America’s First Business Cycle: A Reappraisal of the Recession of 1797 and the Macroeconomic Events of the 1770s

0:00It's my great pleasure to be here today. Like Mark said, I was a student here. I was actually a summer fellow. And now to be returning as a lecturer is something that I always wanted to do and I'm very happy about that. My talk is about the recession of 1797 and specifically I'm going to be arguing that it was created by Credit Expansion on the part of the First Bank of the United States. So I've envisioned this as a kind of continuation of a Rothbardian research program. So those of you familiar with Austrian economics know Rothbard bequeathed to us two active research agendas, at least two.

0:46One being applied anarcho-capitalism, which is near and dear to my heart, but I'm not going to be talking about that today. and the other one is Revisionist Economic History, which is what I am going to be engaged in. So I have a picture here of Alexander Hamilton and I was at a talk a couple years ago where Tom DiLorenzo was presenting his book on Hamilton's Curse and he described Hamilton as a rat who betrayed the American Revolution. Now I don't know about you, but I was offended by this because in my opinion, Professor Dr. DiLorenzo was far too kind to Alexander Hamilton.

1:33The Bank of the United States opened its doors for operation in December of 1791, and the first recession in American history happened in December of 1796, and it was a mere five five years after the creation of de facto central banking in the United States. Now what interests me about this connection is it hasn't really been explored by any Austrian economist. So in Tom D. Lorenzo's book, he argues that Hamilton bequeathed to us a legacy of central banking which has resulted in macroeconomic fluctuations that we're still dealing with today. However, he doesn't specifically relate the first recession in United States history to 2, Central Bank Expansion. So what I see myself doing is kind of pinning the tail on the donkey.

2:26In this case, the donkey being the arrogant, overweening Alexander Hamilton and the economic program of the Nationalists. So, okay, let me just, many of you don't know anything about the recession of 1797. Many of you probably aren't aware that there was a recession in 1797. So by way of introduction, sorry about that. So by way of introduction, I'm gonna begin with some historical details about the recession. This is Robert Morris, the infamous This is Robert Morris, who was the sort of guiding father of Alexander Hamilton in his nationalist party, and in February 1798, after a spectacular fall from fortune, Morris, who was the famed financier of the revolution and was previously one of the wealthiest men in America, was arrested and put in debtors' prison.

3:37So he and his partner John Nicholson had issued $10 million in paper debt claims, and when this paper pyramid collapsed, he was ruined and the economic loss was felt by his extensive list of creditors, which included pretty much every one of prominence in America at that time. Morris and Nicholson weren't alone in their fate, they're just the biggest players in a recognized bubble of speculation. This bubble began to burst in late 1796, leaving a flurry of economic failure and distress So Jefferson proved prescient when he wrote, quote, The prison is full of the most reputable merchants, and it is understood that the scene has not yet got to its height." So that was a letter to Madison. The contemporary Theodore Sedgwick was delighted by the bursting of this bubble.

4:25He said, quote, The bursting of this bubble is a very happy circumstance, So vast numbers, and among them, many worthy people are involved in ruin by it." So he's sort of like the Murray Rothbard of this day, I can just imagine Murray. He's like, you've got to flush out those malinvestments. So the ruin of these well-prominent traders wasn't contained in them alone, but it was There's actually more widespread economic downturn and as you can see from these figures on GDP per capita, GDP fell from a peak of $1,284 in 1796 to $1,216 in 1798 which was a decrease of about 5.3% and industrial production fell as well.

5:28This is the index by Davis that's a little less suspect than the GDP figures that we have. And it shows a fall in industrial production of a little over 7%. So the nascent American economy was experiencing its first recession. So what caused this recession? So I'm going to argue that it was caused by big expansion on behalf of an over-expansion by the engagement by the Bank of the United States. So, when it began operations, it immediately started to pump in new injections of credit into the economy with an initial capitalization of 2 million. I'll show you numbers in a minute here, but it reached a number of about 7 million by 1794, and this was on top of an original money supply of like 10 to 15 million, so that's a pretty significant increase.

6:24So obviously all this credit expansion resulted in inflation and a reduction in interest rates. So the inflation sort of created, I guess, a marginal disincentives, I guess, to saving and lending, and there was malinvestment, we'll get to that, and this sort of over-expansion was brought back into heel through the price species flow mechanism. In other words, there was an overexpansion which created disparities in the price level between America and other economies. So this caused a reduction in net exports, and to pay for the trade balance, the species was exported abroad.

7:14There was a credit contraction and a monetary contraction, you know, beginning in late 1796, and I guess the highly leveraged traders experienced a credit crunch and they began suffering economic failures. I suppose I should say a couple words really quick about the Bank of the United States itself. It sort of represents the culmination of Hamilton's liquidity expansion scheme of the 1790s. So there was multiple planks of this program. The most pertinent ones to this discussion were the assumption of the state and continental congress debts that were issued to finance the revolution.

8:05So Hamilton, of course, wanted to assume these debts to create a class of special interests that would support the federal government and he wanted to benefit Northeastern mercantilist interests. And so as part of his speculation scheme, the individuals who wanted to buy into the stock of the first bank of the United States had to pay three-fourths in newly created Government Debt, bonds, you know, debt instruments, bonds, and then the bank itself would also provide the means to sort of pay back its obligations, so it's like the circularity. I think Tom DiLorenzo has it right when he calls it a bank job.

8:54So I guess the first question we have to explore is, was the expansion that took place just a normal credit expansion or was it an over expansion? So expansion of credit in and of itself isn't necessarily a bad thing, right? In an advancing economy, that's what we want, it causes increased wealth. The problem is only if there is an over-expansion, which is why central banking is bad. So in the early 1790s, a lot of historians and economists have argued that American accounting was credit constrained, it was liquidity constrained. So in other words, individuals, traders or merchants might have ideas for business ventures that would potentially be profitable, would probably be profitable, but they're unable to obtain financing because of the lack of scarce VC.

9:45And so this expansion by the US, far from being a bad thing, was actually just a means in which people could accomplish the gains from trade, intermediated through the financial System of the Bank. And so I've labeled that the benign expansion hypothesis. And you know, there's some truth to the fact that the economy was credit constrained, but in opposition to this benign expansion hypothesis, I want to offer up my alternative malignant expansion hypothesis, in which I claim that the BUS overexpanded, sending it to a classic trade cycle, the sort that, you know, Ricardo would have talked about. So whenever you're engaging in this sort of applied historical work, you have to ask your two self two questions.

10:34One, does the economic theory you're using make sense? And then two, you know, did it actually happen? So this is sort of like the difference between validity and applicability and praxeological law. And so on the first step, subject of the theoretical potential for an overexpansion by the Bank of the United States, first I have to explain what overexpansion means. means an expansion of credit beyond the amount that people would want to hold at the price of par with species, so it's just basically surplus. And normally, under conditions of unrestricted or free competition in banking, the expansion of credit is limited by marginal rising costs of keeping deposits and notes in circulation.

11:24And so there's increasing marginal costs of getting people to hold on to your notes, there's declining marginal benefits, say of making loans. And so the most profitable level of expansion for any given bank is given by equating the marginal benefits and the marginal costs of the bank expansion. So in this way, competition is what provides the check against an overexpansion. So, if one bank engages in expansion beyond the profit maximizing level, then it suffers a loss of reserves to other banks in the banking system or, you know, so either, if I put out a bunch of notes that people don't want, they either present it back to me for direct redemption of specie or, probably more probably, they deposit it in their bank account at their own bank and then that bank, you know, takes the claims, gives it back to the first issuing Bank and asks for it to honor the redemption of its notes and either way the over-expanding bank will suffer a loss of reserves and is forced to contract.

12:29Now a sort of competitive check on the over issuance of credit doesn't exist with respect to a central bank or a bank that enjoyed legal privileges like the first bank of the United States. The Bank of the United States wasn't a central bank quite in the sense that we understand that today. It didn't regulate the commercial banking system. Although, for that reason, Richard Timberlake and others have argued that it couldn't have been intended to be a central bank. On the other hand, it did sort of start engaging in monetary policy right off the start, right from the start. So, in an article by Colin Sill and Wright, they talk about, you know, there was this sort of expansion set off a financial panic in 1792 in Hamilton Hamilton as part of the treasury along with the bank engaged in sort of an early form of open market operations.

13:20So you can see that it's sort of a quasi-central bank. My preferred definition of a central bank is any bank that enjoys exclusive legal privileges and is also the government's banker. So under this definition then the first bank of the United States would be a central bank. Now what specifically were its legal privileges? Well, the first one was an exemption on unit banking. So at the time, if you wanted to start a bank, you usually had to get a charter from the state and you weren't allowed to branch across states or usually even to have multiple branches within the same state. So obviously this is going to weaken the banking system quite a bit. But in terms of the first bank of the United States, they want to overcome this sort of weak banking system, this hurdle to having strong banking, so they wanted to set up a more centralized bank that would have branch offices in several states, so like first five cities and then seven, right,

14:20and so on. And the second legal privilege that it had was its notes were accepted in payment of custom duties, so you could pay your taxes in it. This is kind of like a quasi-legal tender status privilege. And so, the upshot of all this is that the Bank of the United States notes were useful in ways that the notes of other banks were not. They were good as gold for most purposes, including paying your taxes, and so what this means is that if the Bank of the United States, the central bank, was to engage in an over-expansion, it wouldn't immediately be disciplined by competition. The other banks, on the contrary, would find it advantageous to hold these notes as reserves. Why? Because it's sort of a cheaper substitute for gold, or it was actually silver at this time, for specie.

15:09So, on the theoretical side at least, it seems to me that there could be an overexpansion. So the question is, was there an overexpansion? Well, in order to engage this empirical evidence, I'm going to ask a couple of questions first. How big was the expansion, compared to the existing money supply? But the key, you know, link in my argument is going to hinge on whether or not you think it's big enough to have influenced prices. So, you know, the wholesale level of prices, interest rates and international trade. Well, let's see how big it was. So here's the selected items from the balance sheet of the first bank of the United States. in the United States. The red note is the banknotes and deposits, and you can see it starts off at basically zero in 1791, and then shoots up immediately to about two or three million.

16:03There's this sort of minor contraction that takes place, and in 1792, around March of 1792, there was actually a securities, the first securities bubble popped in the United States, so some economists have argued that it was this contraction that caused that but you can see it's relatively minor right it's sort of almost an uninterrupted expansion all the way until 1794 and so you see by 1794 it's a peak of about 7 million ish and it kind of tapers off right for some of the remaining years And, as you can see, here's a graph of the monits and select monetary components.

16:49This is the graph I just showed you, basically, of the U.S. banknotes and deposits. And, you know, this is the amount of specie, and then this is the M1, or whatever, the full money supply. And you can see that it's basically going to be an inflation all the way until 1795 and then there's suddenly the deflation after that. So there's kind of like this wild swing in prices. As evidence of that, here's the CPI inflation rate over the 1790s. You can see in the early half, inflation was below 5%. And then after the US goes into business, it shoots up to double digits, 10%, 14%, and then suddenly it collapses.

17:40So just to anticipate my argument, a sudden swing is probably not a good thing for economic activity. Same with wholesale prices, they're even more volatile than the average price level. So, you have, you know, a negative 30 percent, wholesale price is falling by 30 percent in 1791 and then all of a sudden it shoots up to 60 percent and then shoots back down to negative 30 percent, right? Well, what's the consequence of, for the moment I just want to concentrate on the expansion, so, and the inflation. So what's going to be the immediate consequence of this inflation? Well, you would assume that the, if the market, it enters the market at a specific point, right, so there's a cancel on effects and presumably, if it enters in the market for loanable funds and the market's going to clear after increasing the supply, then the price has to fall and that's all I'm showing here.

18:44So what I'm saying is that these are, this is just a calculation of the real yield. So interest rate data is difficult to find in the 1790s, but this is the real or inflation adjusted yield, this red line, oh sorry, this is the real yield or the inflation adjusted interest rate basically, so the standard methodology is the rate on US treasuries represents sort sort of like the riskless inflation rate, well that's not necessarily the case here because all these U.S. 6% bonds were new and maybe there was a risk premium, but in that case then, you know, some of that, it would actually be, this line would be too high.

19:31So it's actually, you know, good for my argument, not bad. So you can see that starting around 1792-ish, you know, the real interest rate takes a steep Nose Dive actually becoming negative. And so you have to think about what kind of incentive is this going to give to entrepreneurs and what I'm like I had no direct evidence of this here right but I'm arguing that this expansion creates a deviation in the you know interest rate and it's making it lower than what the natural rate is so the actual rates lower than the natural rate and you're gonna get malinvestment, classical sort of BUS style cycle. I mean in 1795 the real interest rates like negative ten percent so if I'm you know trying to make an investment and I know that I'm gonna be paying back money that's worth ten percent less than the money I borrowed let's say and this is like free money you know they're paying me to take out a loan why wouldn't I

20:32right so so sort of makes sense so okay so I'm so there's this over expansion the BUS well what corrects the over expansion so I just argued that it's not going to be by competition but as an economist we know if there's a disequilibrium it's there's going to be forces that tend to bring it back into equilibrium right or at least into line with what people's preferences are and in this case the correction mechanism is brought about by the price-species flow mechanism so as I was explaining earlier you know the differential in price levels causes people you know Americans to purchase more foreign goods foreigners to purchase less American goods you have to clear the trade deficit you export money abroad right but the problem with this well there's two problems The first one is that the process of adjustment is slow, so I'm arguing this takes several years for this whole dis-coordination to work itself out, and it requires a sort of painful monetary contraction to take effect.

21:45And the other thing is the loss of reserves aren't limited to the over-issuing bank but affects the banking system as a whole, so foreigners are asking, or people are making Purchases Abroad, and to pay for that they're asking any species, and the species is coming from wherever their bank is, not necessarily the over-issuing bank. Well okay, so those are actually a decline in x-axis, first of all let's take a look at the current account, actually the capital account, well either one, or the opposite. So, all right, well, we noticed that inflation sort of hit it, here's where the expansion, like the credit expansion sort of tapered off, 1794, where the sort of price swing began, and around 1794, 1795, well, you know, there's exportation of species of 13 million dollars, that's basically the same as the drug that I showed you earlier in the monetary components, right?

22:46So where is the gold going? Like earlier I showed you that, you know, the species was declining, or where did it go? Well, presumably people aren't melting down silver to make candlesticks, right? It's going overseas. And that's just what I'm showing you here. okay so why was this a problem well you can see starting in 1795 there's this correction that I explained before the prices start falling and the real interest rates shoot up and so so the real interest rates start shooting up and at the time what you have is people are mostly borrowing in accordance with the real bills doctrine right so there's short-term lending and so if I'm financing you know my enterprise I'm basically borrowing short and then have to keep rolling it over well what happens to these traders you know starting well just look at it you know what what when would you predict the problem is going to set in, it's going to set in around 1797. So the entrepreneurs go and they're trying to refinance basically and they're suffering from a lack of credit or at least they can only find credit to continue.

24:26do their enterprises at really high interest rates basically so they complain about the lack of money. The money is expensive is I think what they call it. So basically what the problem is is that this credit crunch is squeezing them out and they all start failing. I just briefly want to talk about some alternative explanations. So this recession hasn't been talked about too much by either historians or economists. The Nobel Prize winner Doug North basically ignores it, right? So in his book, his early work on economic growth, he's looking at this period, you know, early from like 1792 to 1860, and he argues that, you know, this was a period of, you know, very strong sustained economic growth in the United States, and he sort of ignores the temporary deviations, he's sort of aware that there was like this minor contraction that took place, but he just sort of assumes it away and argues that it was just following events overseas.

25:43So here's the quote, it says, quote, one lead look no further than to events in Europe to account for almost every twist and turn in the fortunes of the American economy during these years, close quote. I think this sort of ignores the overlooks. I guess he wasn't really interested in macroeconomic fluctuations, but it sort of just overlooks and the potential of things going on in the domestic economy to create this coordination. And there's this other guy, Richard Chu, he's a historian who wrote an article very recently and he argues that the recession was caused when the Bank of England suspended specie payments in February of 1797 and then that combined with French privateering during the The Quasi-War and the Yellow Fever sort of combine to create this, like, you know, perfect storm.

26:31And to me, this is kind of a historian's explanation. So usually, you know, if there's a problem, right, they don't have, usually don't have theory, economic theory. So they say, well, what happened before that could have caused it? Anything that looks bad, they sort of just latch on to. And in this case, the Yellow Fever, well, you know, there's war and disease basically throughout this period. So why specifically does it happen now? and the argument that the Bank of England suspension of specie payments caused the depression might make sense but remember it's kind of hard to understand how suspension of specie payments in February 1797 can cause an economic contraction that began in February 1796, or I mean in December of 1796. So the timing is kind of off for his explanation. I'm not going to argue that this suspension of specie payments by England didn't influence things. I mean obviously that's going to be the problem because this domestic economy that's already experiencing problems getting credit, now it's sort of its other alternative source of credits removed

27:36and so there's nowhere for people to get money to complete these sort of investments that they have. Not just for like in 30 seconds, I just want to show what was this overinvestment or malinvestment. Well, it's kind of hard to, and the evidence is kind of sparse, but here is just a preliminary table of highly capital-intensive industries that went bankrupt over, so this is the year where they started, these are the failure rates, so particularly in manufacturing, most of these large, particularly like the SMM, Society for Useful Manufacturers, went belly up, and so it seems like there's some, there's definitely some evidence that maybe it's not Not just a sort of overinvestment story a la Lucas, but there might actually be a discoordination in the inter-twin-poral structure of production, as argued by sort of macro-based macroeconomics or capital-based macroeconomics.

28:36So in conclusion, I just want to say that I hope I've persuaded you into looking into So this in more detail, other Austrian scholars. I believe the recession of 1797 comes through the failure of legally privileged central banking, first by artificially lowering interest rates and stimulating investment and discoordination, and then by creating accounting-wide contraction as the credit was forced to come back into equilibrium. So thank you. Thank you very much.