Saturday, August 23, 2008

Panic of 1893: Another Example of Politicians Causing A Mess

"History doesn't repeat itself but it does rhyme." - Mark Twain

Indeed, looking back at the antecedents of the Panic of 1893 it seems as if we are reading in half measure the newspaper headlines over the last year. The economic hardship experienced during said depression was incomparable until then in the history of the United States. Politicians, who mascarade their ambitions for power in good intentions, were the progenitors of this economic mess.

During the 1880s, the U.S. economy was growing tremendously thanks in part to the economic shift from an agrarian to industrial society. The U.S. was becoming efficient in producing manufacturing goods that not only were sold locally but also were demanded internationally. The high economic growth and the coincidental increase in aggregate consumption led farmers to take on excessive debt to increase their productive capacity. In addition, the railroad industry had similarly overextended itself, as it believed demand would continue to expand from the people living west of the Mississippi. During this decade we witnessed something that today seems inconceivable: economic growth and deflation. Excessive debt in a deflationary environment, however, is a deadly combination for debt holders, because the value of money that is paid increases with time. Moreover, deflation meant that agricultural products became cheaper, thus producer's profit margins were squeezed. Nonetheless, for the industrialists (i.e. manufacturers) lower prices translated into a bonanza domestically and internationally resulting from greater demand for their products. During that time also, the U.S. (and the rest of the world in fact) operated under the gold standard, which meant that every dollar was backed gold. In other words, every dollar could be redeemed for that precious metal. This fixed exchange rate mechanism implied that monetary policy had limitations: money supply could not be manipulated by politicians without dire consequences. This is important to note because farmers (and other debt holders) wanted an inflationary monetary policy.

The government, seeking to please a voting block ahead of national interests, in 1890 passed the Sherman Silver Purchase Act, which required the federal government to purchase a fixed amount of silver with U.S. notes (i.e. dollars that were backed by gold). The net effect of this action caused the money supply to increase. Since gold had decrease in value relative to silver, widespread fear began to overtake the market that the U.S. would abandon the gold standard. Foreign and domestic holders of U.S. notes began to redeem them for gold. This generated a massive run on banks which ultimately led many to fail. The financial debacle spread to the real economy causing a number of bankruptcies. So the intentions of the government to help a special-interest group turned into a nightmare for everyone. It is estimated that during mid-to-late 1890s, unemployment ranged from about 11% to 18%. This anecdote makes us recognize that surely politicians will claim to exercise good judgment when using someone else's money to bailout others from the consequences of their actions. The notion that the 19th century was completely laissez fair does not hold under closer scrutiny. Today, nothing much has changed with respect to this aspect, as the U.S. federal government continues to want to manage economic expectations under the good stewardship banner. But as the old adage says, "the road to hell is paved with good intentions."

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