James Narron and David Skeie
As we observed in our last post on the Continental Currency Crisis, the finances of the United States remained chaotic through the 1780s as the young government moved to establish its credit. U.S. Congress was finally given the power of taxation in 1787 and, in 1789, Alexander Hamilton was appointed as the first Secretary of the Treasury. Hamilton moved quickly to begin paying off war debts and to establish a national bank—the Bank of the United States. But in 1791, a burst of financial speculation in subscription rights to shares in the new bank caused a tangential rally and fall in public debt securities prices. In this edition of Crisis Chronicles, we describe how Hamilton invented central bank crisis management techniques eight decades before Walter Bagehot described them in Lombard Street.
From Political to Financial Revolution
Although the American political revolution ended in 1783, it was soon followed by a financial revolution as the United States implemented a number of key reforms common to modern financial systems. The first American mint was established in Philadelphia in 1786 in a move to create a more stable currency. In 1787, Congress was given the power of taxation to pay off the debt, which helped the United States make significant progress toward more stable public finances. And after Hamilton was appointed Treasury Secretary, he worked to pay off war debts, in the process creating an active securities market in what were called U.S. Sixes—the U.S. 6 percent bond that the Treasury issued in 1790. But it was Hamilton’s second Report on Public Credit, delivered to Congress in December 1790, in which he called for a national bank, headquartered in Philadelphia.
The Bank Scrip Bubble of 1791
Congress approved the Bank of the United States in early 1791, and the subscription rights—called “scrips”—to the July 1791 public offering were heavily oversubscribed. The $25 scrips were a down payment on the $400 per share bank stock, with the balance due over the course of the next two years. But only a quarter of the $400 due was in gold or silver specie; the remaining 75 percent was to be paid in Treasury securities.
From the oversubscription, it was clear that demand for shares in the Bank was strong and the price of bank scrips in the secondary market initially doubled, before going even higher. And because investors needed U.S. Treasury securities for a substantial portion of the future payments, the price of securities rose as well. But just as rapidly as the prices had run up in July, they fell just a month later in August. Fortunately, the Treasury had previously set aside a cash surplus, in what was called a sinking fund, to buy securities in the open market in the hopes of retiring some of the national debt early. So as the securities market fell and credit became constrained, Hamilton used the sinking fund to purchase securities in the open market, and the mini-panic came to an end by September. Hamilton’s early use of “open market operations” had effectively stabilized interest rates.
Panic of 1792—Wall Street’s First Crash
In late 1791, a former Treasury Department assistant and later speculator and businessman William Duer conspired to corner U.S. securities. Duer and his co-conspirators borrowed heavily to do so. At the same time, the Bank of the United States opened in December 1791 and began making loans and issuing banknotes. So as Duer borrowed heavily to finance his securities purchases, and as the Bank expanded credit, the price of U.S. Sixes rose from 110 to 125 from early December 1791 to mid-January 1792. But by February 1792, depositors began returning liabilities for gold and silver specie and the Bank slowed its credit expansion, as did other banks, creating another credit crunch.
By early March 1792, U.S. Sixes fell back to nearly 115, but because Duer was long U.S. securities, he was unable to pay his debts. By early March, Duer defaulted. Duer’s debt was overwhelming and his default caused a selloff in the securities market. By March, U.S. Sixes fell to 95. But once again, Hamilton moved quickly to calm the markets. By mid-March, in coordination with the Bank of New York, Hamilton began a series of lender-of-last-resort operations in the Treasury market, authorizing open market purchases of securities at a penalty rate of 7 percent, but against all good collateral in the form of Sixes presented. By April, the panic had subsided.
Eighty Years Before Bagehot and the Seeds of the New York Stock Exchange
The Panic of 1792 appears to have been effectively managed with little or no long-term spillover to the economy. And most importantly, it didn’t derail the financial and economic revolution taking place. What’s more, key features of Hamilton’s market intervention predate Walter Bagehot’s famous rules for central bank crisis management by nearly a century. For example, Hamilton instructs Bank of New York to lend on good collateral, in this case U.S. Treasury securities, at a penalty rate of 7 percent on the U.S. Sixes. This action was coordinated with the bond dealers in New York so as not to drain gold and silver specie from the banks. And this coordination ultimately led to a May 1792 meeting of twenty-four broker-dealers under a buttonwood tree on Wall Street, who signed an agreement of cooperation, an act many historians view as the origin of the New York Stock Exchange.
While mismanagement of one financial crisis may sow the seeds of the next, effective management by Hamilton prevailed and the United States was able to avoid another financial crisis until 1819. How should Hamilton’s early example of market crisis management be compared with the later, more famous “Bagehot’s dictum” for a central bank to lend freely to solvent banks during a banking crisis at a high interest rate against good collateral? Bagehot explained this strategy in this way:
First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.
Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer . . . . No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business . . . . The great majority, the majority to be protected, are the “sound” people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse. (Lombard Street, Chapter 7, paragraphs 57-58).
In fact, Hamilton’s actions even predated the predecessor to many of Bagehot’s principles contained in Henry Thornton’s 1802 An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. So who deserves credit for the original doctrine of lender of last resort? Do Bagehot’s words speak louder than Hamilton’s actions? Tell us 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.
David Skeie is a senior economist in the Federal Reserve Bank of New York’s Research and Statistics Group.