Welcome to Finance and Fury, the Furious Friday edition.
Last Friday, we went through theory versus practical reality of public infrastructure spending – roads and railroads are needed.
In this episode - Look back at an economic crash – in relation to infrastructure – I Know there are differences – but illustration of when too much of a good thing can go bad – especially when economic or development policies create a reliance to the economy on economic growth – especially when there is speculation involved
What am I talking about? Crash of 1873 - What was it –
To start – US coming out of their Civil War(1861-1865) – in an effort to deal with unemployment and economic fallout- infrastructure was proposed – The US has a long history of government job creation program – Job creation efforts were undertaken at the local level by cities or state by state – During the 1857, 1870s and the 1890s economic crisis and depressions going on New York, Boston, Phili – developed municipal programs to aid the poor or unemployed – But the administration and financing of these programs presented major problems for each city or state – Logistics was one but funding was another major one – Led to the proposal for statement government to take over for cities and for the federal government to take over from the states – assumed the responsibility for these work relief programs So a boom in railroad construction commences - 33,000 miles (53,000 km) of new track were laidacross the country between 1868 and 1873 Back then - the railroad industry was the nation's largest employer outside of agriculture due to the work programs – Most of the boom in railroad investment was being driven by government land grants and subsidies to the railroads - involved large amounts of money and but due to the size started becoming a ticking timebomb of financial risk a large infusion of cash from speculators caused spectacular growth in the industry as well as in construction of docks, factories and ancillary facilities that process the goods needed for construction – timber, etc – But how long does it take for infrastructure like railroads to make a return – years – so the capitalwas involved in projects offering no immediate returns Now enters the Coinage act 1873 In 1871 - the German Empire ceased minting silver thaler coins in 1871 – most countries had gold and silver coins – similar to today but back then they were the actual metal, not just imitations But Germany doing this caused a drop in demand and downward pressure on the value of silver Less demand lower prices But this had affects in the United States One effect was in the mining industry – as the US was where much of the supply of silver was mined But also on their monetary system – United States Congress passed the Coinage Act of 1873 - changed the US silver policy Before this - backed its currency with both gold and silver - minted both types of coins This Act moved them to a de factogold standard – resulting in no longer buying silver at a statutory price or allowing for silver to be converted from the public into silver coins Statutory price used to be a monetary tool – set the price of metals like gold and silver based around the money supply – So the immediate effect of depressing silver prices and also changing the coinage law reduced the domestic money supply – this resulted in raising interest rates – hurting those who carried heavy debt loads This perception of instability in United States monetary policy caused investors to shy away from long-term obligations, particularly long-term bonds. The problem was compounded by the railroad boom, which was in its later stages at the time – started kicking off company failures One of the biggest failures - In September 1873, Jay Cooke & Company, a major component of the United States banking establishment, found itself unable to market several million dollars in Northern Pacific Railway bonds. Cooke's firm, like many others, had invested heavily in the railroads on both sides – the ownership but also selling bonds (the debt) in the investment to investors Around this time investment banks were anxious for more capital for their enterprises in railroads – easy cash cow and could get government loans – but new monetary policy of contracting the money supply (again, also thereby raising interest rates) made matters worse for those in debt – those who speculated on infrastructure investments – that wouldn’t see returns for years – were no left holding the bag with higher interest repayments In addition – put a halt on more infrastructure spending – there were plans by Cooke and other entrepreneurs to build the second transcontinental railroad, called the Northern Pacific Railway. Cooke's firm provided the financing - ground for the line was all ready to go - But just as he was about to swing a US$300 million government loan reports circulated that his firm's credit had become nearly worthless – loan was ceased and in September 1873, the firm declared bankruptcy. Another flow on effect – was on the insurance industry - Many US insurance companies went out of business as deteriorating financial conditions created solvency problems for life insurers – they invest in a low of what is seen stable investments – like bonds Other effects- The failure of the Jay Cooke bank, followed quickly by that of Henry Clews - set off a chain reaction of bank failures Factories began to lay off workers as the United States slipped into depression. The effects of the panic were quickly felt in New York, and more slowly in Chicago, Virginia City, Nevada (where silver mining was active), and San Francisco. The New York Stock Exchange closed for ten days starting 20 September – first time in history that the market was closed By November 1873 some 55 of the nation's railroads had failed, and another 60 went bankrupt by the first anniversary of the crisis. Construction of new rail lines plummeted from 7,500 miles (12,070 km) of track in 1872 to just 1,600 miles (2,575 km) in 1875 – remember that this had become one of the backbones of the economy 18,000 businesses failed between 1873 and 1875 – flow on effects of banks failing but also companies providing goods and services to the railroad industry Unemployment peaked in 1878 at 8.25%. Building construction was halted, wages were cut, real estate values fell and corporate profits vanished Further flow on effects created a second business slump by 1877 – example - the market for lumber crashed, leading to several lumber companies going bankrupt With the depression, ambitious railroad building programs crashed across the South, leaving most states deep in debt and burdened with heavy taxes. Retrenchment was a common response of southern states to state debts during the depression. Social unrest and Rioting – In 1877, steep wage cuts led American railroad workers to launch the Great Railroad Strike. Initial protests broke out in Martinsburg, West Virginia when the Baltimore and Ohio Railroad (B&O) cut worker's pay for the third time in a year. As the workers began rioting, with reports of looting and attacks on civilians and police - dispatched federal troops. Within the week, similar riots had erupted in Maryland, New York, Pennsylvania, Illinois, and Missouri.Summary of events - Why did it go bad
The Panic of 1873 arose from investments in railroads. Railroads had expanded rapidly in the nineteenth century Eventually – as investment in railroads continued, new projects outpaced demand for new capacity - returns on railroad investments declined – remember they were already delayed in nature – You had a share market crash in most major financial centres -USA, EU with Vienna - investors divested their holdings of American securities, particularly railroad bonds This mass selling depressed the market, lowered prices on shares and bonds, and impeded financing for railroad firms - Without cash to finance operations and refinance debts that came due, many railroad firms failed others defaulted on payments due to banks Large banks then failing changed investors expectations. Creditors lost confidence in railroads and in the banks that financed them. Stock markets further collapsed. The panic spread to financial institutions in Washington, DC, Pennsylvania, New York, Virginia, and Georgia, as well as to banks in the Midwest, including Indiana, Illinois, and Ohio. Nationwide, at least one-hundred banks failed.
What is happening today?
There is a Push for large infrastructure spending – a lot of speculation surrounding this - Push for spending to help boost economic growth and to provide employment Investment speculation – from Super funds involvements – Government policy as well Also have large investment funds that are looking at this – if you cant beat them join them Not on railroads – but Mostly on the same thing – green infrastructure ROE – is it low or high? ROE is relatively low – it is high cost but thanks to Gov subsidies it can provide a profit – but what if these go away? Or – what if supply outstrips demand? If most of the projects over time have little demand – lower ROE – similar to the railroads – diminishing marginal returns on everything Interest rates are low – so the borrowing costs of any infrastructure will be low for some time and lots of funds will come from Governments or Super funds – so it isn’t their money Either invest the money in the project – or buy bonds in the project (capital notes) to finance themCan the same thing happen as the crash –
Not likely – there is a safety net now in the financial system and Central banks – Liquidity issues? More QE or bailouts – Super funds can put a lot of their money into this and have the guarantees of the debt not being too risky Especially in low interest rate world – but if we go through a new monetary system – if it creates higher interest rates then the amount of debt around would create massive issues But is it a good idea? Well time will tell – the debt on the infrastructure projects will be around for a while But may be a similar thing to Chinas WMPs – a shadow banking rolling ponzi scheme – Takes long time to get a return on infrastructure projects from implementation to be in working order – A lot can change in economic conditions over the 5-10 years it may take to see ROE on these projects Taking more debt out and if it isn’t quality investments – where supply outstrips demand – the infrastructure policy could be another trap in the future for another bubble and collapse
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Links -
https://www.federalreservehistory.org/essays/banking_panics_of_the_gilded_age
