Wall Street’s First Panic Shows Wisdom of Bagehot Rule

On April 19, 1792, a Manhattan securities speculator named William Duer sought protection from his creditors. Literally. A mob of several hundred of them formed, seeking a rough form of justice.

“We will have Mr. Duer,” they chanted. “He has gotten our money.” Not very catchy, even by the standards of the day. But the mob dispersed only after the sheriff appeared and made clear that he would protect Duer, with force if necessary.

In the days that followed, some creditors threw stones at the walls of the debtors’ prison where the infamous speculator was held. One creditor eventually made it inside with a brace of pistols and challenged Duer to duel. Duer repaid the challenger in cash on the spot.

Unable to satisfy his other creditors, whom in aggregate he owed between $500,000 and $3 million (or roughly between $33 billion and $196 billion in 2012 dollars), Duer remained in debtors’ prison almost until his death in 1799.

Duer was a victim of a classic asset bubble and his own hubris. In the second half of the 1770s and the first half of the 1780s, Americans had paid dearly for their independence from Great Britain in both blood and treasure. By 1787, the national government and most state governments were bankrupt, either in outright default or making interest “payments” with IOUs. Interest rates were high, the economy was in shambles and government bonds were below investment grade.

Ratification and Reform

But ratification of the Constitution and the financial program put into place by Treasury Secretary Alexander Hamilton shifted sentiment and conditions 180 degrees.

By the early 1790s, the credit of the national government, which had bailed out the states by taking over their wartime debts, was rising fast. Interest rates plummeted as the entire economy hummed for the first time since the French and Indian War.

Before long, some investors were borrowing heavily from banks to finance speculation in government bonds and the shares of the nation’s new (and mostly private) central bank, the Bank of the United States.

Sensing the opportunity of a lifetime, Duer resigned from his post as assistant to the Treasury secretary and joined the game. He tried to gain control of the Bank of New York (now the Bank of New York Mellon) by buying shares, apparently intending to pilfer it to fund an attempt to corner the U.S. bond market.

It was a bold plan, but it was ultimately thwarted by other speculators and a change in monetary policy.

As government-bond and equity markets soared in early 1792, Hamilton and Thomas Willing, president of the Bank of the United States, encouraged banks to curtail lending -- especially to known speculators, of which Duer was the most notorious.

Suddenly crimped for cash and still a long way from controlling the Bank of New York, Duer began to sell IOUs at steep discounts to just about everybody, including, according to a contemporary observer, “merchants, tradesmen, draymen, widows, orphans, oystermen, market women, churches and even common prostitutes.”

When Duer soon defaulted, visitors to Manhattan reported that they “scarcely entered a house” in which they “did not find the woman in tears and the husband wringing his hands.”

As panic rippled through the money centers of New York, Philadelphia and Boston, the ill effects of Duer’s failure were called “beyond all description.”

Pall of Uncertainty

With the prices of government bonds dropping by up to 25 percent in just a few days and bank stocks also falling rapidly, many investors were hurt. Confident that stock and bond prices would hold firm if not continue to rise, some had borrowed to buy and now faced crippling losses when their loans fell due. Because some 95 percent of retail transactions in early America were on “book account,” storekeepers and other retailers worried that many of their customers’ accounts would turn into “bad debts.”

A pall of uncertainty began to hang over the entire economy.

Yet, instead of considering Duer too big to fail or bailing out his creditors, the government applied what would later be called Bagehot’s Rule: It induced the banks to lend freely, but at a penalty rate, to anyone who could post good collateral. It did so by asking nicely, making promises and sharing its cash.

There were only a handful of banks in operation and Hamilton was on especially good terms with two of them, the Bank of the United States and the Bank of New York, both of which he had helped to found. Willing had close ties to the Bank of North America in Philadelphia, where he had served as president for a decade. When the Bank of New York wavered, Hamilton, fearful that it was extending itself too far, deposited government funds and promised not to withdraw them until the panic subsided. He also extended credit to merchant importers for the tariffs and other duties they owed.

Solvent people and firms quickly resumed business as usual and bankruptcies were dealt with as prescribed by law. In other words, prudent business practices were encouraged and those that posed systemic risks punished. Not surprisingly, more than 20 years passed before a crisis of similar magnitude struck again.

The Federal Reserve acted as a lender of last resort during the scary days of 2008 and thereafter. It didn’t follow the Hamilton-Bagehot rule when doing so, however. History suggests that as a result it may have increased moral hazard -- and perhaps the chances of another financial meltdown.

(Robert E. Wright is the Nef Family Chair of Political Economy at Augustana College in South Dakota and the author of numerous books, including, with David Cowen, “Financial Founding Fathers: The Men Who Made America Rich.” The opinions expressed are his own.)

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