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In the 1860s and '70s in the city of Philadelphia, every gentleman who wore a diamond pin or employed a governess knew that there were three things he could always rely on: the Pennsylvania Railroad, Girard's bank, and the King James Bible.
But the crash of the stock market in September 1873 seemed a perfect catastrophe. Penn stock dropped nearly 20%, Girard's bank briefly closed its doors, and the Bible seemed cold comfort. A panic had hit in New York's Wall Street on Sept. 19. Ten days later, anxious men crowded the outer doors of the Philadelphia stock exchange; others sought to withdraw greenbacks from savings banks. Poor and rich alike sought liquidity by redeeming every paper asset for gold and currency. The Depression of 1873 had begun.
From 1873 to 2008
That depression looks a lot more like our current financial troubles than the Depression of 1929. The Great Depression had much more to do with overlarge inventories of industrial goods (wristwatches, camera film, washing machines, and automobiles, for example) and the drawn-out results of extreme protectionism. In 1929, the United States saw a sustained drop in gross domestic product that did not right itself for five years.
While many disagree about its root causes, the GDP numbers suggest that 1929 was at base an industrial depression that spilled into banking. But the Panic of 1873 was a bank depression that spilled everywhere else. It was much like our current difficulties, though its footprint on financial and commodity markets was very different, and in Europe, it lasted more than six years.
How did it start? In 1873 as today, we can lay the fault with bad mortgages. But the problem did not start in the United States: It began in Europe, where three empires -- France, Austria-Hungary, and Prussia -- sought to concentrate their city centers by founding new savings banks for workers and the middle class.
They were not exactly the Fannie Maes and Freddie Macs of the 1870s, but they did permit loans to middle-class borrowers that -- in retrospect -- seemed rather dodgy. These were loans that the older, more conservative merchant and city banks would not touch. Thousands of investors, large and small, took advantage of these new loans. Massive building projects began in the capital cities of Paris, Vienna, and Berlin. A housing bubble had begun.
America enters the picture
But this prosperity rested on a coherent system of trade between Central and Eastern Europe on the one side, and Britain on the other. Central Europe provided cattle, pork, rapeseed oil, wheat, and flour; Britain produced tin, coal, woolens, and manufactured goods. The mutual exchange of goods under a system of free trade seemed to benefit both parties.
But by around 1868, America had come into the picture. Previously an exporter of cotton, America changed its export strategy after the Civil War. American farmers and merchants crafted a system to export wheat by the boatful. They shipped vast quantities from Chicago to either Philadelphia or New York. From there, wheat traveled by steamship to Liverpool or London, where it could be unloaded into massive flour mills.
A transatlantic telegraph completed in 1866 assured that wheat was shipped just as prices were climbing. By 1871, British flour millers shifted their source of supply, taking imported grain largely from the United States. For merchants who brought wheat from Russia's Black Sea ports, and for flour merchants who shipped from Northern Germany, the shift was devastating. Central European exports to England dropped precipitously. American kerosene, a new lighting product, replaced Europe's rapeseed oil.
As Central European exports to Britain dropped, many began to wonder whether Vienna and Berlin were overbuilt. The new savings banks in Austria were the first to tumble, in May 1873. By the end of the month, stock markets had crashed in Austria and Berlin. The Bank of England, anxious to protect its capital from banks with mortgage problems, raised the interbank lending rate -- which hit America very hard.
On Wall Street, the biggest victims were interstate railroads: Tom Scott's Texas & Pacific, C.P. Huntington's Chesapeake & Ohio, and Jay Cooke's Northern Pacific. All three were furiously laying track. In the 19th-century U.S., one issued bonds for track once it was laid, and then sold the bonds in Europe. Bonds used to represent actual objects -- railway cars, steam engines, or track laid -- under the premise that if the railroad failed, bondholders could get their money back when the objects were sold at auction.
By the late 1860s, however, railway directors were playing fast and loose with these financial instruments. They created new bonds such as "second-mortgage guaranteed scrip" or "gold bonds, English scrip," whose value few people understood. What was the underlying value? Nothing, as it turned out.
Scott, Huntington, and Cooke all tried to sell railway bonds in Britain, but were uncomfortable with the state of the market in 1871-72. Other bonds seemed safer -- particularly French national bonds issued after the Franco-Prussian War. None of the three wanted to release bonds on the London markets and have people see that buyers were paying $0.80 cents on the dollar or less, so they held them to wait for the bond market to clear. And they waited. But when the interbank lending rate shot up in 1873, they were suddenly in trouble.
Short-term notes were coming due, but none of the railway's banking houses could pay them. In September 1873, Jay Cooke, one of the most trusted names on Wall Street, proved unable to pay his 60- or 90-day notes. Jay Cooke & Company closed its doors, and a run on Wall Street began. A cascade of bank failures continued for more than four years in the United States.
Who survived? The names might be familiar. J.P. Morgan, the Lehman Brothers, and Marcus Goldman ultimately thrived after the worst of the panic had subsided. Morgan had operations in Britain; Goldman and the Lehmans were in the cattle commodity markets -- the only bright spot in 1874.