We Austrian economists like to point to the Panic of 1857 as a perfect example of how the free market deals with financial panics absent government interference. But, is that the whole story?
Moreover, this history lesson has some important implications for President’s Trump’s newly-invoked tariffs on low-order goods like steel, aluminum and softwoods.
A blog this morning by Martin Armstrong got me thinking about this. He brought up the Coinage Act of 1857, passed in February of that year. This was the act that revoked the ‘legal tender’ status of foreign specie coins.
In all of the discussions I’ve found on the Panic of 1857, no one brings this point up. Even this Master’s Thesis by Peter Kostadinov (2015) makes no mention of it. It does a good job of explaining the Austrian argument, however, and is certainly worth your time.
The Wikipedia entry focuses on the Dred Scot Decision of all things. Yikes!
Up until that point there was a need for foreign coins to be accepted in the U.S. economy. When the Constitution was ratified after the implosion of the government under the Articles of Confederation the treasury was broke. It had no practical ability to mint and coin money.
So, for more than 60 years foreign coins, like Spanish 8 reals and British Sovereigns, were used by businesses to fund their operations.
That changed in 1857 with the passage of new Coinage Act. And it had the predictable effect of upending the circulation of currency throughout the economy. As old, word Spanish silver coins were turned into the treasury to be re-minted and U.S. coinage distributed.
Thanks to the California Gold Rush and other factors the U.S. Government was finally able to keep up with the demand for currency.
In effect, the U.S. put up a massive protection barrier, or tariff, on foreign currencies. And the results were to place a much higher demand on hard currency versus bank notes which also circulated at the time.
The Savings Mismatch
As Mr. Kostadinov points out in his thesis, the Crimean War created huge demand for U.S. agriculture in the early 1850’s. This added fuel to the already raging railroad boom to bring U.S. goods to port and sell in Europe.
With the war ending in 1856, that demand slacked off and agriculture prices fell. So, too, then does the influx of capital into the U.S. During this boom, however, the banks were engaging in ever more shady loan practices, drastically increasing the circulation of bank notes, still redeemable in specie, but with lower and lower reserves backing them up.
This results in massive railroad over-capacity thanks to a radical expansion of the real money supply. This expansion is not supported by the pool of real savings based on an expanding work force and production but rather simply the mis-pricing of money.
In the image above, the curve on the left shows what happens thanks to real economic growth and the resultant savings generated. Loanable funds rise (from A to B) and interest rates fall (from i to i’) as higher savings (from curve S to S’) underwrites increased time-based risks.
The figure on the right shows what happens when growth occurs thanks to a money-supply expansion absent any other changes. The increase in money supply increases the loanable funds again from A to B, which again moves interest rates down to i’, but the real capital available to support the expansion is lowered from A to C.
This is the underlying source of the crash in 1857. No amount of liquidity injections will overcome this because humans do two things at lower interest rates:
- Save less and consume more
- Invest in longer time-horizon projects because interest-rate carrying costs are lower.
So the railroad banks using hot money flow from Europe levered up their loan portfolios, creating paper money to fund railroads to nowhere.
Add into the cooling capital inflow there is a secondary demand for specie thanks to the new Coinage Act, replacing over-valued Spanish coins, now old and worn, with new ones from the U.S. mint.
Now there is an even bigger mismatch between the amount of specie demanded to service debt and dividend payments on railroad bonds and the localized supply. Once one bank failed, Ohio Life Insurance and Trust Company, the resulting liquidity crunch would hop from bank to bank and across the shores to Europe, where all of this started in the first place.
The Trump Conundrum
Fast forward to the 1930’s and the reviled Smoot-Hawley Tariff. The main effect of the tariff was not the curbing of imports to the U.S. It was the reciprocal trade war that resulted and the collapse of U.S. exports.
But, again, that comes down to a demand for the currency. Trump is looking to use the tariffs to force a renegotiation of NAFTA, which I’m all for. In fact, I say, get rid of NAFTA all together and with it, by extension, the need for tariffs.
But, tariffs on steel, aluminum and other input items with raise domestic prices here which will shift profits from higher-order goods producers, say cars, to lower-order producer industries like steel.
Higher order goods, by definition, are higher value-added goods, otherwise they wouldn’t exist without government subsidy.
The other effect will be to spark a tit-for-tat trade war which will see a reduction of U.S. exports of said higher-order goods. For the same reasons that economic sanctions don’t work, tariffs don’t work.
All price floors and price ceilings create shortages.
With the Fed raising interest rates and reversing QE, demand for U.S. dollars abroad will rise dramatically to service the trillions in foreign owned U.S. dollar denominated debt.
And tariffs will result in a much slower output of dollars into the world economy, fueling an upward spiral of dollar demand as global money velocity falls further.
Parallels to 1857
The parallels to 1857 are as follows.
Trump’s tariffs will kick off a slow down of trade which will put downward pressure on the euro, upward pressure on rates and add fuel to the worries over Europe’s basket of bad sovereign debt.
Similar to the Coinage Act, the tariffs will exacerbate trends that are already in motion.
While European hot money flows have yet to create bubble-like conditions here in the U.S. they are having an effect, a rising stock market and flatter U.S. yield curve.
That will fuel the demand for dollars sending the dollar higher, along with interest rates here. But, unlike in 1857, where that money would be turned into savings, it will go to service the mountain of debt and undermine the sustainability of growth.
Higher rates will ultimately just be used to pay off some of the current unfunded liabilities. And we’ll still have an unsustainable boom here in the U.S.
In turn, that stronger dollar will collapse exports further bringing a recession or worse to us after Europe’s sovereign debt crisis is past its worst.
And from this post to the market’s ears, Zerohedge just informed us that the LIBOR-OIS spread has blown out to its widest level since 2012 on just these fears. 3 month LIBOR-OIS is the spread that best approximates interbank dollar liquidity.
While this is a simplification of the various catalysts behind the spike in Libor-OIS, here is a quick summary of what is going on – the expansion of Libor-OIS and basis swaps have been impacted by a complex array of factors, which include:
- an increase in short-term bond (T-bill) issuance
- rising outflow pressures on dollar deposits in the US owing to rising short-term rates
- repatriation to cope with US Tax Cuts and Jobs Act (TCJA) and new trade policies, and concerns on dollar liquidity outside the US
- risk premium for uncertainty of US monetary policy
- recently elevated credit spreads (CDS) of banks
- demand for funds in preparation for market stress
So, in short, currency outflows from savings, increasing foreign demand for dollars, and fears of a currency supply and demand mismatch.
To support point #3, I give you the updated version of the state of Foreign Central Bank U.S. Treasury Holdings on reserve with The Fed. In other words, the amount of money the central banks have to dump into the market to defend against their currencies getting killed in the event of a swiftly rising dollar.
I’d say someone is preparing for a panic in the near future.
Why Buchanan was Da Man!
In all this talk about the Panic of 1857 the big question is, “How long did it last?” The answer? Just over 3 months.
There was no central bank to bail out the banks and spread the suck to everyone else except them. President Buchanan, wildly reviled by history because it’s been written by the statist winners, refused to help them.
Instead, he shored up the state banks to ensure liquidity for the real economy, using all of that new legal tender to do so. The Coinage Act was an unnecessary intrusion into the marketplace for money.
To his credit, Buchanan even pushed for legislation that would revoke a bank’s charter if it couldn’t meet its obligations.
He was an opponent of bank credit “paper” money. And it was his response to the crisis that forced the banks in trouble to close, work out their problems, and re-open if they could. In short, he was the last President to stand up to the banks in the U.S. and win.
No wonder they had it in for him three years later.
But, the lessons of the Panic of 1857 are there for all to see, excesses in the free market can and will be corrected quickly if allowed to and the whining of rentiers like the departed Gary Cohn summarily ignored.
Moreover, much of what government can do to help the situation is stay completely out of the way.
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