retirement.54 This rather royal flush of old, stately wealth allowed the younger, more risky investors to take control of Wall Street, creating an opportunity for institutional change.

While the younger class never was able to fully conquer the New York Stock and Exchange Board, the aftereffects of 1857 culminated into a sort of power struggle between the two classes through the 1860s. After the Panic, the Board began to crack down on rival exchanges. The leadership banned its members from trading elsewhere, and instituted strict consequences should an investor defect from the policy.55 Citing other exchanges as lawless places of corruption, the Board even encouraged the police to forcibly shut down other trading institutions, which was somewhat successful throughout the decade.56 Witnessing this persecution, the “rejects” and persecuted exchanges banded together in 1864, forming the aptly named Open Board.57 Informally known as the “Coal Hole” because it was first established in a former tenement, the Open Board followed some of the riskier practices favored by the younger element. Most significantly, the Open Board traded constantly between the hours of 8:30am to 5:00pm, six days a week.

Drozda 12 Additionally, the Open Board instituted the floor grouping as previously described in the Eerie example, which became known as the “specialist system,” because often one specialist would remain in a single location to facilitate the trading of a certain stock.58 As the 1860s came to a close, the Open Board had gained in influence and grew larger in wealth than the New York Stock and Exchange Board.59 The progressives had seemingly won, but instead of accepting defeat, the N.Y.S.E. merged with the Open Board in 1869 to simply absorb the competition.60 The result was a now larger but divided N.Y.S.E., one floor which remained on the auction system, and the other that utilized the all-day trading and specialist system.61 Eventually, the auction system was phased out completely. The result was an official exchange that had incorporated an allday framework, again rendering trading faster, and thus creating a capability for velocity of money to change quickly (via the volume to velocity chain described previously).

New technology invented in the 1800s constituted the third financial innovation, resulting in a faster speed of communication for financial information. Following the invention of the telegraph in 1832, Western Union was founded in 1856 and began to build wire across the country, which had obvious applications for investors.62 To meet popular demand, the company finished its “continuous telegraph” project in 1866, in which stock prices could be sent in real-time to other brokerage houses around the country, all connecting to New York.63 By 1868, this primitive stock ticker was available in Manhattan for $25.64 In addition to tickers, the new all-day trading required faster financial intelligence networks to collect any potentially relevant news. As the younger investors continued to gain influence during the 1860s, those investors often knew of Civil War victories and losses before President Lincoln.65 This new network resulted in

Drozda 13 faster communication of financially relevant information, which meant news of a panic could spread and subsequently shake the markets sooner. A major headline thus had the ability to drastically change velocity.

The final innovation was the development and centralization of new financial institutions in New York City. A soon booming financial sector attracted even more of this construction. These new institutions and services primarily came in the forms of larger traditional banks, life insurance companies, underwriting, and specialized investment banks. While creating faster communication through geographical congealing, the new sector also opened the door to riskier, interconnected investing, which helped create the proximate cause of the Panic: Cooke’s firm and connected institutions failing.

The growing number of banks by 1873 in Manhattan can be attributed to the passage of the Independent Treasury System in 1844.66 The legislation created a system of sub treasuries for government funds to be distributed and stored in various cities across the country.67 This policy was especially popular (and therefore politically necessary) with farmers who highly mistrusted centralized banking power, who remained aligned with the Jacksonian Democrats, the group who originally opposed the Second Bank of the United States. Money in the private sector followed a similar path at first, as farmers deposited money in only the banks they trusted, which were small, local establishments.68 Yet as railroads were built and farmers began to ship goods across regions, Western banks began to deposit parts of their reserves in New York banks, so that merchants and transporters could redeem their profits at the other end of the transcontinental line.69 Existing banks in New York City soon expanded, while others were founded to service the trend. The growth eventually created rather large and influential banks, purely as a

Drozda 14 private sector, or free market, phenomenon, ironically in opposition to what the farmers originally tried to prevent. The now large and still growing reserves also began to attract other financial services.

The first of these services were life insurance companies. By nature, life insurance companies require a large amount of capital to begin operation. Remembering that most banks were localized and small due to farmer mistrust and the sub treasury system, New York became one of the few places to find banks that were now large enough for such sizeable loans. Additionally, life insurance companies may have been a source of investing for other new Gilded Age organizations, especially railroads. Given that life insurance was already specialized towards high magnitude and long term loaning, this trend seems highly plausible.70 With longer payout windows for policies, that money could have been invested elsewhere in the meantime. Lance E. Davis, economic historian at the California Institute of Technology, notes that these sort of practices may have been much more profitable than the life insurance itself.71 One such early example was the Ohio Life & Trust Company, which “specialized in placing Eastern and foreign funds in Western investments, especially land, railroads, and commodity futures.�72 Ohio Life later became insolvent following the Panic of 1857 after, conveniently, stock prices, including railroad stocks, plummeted.73 Thus, not only did life insurance companies help contribute to the growth of and geographic congelation of the financial sector to New York, but the companies themselves may have added themselves to an increasingly complex web of investment tied to the railroads.

Finally, underwriting and investment banks were first introduced during the period, again driven by the combination of brokerage houses and sizable banks that now

Drozda 15 existed in New York City. Before 1873, J.P. Morgan underwrote his first security, creating the concept of “preferred stocks.”74 According to Davis, its affect was to “greatly [speed] investor acceptance of new types of issues.”75 Jay Cooke then institutionalized this practice to create the first investment bank, founding the very company that directly caused the Panic, Cooke and Co.76 As opposed to a bank in the classical sense, which performs many activities including investment, these new specialized banks focused solely on investing.77 By underwriting securities and serving as the middleman between company and investor, these firms reduced perceived risk, raised capital, and then directed that capital to hopefully profitable projects.78 These institutions contributed to the growth of the financial machine in New York while simultaneously making investors more confident, thereby encouraging further riskier investment.

Therefore larger banks, life-insurance companies, and investment firms all centralized to Manhattan. However with these new services, a more complex web of debt (tied to either railroads or other industrial companies) was created between the different institutions. Moreover, underwriting and the creation of middlemen created a reduction in perceived risk, when in reality, the collective owning of debt may have simply spread potential problems wider should a default occur.

As it relates to the velocity of money, the “district jelled” into the “bankinginsurance-brokerage complex” that it is today.79 Sobel notes that the stables and taverns “that had dominated the landscape since the colonial era were torn down and replaced” by the new business landscape.80 With geographical congealing, information could travel faster, given that a large investing community now lived and worked in close proximity.

Drozda 16 Thus news of a panic could travel much faster than before, allowing shocks of confidence to in turn quickly and drastically affect the markets.

Innovation, Velocity, and the Equation of Exchange With rival exchanges, all-day trading, new trading technology, and centralized financial services, the velocity of money now carried with it the ability to fall quite quickly should a panic occur. However, this phenomenon was only localized to New York City, as data suggests that the velocity nationally decreased steadily in the years both before and after 1873, seemingly less affected by the Panic. Using PQ = MV (P = Price Level, Q = Quantity of Output, M = Money Supply, V = Velocity of Money), this section will confirm the rapid decrease in velocity locally.81 Additionally, the imbalance between velocities will suggest proof of a divided monetary system that further worsened the Panic.

The following calculation for national velocity uses both GNP and money stock estimations (see Tab. 1 and 2). The money stock during the period was a rough combination of a bimetallism standard (primarily gold with some silver) as well as Greenbacks.82 GNP, or Gross National Product, can be substituted for PQ (price*quantity = total economic output). Inputting PQ and M, we see a relatively gradual decrease in velocity both leading up to and following the panic on a national level (see Table 3).

Drozda 17

1869

$735

1870

$779

1871

$844

1872

$1,041

1873

$1,070

1874

$1,066

*1875

$1,151; $1,185

*1876

$1,158; $1,152

*Data was collected twice per year

Table 1. Supply of Money Nationally per Year (in millions).

Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States 1867-1960 (Princeton, NJ: Princeton University Press, 1993), 704.

1869

8.21

1870

8.41

1871

8.69

1872

8.81

1873

9.17

1874

8.85

1875

8.92

1876

8.68

Table 2. Price Level*Quantity (= nominal GNP) per Year (in billions).

Source: Nathan S. Balke, "The Estimation of Prewar Gross National Product: Methodology and New Evidence," Journal of Political Economy 97, no. 1 (1989): 38-92, accessed July 8, 2015.

Drozda 18 1869

11.17

1870

10.80

1871

10.30

1872

8.46

1873

8.57

1874

8.30

*1875

7.75; 7.53

*1876

7.50; 7.53

*Data was collected twice per year

Table 3. Velocity as calculated by PQ/M (ratio of).

As national velocity steadily and gradually decreases, local New York City velocity decreases rapidly by the same calculation following the Panic. First, price levels: given that economic data from pre-1929 is generally sparse, even less data exists on a city-by-city basis. Thus to circumvent this problem, New York state data was used to determine local price levels instead of New York City. While not a perfect indication, New York City did makeup a greater than average portion of the state’s economy.

Price levels are estimated via the prices of groceries, clothing, and other goods, a total of 35 different products to create a makeshift CPI market basket. Repeats of the same products were excluded. Like the price levels themselves, data for consumption rates of these products is also rare. However it can be assumed that the consumption of basic goods is somewhat equal; a sack of potatoes, coal, and shirtings, for example, are usually purchased between a weekly and monthly basis. Thus the products are averaged and weighted equally (see Table 4).

Drozda 19

1867

$60.34/35 = $1.72

1869

$52.82/35 = $1.51

1874

$48.45/35 = $1.38

Table 4. Price Level of New York (calculated via averaging of 35 products).

Source: United States Bureau of Statistics, Labor in Europe and America: A Special Report on the Rates of Wages, the Cost of Subsistence, and the Condition of the Working Class, in Great Britain, France, Belgium, Germany, and Other Countries of Europe, also in the United States and British America, by Edward Young (Philadelphia, PA: S. A. George & Company, 1875), 798, accessed March 24, 2016.

For the period between 1867 and 1874, the averages yield a 19.77% decrease in price level, or an approximately modest 2.82% deflationary rate each year. During the relatively short period (up to the Panic, excluding 1874), Q, or quantity of output, can be assumed to be rather stable as well, if not increasing when accounting for the growth of the financial sector via the previously mentioned innovations. Therefore, at least leading up to the Panic, the local PQ can be assumed to be relatively stable given the decrease in one is leveled out by the potential increase in the other.

As for local money supply, it remains relatively stable both before and after the Panic, fluctuating within the $220M to $240M range (see tab. 5). Factoring this data into the equation, a constant M and a decreasing P exists after the Panic. Again because of the period, there is limited local GNP data on a city-by-city basis, and thus inferences must be made of Q. Given that there were over 5,100 bankruptcies in 1873 alone, and that a large portion of the New York City economy was now devoted to banking, it is safe to assume that Q fell dramatically as a result of the Panic when combined with the other

Drozda 20 1867

$233,465,776

1868

$212,852,591

1869

$213,370,866

1870

$211,364,433

1871

$220,377,509

1872

$223,943,600

1873

$227,407,600

1874

$220,308,200

1875

$238,499,700

1876

$219,621,000

Table 5. Money Supply of New York Banks (Circulation + Deposits).83 Source: "New York City Banks," The Commercial and Financial Chronicle (New York, NY), 1867-1877, The Bankers' Gazette, accessed March 24, 2016, http://catalog.hathitrust.org/Record/000548353.

effects of a depression.84 Therefore V must have also fallen quickly to equate the loss (see fig. 1).

Figure 1. The Equation of Exchange Following the Panic.

Though the velocity in New York City decreased significantly, there still exists a disparity between the local and national rate of which money was moving through the system. Additionally, a disparity also exists with the money supply; money supply is

Drozda 21 overall increasing nationally but remains stable locally in New York. So what caused the geographical imbalance?

The answer lies in the very nature of the national banking system. Recalling the sub-treasury system from the 1840s, the legislation created a framework that purposely divided publically held money into separate regions. This division spilled-over to the private sector, as local banks were generally small and heavily regulated by the individual states they operated in, therefore preventing ease of transfer across state lines.85 Moreover, farmers’general mistrust of the new, large, centralized banking complex kept these banks small because they had to bend to the demands of their customers. While these same western banks originally helped create the banking complex in New York, the development was a gradual process and did not create official ties to those banks, meaning that transfer was still difficult in an emergency. The difference in velocities proves that obstacles indeed existed between the east and west – functionally creating two independent monetary circuits. Given these obstacles to easy transfer, there would be little relief should banks in New York suddenly require additional money supply because of a panic or subsequent bank runs.

Conclusion and Discussion The Panic of 1873 was ultimately caused by financial innovations – changes in the underlying framework of the economy – and their clash with older policies not capable of dealing with them. Rival exchanges, all-day trading, new trading technology, and affiliated financial institutions created the ability for velocity to fall quickly locally in Manhattan. The innovation resulted in a situation in which the news and stock market reaction to any failure could develop quickly into a full-blown panic. Moreover, the

Drozda 22 “banking-insurance-brokerage complex” that developed through innovation also carried interconnected debt. When a few institutions in each section failed due to Cooke’s failure, it created the perception of a much larger panic that crossed multiple financial sectors, further spooking investors and the public. Finally, despite the increasing national money supply, little relief would be found elsewhere in the country due to decentralized banking policies and the distrust of the new financial center when bank-runs occurred.

Ultimately, the failure of Cooke’s company and a few connected institutions setoff a panic that, via faster communication from the very same financial innovations, spread news of the few initial bankruptcies at never-before-seen speeds, setting off the chainreaction to create the Long Depression.

On a final note, it is not the aim of this paper to demonize innovation. Innovation in all forms is necessary for progress. Whether it is agriculture or the computer, we all benefit from new technologies. In the context of finance, today’s globalized economy is a modern wonder. International trade and markets have spread prosperity through the exchange of goods, services, and ideas. Online communication has both revolutionized the economy and global politics, democratizing our resources.

Yet innovation also poses new risks. Just as digitalization opened the possibility of cyber-warfare, the risks of financial innovation were made apparent in 1873. Faster trading capabilities and quicker communication, while seemingly beneficial to economic growth, also created a fast and detrimental panic. When Cooke’s and a few other firms failed, a relatively small crisis turned into an unnecessarily large panic. Had news not spread so quickly, bank-runs may have been avoided, which would have at least prevented further bank failures in the week and year following.

Drozda 23 What is necessary is not a backlash to innovation and change, but rather mindfulness of its occurrence and potential consequences. Innovation is inevitable and it is an act of futility to attempt to stop it. In the case of 1873, there was no stopping the invention of the telegraph or the inevitable centralization of a banking system to support the new industrialized economy. Yet safeguards could have been created to prevent the dangerously low monetary levels, or even the bank-runs themselves. Today, fail-safes do exist in the forms of auto-shutdowns in the stock market or governmental regulations to help assuage the dangers of an ever-faster economy. Even in 1873, the N.Y.S.E. was shutdown a week after the panic, but waiting a full week was already too late. Continuing to strike a balance between progress and caution is key to preventing larger and foreseeable calamities, and is the ultimate lesson that should be learned from the Panic of 1873.

Drozda 24 Notes 1

Robert Sobel, A History of America's Financial Disasters (New York, NY: Macmillan Company, 1968), 192-193.

2

Ibid; Gayla Koerting, "Panic of 1873," in Historical Encyclopedia of American Business, ed. Richard L. Wilson (Pasadena, CA: Salem Press, 2009), 2: 632-34.

3

"The Panic of 1873," WGBH American Experience, last modified 2013, accessed January 29, 2016.

4

Ibid.

5

Scott Reynolds Nelson, "The Real Great Depression: The Depression of 1929 is the Wrong Model for the Current Economic Crisis," The Chronicle of Higher Education, October 17, 2008, accessed January 29, 2016.

6

"The Panic of 1873," WGBH American Experience.

7

John Lubetkin, Jay Cooke's Gamble: The Northern Pacific Railroad, the Sioux, and the Panic of 1873 (Norman, OK: University of Oklahoma Press, 2006), accessed September 5, 2015; Charles D. Cashdollar, "Ruin and Revival: The Attitude of the Presbyterian Churches Toward the Panic of 1873," Journal of Presbyterian History 50, no. 3 (1972): 229-44, accessed September 5, 2015.

8

John A. Dove, "Financial Markets, Fiscal Constraints, and Municipal Debt: Lessons and Evidence from the Panic of 1873," Journal of Institutional Economics 10, no. 1 (March 2014): 71-106, accessed March 14, 2016; Scott Mixon, "The Crisis of 1873: Perspectives from Multiple Asset Classes," The Journal of Economic History 68, no. 3 (September 2008): 722-57, accessed February 4, 2016; Scott Reynolds Nelson, "A Storm of Cheap Goods: New American Commodities and the Panic of 1873," The Journal of the Gilded Age and Progressive Era 10, no. 4 (October 2011): 447-453, accessed March 14, 2016.

9

William Silber, ed., Financial Innovation (Lexington, MA: Lexington Books, 1975); Henry Cavanna, Financial Innovation (London, England: Routledge, 1992).

10

Sobel, A History of America's; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States 1867-1960 (Princeton, NJ: Princeton University Press, 1993).

11

Koerting, "Panic of 1873," in Historical Encyclopedia of American, 2: 632-34; John Micklethwait and Adrian Wooldridge, "First Came the Railroads," in The Company (New York, NY: Modern Library, 2003), 60-62.

12

Koerting, "Panic of 1873," in Historical Encyclopedia of American, 2: 632-34; Charles R. Morris, "Chapter Eight: The Newest Hyperpower," in The Dawn of Innovation (New York, NY: PublicAffairs, 2012), 274-75.

13

Bureau of the Census, Historical Statistics, Doc., at 200 - 205 (1949). Accessed July 8, 2015.

Drozda 25

14

Ibid.

15

Ibid.

16

Ibid.

17

Sobel, A History of America's,156-158.

18

Ibid.

19

Ibid., 159.

20

Ibid.

21

Christopher Whalen, Inflated: How Money and Debt Built the American Dream (Hoboken, NJ: John Wiley & Sons, 2011), 49-50.

22

Sobel, A History of America's, 159.

23

Ibid., 160-61.

24

Ibid.

25

Ibid.

26

Ibid.

27

Ibid.

28

Ibid.

29

Ibid., 166-170.

30

Ibid.

31

Ibid.

32

Ibid.

33

Ibid.

34

Morris, "Chapter Eight: The Newest," in The Dawn of Innovation, 274-75; Sobel, A History of America's, 166-170.

35

Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. (Hoboken, NJ: John Wiley & Sons, 2005).

36

Sobel, A History of America's, 174.

37

Ibid.

38

Ibid., 178-79; Ibid., 174.

39

Ibid., 187; 174; Ibid.,187.

40

Milton Friedman, "The Crime of 1873," Journal of Political Economy 98, no. 6 (December 1990): 1159-94, accessed January 24, 2016.

41

Ibid.

42

Ibid.

Drozda 26

43

Ibid.

44

Sobel, A History of America's, 86.

45

Ibid.

46

Ibid.

47

Robert Sobel, Inside Wall Street (New York, NY: W. W. Norton & Company, 1977), 27-29.

48

Ibid.

49

Ibid.

50

Sobel, A History of America's, 86.

51

Ibid.

52

Ibid.

53

Ibid.

54

Mary Hurd, "Panic of 1857," in Historical Encyclopedia of American Business, ed.

Richard L. Wilson (Pasadena, CA: Salem Press, 2009), 2; Sobel, A History of America's, 114-115.

55

Sobel, Inside Wall Street, 27-29.

56

Ibid.

57

Ibid.

58

Ibid.

59

Ibid.

60

Ibid.

61

Ibid.

62

Ibid., 30-31.

63

Ibid.

64

Ibid.

65

Sobel, A History of America's, 114-115.

66

Ibid., 91-93.

67

Ibid.

68

Ibid.

69

Ibid.

70

Lance E. Davis, "The Evolution of the American Capital Market, 1860-1940: A Case Study in Institutional Change," in Financial Innovation, by William L. Silber (Lexington, MA: Lexington Books, 1975), 9-44.

Drozda 27

71

Ibid.

72

Sobel, A History of America's, 1968. 100.

73

Ibid.

74

Davis, "The Evolution of the American," in Financial Innovation, 9-44.

75

Ibid.

76

Ibid.

77

Ibid.

78

Ibid.

79

Sobel, A History of America's, 115.

80

Ibid.

81

Campbell R. McConnell, Stanley L. Brue, and Sean M. Flynn, Economics: Principles, Problems, and Policies, nineteenth ed. (New York, NY: McGraw-Hill Irwin, 2012), 738739.

82

Ibid., 78-79.

83

"New York City Banks," The Commercial and Financial Chronicle (New York, NY), 1867-1877, The Bankers' Gazette, accessed March 24, 2016.

84

Sobel, A History of America's, 192.

85

Ibid., 91-93.

Drozda 28

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