Disrupting America's Economic System Term Paper

Pages: 50 (13568 words)  ·  Bibliography Sources: ≈ 117  ·  File: .docx  ·  Level: College Senior  ·  Topic: Economics


The U.S. Treasury, led by Andrew Shaw, subsidized these gold flows by offering to temporarily place public deposits in banks if they imported gold from abroad.

The policy lowered the gold import point by offsetting the interest lost while gold was in transit. Goodhart [1969], however, notes that the gold import point was often low enough to have justified specie inflows without the subsidy. In the fixed exchange rate world of 1906, such large gold outflows were a significant threat to a country's ability to maintain the par value of its currency, which, for the pound sterling, was $4.867.

Faced with its lowest ratio of reserves to deposits since the 1893 crisis, the Bank of England nearly doubled its discount rate, from 3 1/2% on September 12 to 6% on October 19. Furthermore, the Bank held the discount rate constant for the remainder of 1906 and then subsequently lowered it in early 1907. This would seem to indicate an easing of credit conditions in England. On the contrary, the Bank of England had, in effect, closed down credit facilities with American firms when it raised the discount rate in the autumn of 1906: the central bank threatened joint stock companies with a 7% rate on money if they did not stop discounting U.S. finance bills, credit instruments used to borrow overseas in anticipation of profit from exchange rate fluctuations. The actions practically cut off gold exports to the United States. England reversed its position from a net gold exporter to a net gold importer. England successfully defended the dollar/sterling exchange rate, but at what cost?

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Friedman and Schwartz [1963] argue that the Bank of England's policy toward American finance bills altered the normal course of gold arbitrage and pushed the United States into recession. Typically, American banks and trust companies drew finance bills payable in pound sterling on their correspondent banks in London during the summer. They would then sell sterling bills for dollars; this would result in a gold shipment to New York. The finance bills would be covered in the autumn when the demand for dollars was high following the export of U.S. agricultural goods to Europe.

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Forced by the Bank of England to pay off their finance bills upon maturity, American firms liquidated their stock portfolios in the spring of 1907. The stock sell-off led to a short but sharp "Rich Man's Panic," helping to push the United States into recession, (Calomiris: 1989).

European central banks exacerbated New York's liquidity crisis by raising their discount rates throughout 1906 and 1907. Open market rates in Berlin and Paris generally exceeded call money rates in New York by two to three percentage points during the first nine months of 1907. Interest rate hikes, in conjunction with the repatriation of finance bills drawn in London, led to the export of nearly $30 million in gold from the United States in the summer of 1907 (Moen and Tallman, [1990]; Tallman and Moen, [1998]).

The New York money market entered the fall of 1907 low on cash reserves and primed for a panic. On Tuesday, October 22, New York's second largest trust company, Knickerbocker, experienced a run following news that the firm was in financial trouble. A day later, panic-stricken depositors ran on two other large trust companies, followed by several national banks. Within a few weeks, the panic spread to other regions of the United States.

Several measures were taken to contain the crisis. The New York Clearinghouse Association issued loan certificates, a money substitute used to clear accounts between banks. Clearinghouse loan certificates artificially increased the money supply and freed up currency for depositors who demanded cash. Federal aid came in the form of public funds deposited by the U.S. Treasury at key New York City banks, and J.P. Morgan formed a money pool with bankers to provide liquidity assistance to trust companies and the stock market (Donaldson, [1993]; Ramirez, [1995]; DeLong, [1997]). These measures eased conditions in the money market, but failed to prevent the suspension of specie payments (Moen and Tallman, [2000]).

As short-term interest rates rose to over 10%, gold poured into the United States from England and the rest of Europe. The United States imported over $100 million in gold during November and December. Although the specie arrived too late to prevent a panic, gold shipments probably shortened the period of suspension and reduced the duration of the recession. On the other hand, specie exports drained European money centers of gold, helping to transmit the "localized" New York panic to international financial markets (Goodhart, [1969]).

Previous research has focused on the role of "excessive speculation" and on the policies of the U.S. Treasury and the Bank of England in propagating the Panic of 1907. These studies, however, have overlooked the role of the San Francisco earthquake in the financial crisis. The payment of claims by British insurance companies to policyholders in San Francisco holds the key to understanding the shock that prompted defensive actions by the Bank of England and the chain of events that culminated in the Panic of 1907.

By the time the transcontinental railroad was completed in 1869, San Francisco had already established itself as the center for export trade from the Pacific Coast region. Endowed with an excellent natural harbor and easy coastal and river access to the agricultural and natural resource riches of the west, San Francisco had developed strong economic ties to other countries, particularly to Britain. Most of the wheat exported from the west coast and bound for England was financed through San Francisco, and a sizeable number of London banks had offices in that city.

At the same time, other British financial institutions sought to expand their business in the area. Prominent among these were the British fire insurance companies. In 1852, the Liverpool & London & Globe fire insurance company placed an agent in San Francisco -- the first such insurance firm (either foreign or domestic) in the city. Two years later, three more British firms were writing business in San Francisco and the first American company set up shop, but it was not until 1858 that a San Francisco-based company was established (Kirschner, [1922]).

By 1890 in California, there were 127 American fire insurance firms, each underwriting an average of $13.5 million in risks. On the other hand, there were 52 foreign firms (more than half of which were British), each of whom underwrote $23.5 million in risks; nearly 27% of California term fire insurance policies were carried by British companies.

In fact, the fire insurance company writing the most policies in California was Liverpool & London & Globe, with total risks of $173 million. In comparison, foreign firms underwrote 28% of all fire insurance policy risks in New York, while in Illinois foreign companies insured less than twenty percent of the value of all risks (United States Census, [1891]).

Twenty-five years later, these patterns persisted. At the end of 1905, American firms underwrote slightly more than half of insured risks with almost forty percent of business still carried by foreign firms, most of who were based in Britain. On the other hand, California-based firms were writing only seven percent of fire insurance business in the state (Kirschner, [1922]). The city of San Francisco was even more dependent on foreign fire insurers than the state as a whole. By the turn of the century, it was estimated that at least British companies (Cockerell and Green, [1976]) had issued half of all fire insurance policies in San Francisco.

One explanation for the dominance of British firms is the long history of trade relations between the city and Britain; another is simple economics: as agents from the London and Lancashire insurance firm noted, the profit on San Francisco business equaled thirty percent -- "three times greater than that yielded by its business generally" (Kirschner, [1922]). Evidently, adjusters failed to consider earthquake risk.

On Wednesday, April 18, 1906, an earthquake of Richter magnitude 8.3 hit San Francisco. Most of the damage was not done by the tremor itself (which was especially severe in areas of landfill where liquefaction occurred) but by the fires that followed. The majority of the city's buildings were constructed of wood; this material was far more plentiful and inexpensive than brick, thanks to the city's proximity to the coastal lumber trade. The combination of close quarters, highly flammable building materials, and earthquake-damaged water mains hampered the efforts of firefighters. Ultimately, more than four square miles -- about half of the city -- was destroyed.

Although fewer than 1,500 of the city's 375,000 residents were killed, damage was estimated at between $350 million and $500 million (Commercial and Financial Chronicle, October 19, 1907). Word of the disaster in San Francisco spread throughout the United States within hours.

Prominent financiers, members of Congress, and foreign delegations all promised aid to the stricken… [END OF PREVIEW] . . . READ MORE

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