Originally posted on Tuesday, May 27th, 2014

James Narron and David Skeie, two meticulously scholarly monetary officials of the Federal Reserve System, publishing, again, valuable lessons from history at the NY Fed’s Liberty Street Economics. This time, about the first Wall Street panic.

Liberty Street Economics

Narron and Skeie:

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.

Panic of 1792Wall 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 [6% interest bonds] 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.

The authors go on to marvel at how Hamilton’s actions anticipated Bagehot’s dictum, set forth in Lombard Street, long before formulated by Bagehot:

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?

The authors conclude, “Tell us what you think.”

This writer thinks that the Federal Reserve System is extremely well served to have two of its career civil servants, Narron, a senior vice president and cash product manager at the Federal Reserve Bank of San Francisco, and Skeie, a senior economist in the Federal Reserve Bank of New York’s Research and Statistics Group, so immersed in the facts that only can be found in what Lewis E. Lehrman, founder and chairman of the Lehrman Institute, calls “the laboratory of history.”