Today’s Crisis: Echoes of 1873

October 27, 2008

Though hardly as grim, today’s economic crisis looks very much like a panic brought on 125 years ago by land speculation, the failure of complex and little understood security deals and cheap goods that undercut traditional industry.

The Panic of 1873 saw the world’s credit and economic development shift from Central Europe toward the United States, leading directly to the industrial concentration that became known as America’s Gilded Age. While big business flourished, average Americans suffered terribly.

Today’s mortgage and banking crisis echoes the Panic of 1873.

In the late 1860s, the leaders of Germany and France created new lending institutions that issued mortgages for residential and municipal construction. These new, easier-to-obtain mortgages launched a building boom, prompting land values to skyrocket. To cash in, borrowers assumed more credit, often using unbuilt or half-built houses as collateral.

As speculation grew, the European economy faltered in the face of competition from the farmers of the American Midwest, who undersold them. By 1871, wheat, food and manufactured goods from the United States had undercut the major markets of Central Europe in what was dubbed the American Commercial Invasion. It is, some historians say, the 19th Century equivalent of goods manufactured in China. These low costs threatened trade.

The shaky economic underpinnings of the economy gave way in late 1872 or early 1873.

European banks failed. The survivors refused to lend to one another because they were unsure which were involved in the mortgage crisis. The interbank rates – the borrowing costs between banks – skyrocketed. The banking crisis hit the United States in 1873.

The crisis hit the railroads first. Railroad had promised investors a fixed return through a series of complex financial instruments that few understood, much like the credit swaps and derivatives of today’s crisis. When a railroad financier couldn’t pay his debts in September 1873, the stock market crashed.

Over the next three years, hundreds of banks closed. Well-financed industrial companies capable of fueling their own growth thrived. Among the names still familiar today are: Andrew Carnegie and John D. Rockefeller. They gobbled up their competition at fire sale prices. It led to the Gilded Age of America.

Everyday Americans suffered. Small factories and workshops closed. Unemployment exploded, reaching 25 percent. Unemployed workers demonstrated in Boston, Chicago and New York demanding that the government create public work projects. Some of the most violent strikes in American history followed.

The parallel to today’s crisis is astounding.

Today, loans were issued to first-time homebuyers who signed up for mortgages they probably couldn’t pay off. Speculators bought properties on credit, hoping to flip the real estate for a quick profit as real estate prices soared.

The mortgages were packaged in complex, little understood securities wrapped with credit swaps and derivatives. When these securities weren’t covered, banks failed.  The price of short term loans skyrocketed as banks hoarded cash, refusing to lend to one another, in part, over fears of exposure to these mortgage backed securities.

Scott Reynolds Nelson, a professor of history at the College of William and Mary, said in the end the world’s credit shifted from Central Europe to the United States after the Panic of 1873. He wonders whether the current panic suggests a shift from the United States to China and India.