Panic of 1873

On 18th September 1873, Jay Cooke & Co. suspended deposit withdrawals, this led to the onset of what is now know as the “Panic of 1873.” The panic was also the beginning of the original “Great Depression” which is more formally known as the “Long Depression.” The panic was primarily due to the over expansion of the railway sector in the United States, causing over capacity in the sector. By November of 1873, 55 of the nations railway companies had failed and by September of 1874 another 60 failed. Jay Cooke & Co. was one of the leading financial institutions in the U.S. which was at the forefront of lending to the railway sector, the failure of the bank caused a domino effect which resulted in bank runs and liquidation of holdings in the NYSE.

 

Key Factors in the Panic

Jay Cooke & Co.

Jay Cooke & Co., a bank formed in 1861 rose to fame by marketing government bonds during the civil war in the U.S. which lasted till 1865. Post the civil war, the bank started focusing more on lending to the railway sector in the country. During the 1800’s, rail construction was booming in the U.S., hence, there was ample opportunity to lend to the railway sector. Also, sensing an opportunity to sell U.S. railway bonds to European investors, the bank actively marketed these bonds to European investors.

The reduction in demand for American railway securities in Europe was catastrophic for the bank since it had based its entire plan on European demand for U.S. railway securities. The fall in demand for these securities led to the bank owning 75% of Northern Pacific Railroad. As liabilities became know to the public, people started withdrawing their deposits from the bank, ultimately leading to its failure.

 

Germany, U.K. & Europe

There was a high degree of demand for U.S. railway securities in countries like Germany. U.S. banks such as Jay Cooke & Co. sensing this opportunity marketed railway securities to the Germans. This demand for securities was augmented by the £200 million which France was required to pay to Germany after being defeated in the Franco-Prussian war. Thus, money flowed to the U.S. from countries such as Germany, funding the boom in railway construction.

This continued until Germany underwent a series of economic reforms in 1873 which created an opportunity for German investors to invest closer to home. Hence, funding for the U.S. railway construction boom from Germany dried up.

In Addition to this, in May of 1873, a European real estate bubble burst, thus, demand for U.S. railway securities in Europe almost completely dried up in the months preceding the Panic.

 

Credibility of the railway sector in the U.S.

The railway sector in the U.S. was marred by frequent scandals. One such scandal was when Union Pacific Railroad got caught using a shell company, Credit Mobilier, to inflate costs to maximise government subsidies for the lines it was building. Another such scandal was when it was discovered that six of the twelve board members at Chicago, Burlington and Quincy Railroad were also stockholders in River Roads Construction company, with whom they had signed a contract to construct a railroad, the contract released the construction company from any obligation if it ran out of cash despite having paid the entire amount to the construction company. Upon further probing it was found that the President of Chicago, Burlington and Quincy Railroad was also the President of the construction company.

Such scandals eroded investor confidence in railway companies, and hence, at the first opportunity to invest closer to home, German investors decided to invest their money in projects closer to home rather than in these companies.

Such scandals also made it very difficult for the U.S. government to bailout the struggling railway companies due to the perception of them being corrupt.

 

The Panic

On September 8th 1873, The New York Security and Warehouse Company suspended payments, it had been lending to southern and southwestern railroads which were now unable to repay.

On September 13th 1873, Kenyon, Cox & Company (KCC), the financial agents and lenders to Canada Southern railway suspended payments. KCC had been trying to sell the railroad to some English investors, when the negotiations failed, KCC suspended payment.

18th September saw the start of the full blown panic, Jay Cooke & Co. suspended payment on that day, this was followed by First National Bank of Washington which was organised by Jay Cooke (the financier).

Now, any bank which had lent to railway companies was in danger since there were runs on banks which had lent heavily to the railway sector.

The failure of railway companies and hence the failure of banks caused investors to gather on wall street on the 19th of September to withdraw securities and money from brokers, investors wanted to withdraw whatever little money they had left in the market, they feared a further collapse in the markets and more bank failures.The New York Stock Exchange closed trading for ten days starting 20th September, when the NYSE reopened ten days later, the panic had not calmed and liquidation of holdings continued.

The U.S. Congress in response to the panic passed a bill to add liquidity to financial markets in March 1874, but it was vetoed by President Ulysses S. Grant. The President feared that the infusion of money would cause inflation in the economy. This proved to be a mistake, Irving Fisher later on argued that the failure in reflate financial markets might have actually made the crisis worse.

Ultimately the U.S. economy had entered a recession due to the panic, this recession lasted till around 1979.

 

Overview

The Panic was primarily caused by the expansion of the railway sector beyond what the demand conditions justified. The situation was only exacerbated by poor corporate governance in the industry.

In addition to the above, European demand for U.S. railway securities fell post the bursting of the European housing bubble and the German economic reforms, hence, banks no longer had the required funding to lend to the railway sector.

Ultimately, the demand conditions and poor governance of railway companies caught up and they started having difficulty in servicing their debt. Since, banks had lent heavily to the railway companies, a default by them caused entire banks to fail, the failing of one bank i.e. Jay Cooke & Co. had a domino effect since any other bank which had lent to the railway sector was seen as being vulnerable, thus, there were bank runs i.e. depositors started withdrawing money from banks en masse. Now, banks give out loans using the money they collect as deposits, thus, if all depositors demand repayment, the bank is bound to fail. This was the fate of many banks. The failure of banks led to the freezing up of credit markets since there was no one to lend money.

Fearing capital loss, investors started liquidating shares in the stock exchange. This lead to a fall in the stock exchange and the New York Stock Exchange closed itself for ten days to let the markets calm down.

 

The panic caused a recession which lasted for 65 moths, the longest recorded in history. The Panic brought the railway construction boom to an end, construction of new lines plummeted from 7500 miles of track in 1872 to 1600 miles in 1878. The ensuing recession caused over 18,000 businesses to fail and caused ten states in the U.S. to go bankrupt. Thus, the panic of 1873 caused a recession which is rightfully called the original “Great Depression” or “The Long Depression.”

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