By Richard Sylla

logging their way through the latest financial crisis, Americans from Wall Street to Main Street have suddenly become interested in history. Along with other financial historians, I am often asked, “Is the 2007 to 2009 crisis the worst the US has experienced since the 1930s?” Yes, it is. “Will the crisis lead to a second Great Depression, in which a quarter of American workers might lose their jobs?” I very much doubt it. “Could stocks again lose almost 90 percent of their value at the peak of the market, as the Dow industrials did from September 1929 to July 1932?” I don’t think so.

My answers are based less on comparing the current crisis to that of 1929 to 1933 than on comparing it with other serious financial crises that did not lead to economic depressions. In virtually every case, bold leadership – sadly missing during the early 1930s – prevented actual or potential financial meltdowns from causing depressions.

The US might have had a serious crisis in 1914 after the outbreak of the Great War in Europe led panicked European investors to want to liquidate their large holdings of American securities. But bold actions led by Treasury Secretary William McAdoo – including shutting down the New York Stock Exchange for four months and issuing emergency currency to US banks – averted a major financial crisis and, of course, a depression.

There was a serious crisis with many bank and business failures in 1907. But bold actions by the great private banker J.P. Morgan averted depression. Morgan forced other banks to cooperate by pooling reserves to save solvent but illiquid banks encountering huge deposit withdrawals. He also bailed out an investment bank and broker by arranging for the sale of a company’s securities, which the bank could not liquidate in panic conditions, to another company in a merger. A short but sharp recession, not a depression, occurred. After the panic, Congress, realizing that Morgan would not be around forever (he was 70 in 1907), reinstituted a central bank by establishing the Federal Reserve. Morgan passed away in 1913. The Fed opened in 1914, after McAdoo saved the day.

In 1825, the Bank of the United States, the early central bank led by Nicholas Biddle, prevented a financial crisis that devastated Britain, America’s major trading partner, from spreading across the Atlantic. It did so by lending liquid US government securities on its balance sheet to other banks under pressure so that they could borrow on the already impeccable collateral of US government debt. The Bank also increased its own lending to add liquidity to the money markets and the banking system. Crisis averted.

My favorite, if little-known, example of bold action preventing a major financial crisis from causing a depression, or even a recession, occurred at the very beginning of US history in 1791 and 1792. People, including historians, tend to forget about financial crises that are so boldly and well-handled that they end quickly and have minimal economic fallout. But we ought to study and learn from triumphs as well as disasters.

Making It New

First, some background. Financial innovation was in the air in the early 1790s. Adoption of the Constitution had given rise to a new and, theoretically, stronger federal government in 1789. George Washington, the first president, chose Alexander Hamilton, his principal aide de camp during the War of Independence, to be the first Secretary of the Treasury.

Hamilton knew his financial history. For a decade before he took office in 1789 his writings were peppered with comments about past Italian, Dutch, British, and French financial innovations. In 1781, while an officer in the Continental Army at a time when US finances were in a shambles, Hamilton wrote Robert Morris, Congress’s newly appointed finance minister, to say, “Tis by introducing order into our finances – by restoring public credit – not by gaining battles, that we are to finally gain our object,” which was “the establishment of American independence!”

Building on these insights, Hamilton, with the support of Congress, embarked on modernizing US financial arrangements, key to making the new republic before long into a major economic and political power. First, in 1790 he established a revenue system and used revenues it generated, as well as new loans, to convert the unpaid debts, national and state, of the war into modern Treasury debt securities. Some $64 million of such domestic debt securities were issued during Hamilton’s tenure at Treasury. Hamilton borrowed another $12 million from Dutch bankers to pay overdue American war debts to France.

Next, Hamilton in 1791 established the Bank of the United States as America’s central bank. For its time, the Bank was a gigantic corporation, with $10 million in capital, a fifth provided by the government and the rest by private investors, who controlled it in order to prevent Congress from having a money-creating machine. This action prompted state governments to charter more banking corporations by providing them with both a model and a challenge: Modernize, or the federal government will do it for you.

Third, Hamilton also in 1791 defined the US dollar as a new world currency in terms of specific weights of gold and silver, making the dollar like the currencies of the leading European nations. The specie (coined) dollar became the monetary base of the country, upon which banks issued credit money – bank notes and deposits convertible into the base.

With these Hamiltonian financial innovations in place, states and private citizens filled out the system. The states issued charters for more banks and other corporations. Citizens applied for charters, established corporations, and formed markets, even stock exchanges, to trade all the new government debt and corporate stock issues that appeared in the early 1790s.

For Americans, Hamilton had created an exciting new world of ample private and public credit as well as opportunities for investment and speculation. As would happen on many subsequent occasions, it went to their heads. The main issue of government bonds rose from 70 to 90 (percent of par) in December 1790, when Hamilton unveiled his plan for a central bank, because the bonds could be used to purchase stock in the Bank if the plan were enacted. It was.

Oops!

When the initial public offering of Bank shares took place in mid-1791, the bonds rose from 90 to 110. At the same time, the rights or scripts entitling the owner to buy a full $400 bank share with installment payments over the next two years rose from an offering price of $25 in July to around $300 (implying a market value of $675 for a full bank share having a par value of $400) over the next six weeks. Some Americans were getting rich … on paper. It was heady stuff, too heady. The market for scripts crashed in mid-August 1791, with $300 scripts plunging to between 110 and 160. The crash also depressed government bonds by more than 10 percent in a matter of days.

Hamilton was appalled. He wrote to his friend, Senator Rufus King, to say that “a bubble connected with my operations is of all the enemies I have to fear … the most formidable.” Then he acted, boldly. Calling a meeting of the Commissioners of the Sinking Fund, a government authority Hamilton had created for just such a moment, he asked his fellow four commissioners to approve up to $400,000 of purchases of government debt to inject liquidity into the sinking markets of New York and Philadelphia. To finance the purchases, Hamilton borrowed from state banks in those cities, as the central bank had not yet opened. Later, he repaid the loans by drawing on Dutch loans to the US.

The medicine worked. In less than a month, the markets stabilized, and soon government bonds rose in price to pre-crash levels. The calm, however, proved temporary. In January 1792, government bonds rose from 110 to almost 130. There were two reasons for the dramatic rise. First, a cabal of New York speculators led by one William Duer decided to try to corner the market’s supply of government bonds before they were needed to pay the next installment, and the cabal borrowed from any and all sources as they executed their plan. Second, there was a huge new source of credit available: the Bank of the United States, which opened in Philadelphia in December 1791. Immediately and rather recklessly, the Bank expanded lending and bank note issuance. The new money was fueling a new bubble.

Le Plus ça Change

Again Hamilton was appalled. “These extravagant sallies of speculation,” he wrote in late January, “do injury to the government and to the whole system of public credit, by disgusting all sober citizens and giving a wild air to everything.” Three weeks later he wrote, “Every existing bank ought within prudent limits to abridge its operations. The superstructure of credit is now too vast for the foundation. It must be gradually brought within more reasonable dimensions or it will tumble.”

But it was too late for gradualism at the biggest bank, the Bank of the United States. Having made excessive loans and issued excessive bank notes, it was experiencing a steady loss of specie reserves, which fell from $706,000 at the end of December to $244,000 in March. The new central bank’s private creditors were expressing their distrust of its stability by asking it to convert its paper promises to specie. To protect itself from the drain, the bank contracted its credit abruptly, not gradually.

The abrupt credit contraction undercut the speculative cabal by causing government bond prices to fall, not rise. On March 8, William Duer defaulted on his obligations to repay extensive loans from his creditors. That caused all hell to break loose in the markets. Government debt fell from 126 on March 5 to 116 on the day Duer defaulted, and then to 95 on March 20, as securities holders rushed for the exits. The national debt lost 25 percent of its value in two weeks. Today that would be nearly $3 trillion.

Bold Strokes

Once more Hamilton swung into action. On March 19, he asked the Bank of New York to accept government bonds as collateral for loans, so that panicked bondholders would not dump them on the market. But it appears that the bank, looking to its own interests, demurred because of the risk of taking on collateral that was sinking in value. Hamilton also told customs collectors they could receive post-notes of the Bank of the United States with a maximum maturity of 30 days “upon equal terms with cash” in payment of duties due. And, using the authority remaining unused in 1791 to purchase government debt, he ordered open-market purchases in Philadelphia.

The next day he reconvened the Sinking Fund Commissioners to authorize still more open market purchases. Two of them, Virginians Thomas Jefferson and Edmund Randolph, Hamilton’s political enemies, resisted, and it took some time before John Jay, another member, could be summoned to join Hamilton and John Adams in breaking the deadlock. Meantime, Randolph changed his mind, and further open-market purchases commenced, continuing until the crisis ended in mid-April.

Meanwhile, Hamilton made more palatable to the Bank of New York his plan to have panicked bond dealers collateralize the bonds for loans instead of dumping them on the market. Now he set the prices at which the bonds were to be accepted as collateral for loans and promised to take back the collateral at those prices should the bank get stuck with illiquid collateral. He told the bank to charge a penalty rate, one percent above the customary rate, to provide the borrowers on bonds with an incentive to repay their loans as soon as possible when the markets stabilized.

Thus did Alexander Hamilton, in the midst of Wall Street’s first crash, essentially formulate Englishman Walter Bagehot’s rules for correct central bank behavior in a crisis: When no one else wants to lend, the central bank should lend freely on good collateral at a penalty rate. And he coupled it with the offer of a repo by agreeing to relieve the bank of any collateral it couldn’t unload. Hamilton was far ahead of his time: It was eight decades later that Bagehot came up with the rules that bear his name.

Lucky for Us

The bond dealers of New York accepted the brilliant plan, collateralizing at Hamilton’s prices and settling their debts by writing checks on the resulting bank balances instead of by dumping securities on the panicked markets. During the crisis, Hamilton urged the banks to keep lending, especially to customers who needed loans to pay taxes, and he promised the banks he would let them keep the government’s money on deposit for as long as needed.

These bold actions ended the panic of 1792 in just a few weeks. Some speculators, including Duer, were ruined, as were some who had lent to them on promises of high returns. Duer went to debtors’ prison, where he was probably safer than he would have been on the streets of New York. The markets stabilized, and government bonds rose back above par. No economic damage resulted. The US economy continued the expansion that began in 1790 for several years.

That appeared to disappoint Jefferson, who redoubled his efforts to undermine Hamilton. He wanted to stop Hamilton from turning Americans into a nation of stock-jobbers, speculators, factories, corporations, and transportation systems, all fueled by credit from banks and capital markets. Better, Jefferson thought, that Americans stick to farming. Hamilton won this battle of titans. But he might have lost had his new financial system collapsed upon moving from the drawing board to reality. Hamilton’s bold actions in a financial crisis had saved the day, and that is one reason why Americans on average are 50 times richer than they were back then.

Back to the future. The reason I do not foresee another Great Depression imminent is that the Fed and the Treasury have been combating the current crisis with just the sort of bold leadership and innovative approaches to crisis management that Hamilton employed in 1792. If the Fed and the Treasury continue in this mode, the crisis will soon be ended, and with some help from the President and Congress in the form of increased public spending to replace reduced private spending, the recession will end well before it becomes a depression. n

RICHARD SYLLA is Henry Kaufman Professor of the History of Financial Institutions and Markets and professor of economics at NYU Stern.