Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

The Crisis of 1907 in the Light of History

[232]... From one point of view ... every economic crisis is a financial crisis. For since values are expressed in terms of money, and since the modern business superstructure is erected on the basis of credit, every economic revulsion expresses itself through the medium of a change in prices; and since the bank is the center of credit operations, every crisis inevitably involves a revolution in the conditions of credit. From this point of view, all crises may be declared to be financial crises.

From another standpoint, however, a distinction may be drawn between financial crises proper and commercial or industrial crises in the larger sense. There may be a financial panic or crisis due primarily to temporary and sudden oscillations in the condition of the money market or in the price of securities. Such oscillations, sharp and sudden though they be, may have but little relation, whether of effect or of cause, to the general commercial and industrial interests. Of this character, for instance, were the original Black Friday in England, in 1745, its namesake, the famous Black Friday in 1869 in New York, as well as many spasmodic fluctuations due either to political rumors like that which followed the Venezuelan Message of 1895, or to temporary speculative manipulations, like the Northern Pacific "squeeze" of 1901. Of a distinctly different nature are those wider disturbances which are traceable to more general economic causes and which, even though they culminate in acute financial trouble, are followed by an industrial and commercial depression of more or less magnitude.

Into which category is to be put the crisis of 1907; and if in the latter, what were its causes?

At the outset it must be remembered that crises are essentially modern phenomena. We have had financial transactions, and that, too, on a large scale, for many centuries and in many civilizations. But crises, in contradistinction to temporary panics, have existed in England only since the middle of the eighteenth, and in other countries only since the beginning of the nineteenth, century. The first crisis in England, barring the financial flurry connected with the South Sea Scheme in 1720, was that of 1763, followed by the minor disturbances of 1772 and 1783, and the more widespread convulsions of 1793, 1810, and 1825. The first crisis in the United States was that of 1817; and it was not until 1837 that we find the first international crisis, spreading from the United States to England and then to France. In Germany the period of important crises was ushered in even later.

Crises, in other words, are products of modern economic life. Modern economic life, however, has as its basal characteristic industrial capitalism, with the factory system and the newer methods of production for a wide market. This transition to modern industrial capitalism began in England in the latter half of the eighteenth century, was initiated in America in the first two decades of the nineteenth century, and took place on the continent at a later date, last of all in Germany. The explanation of crises must therefore be sought in some feature of our modern capitalistic life.

The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence—as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country's executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of a democracy have had the fullest sway. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the "Roosevelt panic," utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis has had its presidential scapegoat, and has been followed by a political revulsion. The crisis of 1857 helped to weaken the Democrats; the crisis of 1873 resulted in a popular majority for Tilden; the crisis of 1884 put Cleveland into the presidential chair; and the crisis of 1893, with the ensuing depression, brought the Republicans back to power.

Opposed to these popular, but wholly unfounded, interpretations is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises. Here we find an interesting and progressive series of attempts to grapple with the difficulties of the problem. For a long time economists and business men advanced the theory of overproduction, forgetful of the fact that there really cannot be any such phenomenon as too much actual production of wealth.

With the disappearance of this doctrine there came into prominence its variant, which put the emphasis on relative, rather than absolute, or universal overproduction, that is, the overproduction of some things and the underproduction of others. This theory also failed to command general assent, for the reason that no one could show in what respects there was any underproduction of wealth, or any lack of particular products during the years preceding a crisis. Others again, have sought the causal fact in underconsumption, alleging that the larger consumption of wealth will in itself take up all the slack of production, and thus obviate a crisis. This explanation also is inadequate, because it overlooks the fact that the real falling off in consumption comes after the crisis has developed and not before; in fact, the period of prosperity which precedes a crisis is generally marked by a prodigious increase in consumption.

The socialists, again, seek to explain crises by the existence of private property in the means of production, and contend that if we were to cease the exploitation of the laborer by the modern capitalistic method, crises would disappear. While, however, agreeing in this general conclusion, they differ in their detailed analyses. Thus Rodbertus maintains that the secret of crises is to be found in the fact that the progress of industry causes a continually greater output of product, while the exclusion of the laboring classes from any participation in this increased productivity involves a relative diminution in demand, and thus ultimately a fall in price, culminating in a crisis. Marx, on the other hand, puts the emphasis on the fact that the necessary fall in the rate of profits (which, according to him, is a result of the surplus value, or exploitation theory) is incompatible with the greatly increased productivity of fixed capital inherent in the present system, and that the clashing of these two incongruous tendencies of modern industrial life brings about a relative overproduction of capital, and gives rise to periodical explosions. This view, finally, is sharply criticised by the latest and ablest of the socialist theorists, Tugan-Baranowsky, who in turn maintains that crises are due primarily to the fact that under the modern system it is impossible to invest the fresh accumulations of capital proportionally in all branches of industry, and that it is this relative disproportion of accumulated capital to the particular demand that causes the anarchy of the market and the recurrent convulsions of industry.

While the socialist scholars have undoubtedly made valuable contributions to the discussion of the problem, they, like the earlier economists, have erred in laying stress on the question of technical production rather than, as is done by the more recent economic thinkers, on that of business enterprise and capitalization. This is manifestly not the place to elaborate a general theory of crises. If we attempt, however, to give the bare outline of the modern explanation. It would be approximately as follows:

The problem of crises or industrial depressions is one of relative capitalization. Under the present system of enterprise, production is carried on in mass for a prospective market, rather than as formerly in small quantities to fill a definite order. Even if it be contended that certain factories nowadays are busy with producing to order, it is none the less true that numerous plants are continually being erected in the expectation that orders will be received in the future. The good times, or periods of rising prices, may be due to many causes—either in general to an augmented gold output, or in particular to the increase in the demand for some special product, whether in the iron industry through a new navy program, or in the clothing industry through the outbreak of a war, or in any other industry through a change of fashion or what not. Prices first rise in the particular enterprise, production augments, the movement spreads to other lines of business, and the new enterprises are financed by loans from the banks or trust companies, or by the sale of securities on a capitalization proportionate to the anticipated earnings. In times of buoyancy we are continually capitalizing anticipated earnings and future hopes, and we do this through the utilization of credit on a large scale. We build railways, put millions into steel plants, "boom" land sites, and form combinations of all kinds, employing the credit facilities granted by the banks, or throwing the securities on the stock market. We "water" the stock or, if that be forbidden by law, we drive the market quotations to a high point, because we think that this is warranted by prospective earnings. Sometimes we say that we capitalize the good will or, in the case of quasi-public enterprises, the franchise; but in all cases we capitalize the future because we believe that we shall earn an income which will justify this capitalization.

The peculiarity, however, of an up-grade movement which rests on modern credit facilities is that we wear magnifying glasses or look at the future in too roseate a light. It is a natural tendency of human nature to capitalize one's hopes and expectations too liberally. If this is done on a continually larger scale, the capitalization becomes so great that actual earnings do not come up to our anticipations or the fear of a discrepancy between actual and estimated earnings begins to obsess us. It becomes necessary to reduce the capitalization to its true dimensions, i. e., to a sum proportioned to actual earnings. This process of readjustment of overcapitalized values obviously involves loss; but readjustment there must be. If the realization of its necessity is sudden, we have a crisis or panic.

In the height of the period of exaltation or prosperity, something happens to disturb confidence. A chance occurrence, a mere rumor, may suffice. Some bank considers its credit too heavily engaged, or suspects the adequacy of the collateral. Just at the flood of the tide, when new demands are constantly being made, it finds itself unable or unwilling to respond. Its refusal starts or intensifies the feeling of insecurity, and with the inability of some important concern to meet its obligations, a failure occurs and the crisis is precipitated. If, on the other hand, the situation is well handled, and if the readjustment of the overcapitalized values to actual earning capacity can be brought about more gradually, we have, in lieu of a crisis, a liquidation and a period of depression which lasts until the up-grade movement again sets in.

Crises, therefore, are not necessarily the result of increased technical production. The important point is not production, but capitalization. There may be overcapitalization, without overproduction. Overproduction of particular things may indeed accompany overcapitalization, but the stress must be laid, not on the relation between production and consumption, as the old writers assumed, but on the discrepancy between the investment and its returns.

While the general features of a crisis are thus everywhere the same, the details differ in each case. Sometimes it is the banks that fail first, sometimes the general business enterprises. Sometimes it is the railway securities that first feel the strain, at other times "the industrials," and at still other times the raw materials. Sometimes the bolt comes out of the clear sky with prices at a maximum, sometimes it is only the last stage of a period of liquidation with progressively lower prices. But however unpredictable and seemingly inscrutable the actual course of events, the fundamental explanation is always the necessary readjustment of capitalization to actual earning capacity.

That this is true of all our crises can be seen from a hasty review. The crisis of 1817 was the result of the first utilization of modern capitalist methods in America. The period of the War of 1812 was marked by three facts: first, the industrial revolution in New England and the introduction of the factory system in the textile industry; second, the great development of internal improvements through canal and turnpike companies; third, the sudden multiplication of banks to finance the new enterprises. The consequence was the so-called "Golden Age," which lasted for several years, until checked by the immense imports from England after the war, and destroyed by the collapse of the overcapitalized undertakings. It was well into the twenties before the country recovered from the industrial depression, and then came the second up-grade movement, which culminated in 1837. This was primarily a land and transportation, rather than a purely industrial, phenomenon. The canals and turnpikes in the East were now being replaced by railways, and the spread of slavery caused a rush of cotton planters, not only to the black belt, but to the pine barrens and hill country of the South. It was primarily land values that were being overcapitalized, and the process went on to such an extent that the annual land revenues of the Government now exceeded the total governmental receipts from all sources of a few years before. Finally, to finance this land movement there were called into being hundreds of the "coon-box" banks, that found a champion in President Jackson in his war against the Bank of the United States. As the period of exaltation had been unexampled, so the collapse was proportionally great. The crisis of 1837, followed as it was by those of 1839 and 1841, was still more serious than that of 1817.

It was again well-nigh a decade before the readjustment of values had been completed. The following decade was in turn marked by five striking facts: first, the gold discoveries of California and Australia, which soon initiated a general rise of prices; second, the consummation of the revolution in the media of transportation by land and water, and the settlement of the entire Mississippi Valley, the most fertile portion of the continent; third, the abolition of the corn laws in England and the opening up of a market for our incipient surplus of wheat; fourth, the era of industrial invention which resulted in the application of capitalistic methods to new classes of enterprise besides the old textile industries; and fifth, the development of free banking with the "wild-cat" institutions to provide the credit facilities for this prodigious overcapitalization. The crisis of 1857, which was the inevitable result, was perhaps still more acute than its predecessors. The continuance of its depressing influence on industry, however, was checked by the economic effects of the Civil War, which gave an artificial stimulus to many forms of enterprise.

In the period immediately succeeding the war, great changes again occurred. The transcontinental roads were completed and the Eastern trunk lines consolidated; the great wheat fields of the country were opened up under the new homestead laws, and the period of large exports began; the Bessemer process revolutionized the iron industry, and the factory system was now applied to boots, sewing-machines, and agricultural implements; the great copper and silver deposits were developed, and the petroleum output grew apace; while the greenbacks and the greenback movement fomented the process of inflation. The discrepancy between the capitalization and the actual earning capacity of the country's business enterprises again became so overwhelming that the necessary readjustment took the form of the convulsion of 1873—a convulsion the depressing effects of which were felt with almost increasing severity for six years.

The crises of 1884 and 1893 were both less intensive and more short-lived than their predecessors, for reasons which it is now not difficult to explain. The resumption of specie payment in 1879 was rendered possible, and was followed by a series of abundant crops which revivified enterprise, and which were aided by the use of agricultural machinery on a large scale. The energy and the capital of the nation, however, were devoted in increasing measure to the transportation industry. This resulted in a perfect orgy of new railroad construction, the entire mileage of the country increasing in five years by 50 per cent. As the overcapitalization was primarily a railway overcapitalization, the resulting reaction of 1884 was essentially a railway crisis, leading to but indirect and temporary disturbances in industry at large. Within a year or two recovery was general, and the prosperous years from 1886 onward were reflected in the existence of a huge surplus of governmental revenues. The live-stock and meat-packing business attained its high-water mark; the textile industries made great progress in the finer grades, and the ready-made clothing industry assumed vast dimensions; the iron and steel industry was revolutionized anew by the invention of the open-hearth process and the utilization of cheap ore from the Lake Superior region; the South was being quickly developed by the Northern capital that poured into the cotton mills and the coal and iron mines; electricity was applied to industry on an increasing scale, and the country took rapid strides in its evolution from an agricultural to an industrial community.

The movement of overcapitalization, however, was somewhat checked by two important facts: the downward tilt of world prices in general, which had been falling since 1873 and which were fast reaching their lowest point; and the relative shrinkage, not only in the amount of the wheat crop, but also in the value of both the wheat and the cotton crops. The resulting reaction of 1893, which was itself partly due to the ill-timed experiments with silver legislation, was as a consequence neither so profound nor so long-continued, since the discrepancy between anticipated and actual values turned out not to be so excessive.

When we come particularly to the crisis of 1907, we find that the general causes were very much the same. The last decade has been characterized by the most unexampled prosperity in our history. The most striking initial cause is the prodigious increase in the gold supply. Whereas the annual average value of the output of gold was under one hundred millions in the first half of the eighties, and only a hundred and twelve millions in the second half, it has grown with such enormous strides that during the past two years it has reached an annual value of about four hundred millions. The result has been a constant rise of prices from the minimum level of 1896. The rapid accumulation of gold, much of which went into the bank reserves, enabled the financial institutions to expand their credit facilities many fold, and as a consequence enterprise flourished in every direction. During the last decade the record crops of cereals and cotton, the extension of dry farming, the effects of irrigation on fruit culture, the development of truck farms, and the unparalleled increase of immigration led to a remarkable enhancement of land values throughout the length and breadth of the land; the output of coal doubled, that of petroleum more than doubled, and that of pig iron, as well as of steel, actually trebled; the huge combinations of capital, now spreading to every form of enterprise, effected prodigious economies and revolutionized business methods; and the transition from the agricultural to the industrial phase of economic development proceeded with unlooked-for celerity. Values were pushed up on all sides and the hopes of a prosperous community were capitalized with a recklessness born of unbounded faith. The pace was too rapid; the reaction was bound to ensue. In the late autumn of 1907 the revulsion was precipitated, with all the familiar accompaniments of an acute panic such as the collapse of several financial institutions, the sudden curtailment of loans, leading to the failures of some prominent business concerns, the hoarding of money, the appearance of a premium on currency, going to over 3 per cent., and the frantic efforts of the financiers to relieve the situation by the importation of gold, the issue of clearing-house certificates and the interference of Government through the dubious expedients of the placing of a new bond issue and the emission of Treasury loan certificates.

The crisis of 1907, however, is on the whole not comparable either to that of 1857 or to that of 1873, for reasons which have thus far perhaps not been adequately discussed. These reasons may be classed under five heads.

In the first place, the very magnitude of the country's resources has been a favorable factor. The unparalleled prosperity of the past decade has made possible the accumulation of a vast reserve in the case, not only of the great corporations, but also of the average business man. This reserve has acted as a buffer to the shock of reaction, and has softened the impact through a speedy restoration of confidence in the excellence of the country's assets and in the real solvency of business.

Secondly, the crops, while not those of a bumper year, have been large and valuable. It is significant that almost each of our great crises in the past has been preceded either by the failure of the harvest at home or by the existence of such a bountiful output abroad as greatly to reduce prices. It must be remembered that, notwithstanding all recent developments, this country is still primarily agricultural, and that upon the varying extent of our great staple crops depends in large measure the effective demand which sets and keeps in motion the wheels of business activity. By a fortunate coincidence, the crisis was attended by a phenomenon which in ordinary times would have spelled prosperity, and which in this extraordinary conjuncture helped to bring back normal conditions.

In the third place, the overcapitalization of values was somewhat less conspicuous than hitherto in our greatest industry—that of transportation. Some of our former crises have, as we know, been brought on primarily by the speculative building of railroads. But whereas in the early eighties the annual increase of construction reached ten and eleven thousand miles, during the past five years, with a railway system three times as large, the annual increment of new construction was only four or five thousand miles. The consequence has been that with the rapid upbuilding of the country the railways have grown up to their capitalization, until it is now reasonably certain that there has been for some little time scarcely any actual overcapitalization. A striking proof of the absence of any real discrepancy between normal values and the capitalization of actual earning capacity is afforded by the congestion of traffic of a year or two ago; and even with only normal business activity it is computed that, in order to prevent this congestion in future and to maintain the railways at a reasonable standard of efficiency, there will be required an annual investment of over a billion dollars.

Fourthly, the crisis of 1907 was preceded by a period of gradual liquidation. General prices of commodities, with a few notable exceptions like that of copper, were indeed high until well-nigh the outbreak of the panic. But the prices of securities had for some time undergone a marked shrinkage. Some, quite mistakenly, attribute this shrinkage to lack of confidence engendered by the governmental policy toward industry; others, with equal readiness and no less extravagance, ascribe it to the distress caused by the exposure of the methods of "high finance" in positions of trusteeship. In reality, however, the depreciation in securities was caused chiefly by the rise in the rate of interest. In fact the one phenomenon is really the other; for where earnings remain unchanged, the capitalization of the earnings depends on the rate of interest. If it be objected that the price of stocks fell because of the apprehended decrease of future earnings, due to lack of confidence, the retort is obvious that this would not suffice to explain the equal or still greater fall in the capital value of bonds, private or public, with a fixed rate of interest. The depreciation was not national, but international, in character; and it applied not only to our railway and industrial securities, but to the English "Consols" as well.

The rise in the interest rate, which explains the fall in the capital value of securities, was due to several causes. First and foremost is the increase in the gold output. For, as is now well established by economic theory and reinforced by the observations of practical men, while any increase in the supply of loanable funds on the call-money market temporarily reduces the "money rate," an increase in the general supply of standard money in the community, on the contrary, raises not only the price level of all commodities, but the price for the use of capital, which we call the general rate of interest. The increase of money as the standard of value inevitably tends to increase the general rate of interest. Again, since the rate of interest is always adjusted to the earnings of the fund of capital at the margin of its employment, the rate of interest has risen because there has been relatively less capital available for employment. The fund of free capital has been rapidly diminishing during the past few years. Hundreds of millions were destroyed in the Boer and Japanese wars; hundreds of millions more disappeared through the destruction of San Francisco and Valparaiso; and countless millions in addition have been utilized to finance the more or less dubious schemes which have sprung up in all countries during the years of prosperity. Even though there was no great overcapitalization of railroads and even though many of the industrial enterprises were really legitimate, the discounting of the future was not quite ample, and the capital was invested more rapidly than the immediate returns would warrant. The replacement fund, in other words, was neither quite large enough nor quite active enough; and with the gradual exhaustion of the available free capital, interest rates necessarily rose and security values as a consequence fell.

The period of liquidation was thus a fortunate event. By checking the movement of exaltation and preventing the level of prices from being so extreme, it kept the reaction from being so great. Where the crest of the wave is lower, the shock of its break is less. Had the ascent of prices and values gone on unhindered, the convulsion of 1907 would have been far more severe. From this point of view, even those who mistakenly persist in ascribing the lack of confidence to the President ought in reality to be grateful to him; for to the extent that he may be said to have superinduced the liquidation of the spring and summer, he assuredly contributed to mitigate the shock of the inevitable reaction in the autumn.

The fifth and final cause of the lesser magnitude of the crisis is the development of trusts. Until we attain the right perspective, it is always difficult to get a correct view of the far-reaching changes which are taking place under our very eyes. Especially true is this of such a veritable revolution as is typified by the modern concentration and integration of industry into the vast combinations known as trusts. There are indeed many disquieting and untoward symptoms in the development of which this is not the place to speak. But as against the undoubted perils of what we are all now coming to recognize as an inevitable process, we sometimes forget to put at least one countervailing advantage which is of especial importance in this connection. The modern trust, as typified in its most developed form by the United States Steel Corporation, is apt to exert an undeniably steadying influence on prices. Precisely because of the immense interests at stake, and the danger of a reaction, the trust with its consummately able management tends toward conservatism. As compared with the action of a horde of small competitors under similar conditions, it is apt during a period of prosperity to refrain from marking up prices to the top notch, and is likely to make a more adequate provision for the contingencies of the market. With this greater moderation is apt to be associated a more accurate prevision, which succeeds in a more correct adjustment of present investment to future needs. The drift of business enterprise in its newer form is thus toward a relative checking of the discrepancy between estimated and actual earnings, or, in other words, toward a retardation in the process of overcapitalization. The history of trusts is still too recent, and in not all of them are we yet able to discern the working out of what ultimately will come to be recognized as the real laws of their evolution. To those, however, who comprehend what this revolution in business enterprise really implies, it can scarcely be doubted that the fruit of this steadying influence and of the better adaptation of the present to the future is already perceptible. Notwithstanding the quite unexampled prosperity of the last decade, the tempo of overcapitalization has been relatively less rapid and the process of readjustment throughout the world of enterprise has therefore been less extreme. Industry has slackened rather than collapsed, and the disturbance itself has been comparatively short-lived, with the prospects of an early rebound. The influence of trusts in moderating crises and in minimizing depressions will doubtless become more apparent with each ensuing decade in the history of modern industry.

While the general causes which are responsible for the crisis of 1907 have been recounted above, there still remains one point of fundamental importance. If we compare our economic history with that of Europe, we observe that acute financial crises have there almost passed away. England has had no severe convulsion since 1866, and in France and Germany also the disturbances are more and more assuming the form of periodic industrial depressions rather than of acute financial crises. The responsibility for the continuance in this country of a phenomenon which is in large measure vanishing elsewhere rests beyond all peradventure of doubt on the inadequacy of our currency system.