Panic of 1907, Federal Reserve Act and Depression of 1920

Posted by PITHOCRATES - December 17th, 2013

History 101

In 1907 the Heinze Brothers thought Investors were Shorting the Stock of their United Copper Company

Buying and selling stocks is one way to get rich.  Typically by buying low and selling high.  But you can also get rich if the stock price falls.  How you ask?  By short-selling the stock.  You borrow shares of a stock that you think will fall in price.  You sell them at the current price.  Then when the stock price falls you buy the same number of shares you borrowed at the lower price.  And use these to return the shares you borrowed.  You subtract the price you pay to buy the cheaper shares from the proceeds of selling the costlier shares for your profit.  And if the price difference/number of shares is great enough you can get rich.

In 1907 the Heinze brothers thought investors were shorting the stock of their United Copper Company.  So they tried to turn the tables on them and get rich.  They already owned a lot of the stock.  They then went on a buying spree with the intention of raising the price of the stock.  If they successfully cornered the market on United Copper Company stock then the investors shorting the stock would have no choice but to buy from them to repay their borrowed shares.  Causing the short sellers to incur a great loss.  While reaping a huge profit for themselves.

Well, that was the plan.  But it didn’t quite go as planned.  For they did not control as much of the stock as they thought they did.  So when the short-sellers had to buy new shares to replace their borrowed shares they could buy them elsewhere.  And did.  When other investors saw they weren’t going to get rich on the cornering scheme the price of the stock plummeted.  For the stock was only worth that inflated price if the short-sellers had to buy it at the price the Heinze brothers dictated.  When the cornering scheme failed the stock they paid so much to corner was worth nowhere near what they paid for it.  And they took a huge financial loss.  But it got worse.

The Panic of 1907 led to the Federal Reserve Act of 1913

After getting rich in the copper business in Montana they moved east to New York City.  And entered the world of high finance.  And owned part of 6 national banks, 10 state banks, 5 trusts (kind of like a bank) and 4 insurance companies.  When the cornering scheme failed the Heinze brothers lost a lot of money.  Which spooked people with money in their banks and trusts.  As these helped finance their scheme.  So the people rushed to their banks and pulled their money out.  Causing a panic.  First their banks.  Then their trusts.  Including the Knickerbocker Trust Company.  Which collapsed.  As the contagion spread to other banks the banking system was in risk of collapsing.  Causing a stock market crash.  Resulting in the Panic of 1907.

Thankfully, a rich guy, J.P. Morgan, stepped in and saved the banking system.  By using his own money.  And getting other rich guys to use theirs.  To restore liquidity in the banking system.  To avoid another liquidity crisis like this Congress passed the Federal Reserve Act (1913).  Giving America a central bank.  And the progressives the tool to take over the American economy.  Monetary policy.  By tinkering with interest rates.  And breaking away from the classical economic policies of the past that made America the number one economic power in the world.  Built on a foundation of thrift, savings, investment, free trade, the gold standard, etc.  Where people saved for the future.  The greater their savings the more investment capital there was.  And the lower interest rates were.

The Federal Reserve (the Fed) changed all of that.  By printing money to keep interest rates artificially low.  Giving us boom and bust cycles as people over invest and over build because of cheap credit.  Leading to bubbles (the boom) in asset prices that painful recessions (the bust) correct.  Instead of the genuine growth that we got when our savings determined interest rates.  Where there is no over-investing or over-building.  Because the limited investment capital did not permit it.  Guaranteeing the efficient flows of capital to generate real economic activity.

Warren Harding’s Tax Cuts ignited Economic Activity and gave us the Modern World

Thanks to the Fed there was a great monetary expansion to fund World War I.  The Fed cut the reserve requirements in half for banks.  Meaning they could loan more of their deposits.  And they did.  Thanks to fractional reserve banking these banks then furthered the monetary expansion.  And the Fed kept the discount rate low to let banks borrow even more money to lend.  The credit expansion was vast.  Creating a huge bubble in asset prices.  Creating a lot of bad investments.  Or malinvestments.  Economist Ludwig von Mises had a nice analogy to explain this.  Imagine a builder constructing a house only he doesn’t realize he doesn’t have enough materials to finish the job.  The longer it takes for the builder to realize this the more time and resources he will waste.  For it will be less costly to abandon the project before he starts than waiting until he’s built as much as he can only to discover he will be unable to sell the house.  And without selling the house the builder will be unable to recover any of his expenses.  Giving him a loss on his investment.

The bigger those bubbles get the farther those artificially high prices have to fall.  And they will fall sooner or later.  And fall they did in 1920.  Giving us the Depression of 1920.  And it was bad.  Unemployment rose to 12%.  And GDP fell by 17%.  Interestingly, though, this depression was not a great depression.  Why?  Because the progressives were out of power.  Instead of the usual Keynesian solution to a recession Warren Harding (and then Calvin Coolidge after Harding died in office) did the opposite.  There was no stimulus deficit-spending.  There was no playing with interest rates.  Instead, Harding cut government spending.  Nearly in half.  And he cut tax rates.  These actions led to a reduction of the national debt (that’s DEBT—not deficit) by one third.  And ignited economic activity.  Ushering in the modern world (automobiles, electric power, radio, telephone, aviation, motion pictures, etc.).  Building the modern world generated real economic activity.  Not a credit-driven bubble.  Giving us one of the greatest economic expansions of all time.  The Roaring Twenties.  Ending the Depression of 1920 in only 18 months.  Without any Fed action or Keynesian stimulus spending.

By contrast FDR used almost every Keynesian tool available to him to end the Great Depression.  But his massive New Deal spending simply failed to end it.  After a decade or so of trying.  Proving that government spending cannot spend an economy out of recession.  But cuts in government spending and cuts in tax rates can.  Which is why the Great Recession lingers on still.  Some 6 years after the collapse of one of the greatest housing bubbles ever.  Created by one of the greatest credit expansions ever.  For President Obama is a Keynesian.  And Keynesian policies only lead to boom-bust cycles.  Not real economic growth.  The kind we got from classical economic policies.  Built on a foundation of thrift, savings, investment, free trade, the gold standard, etc.  The economic policies that made America the number economic power in the world.

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