Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

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.