DeFi and the 1837 crash
Booms and busts are not new phenomena. As Mark Twain said: history doesn’t repeat, but it rhymes. This is definitely the case for financial history. So let’s take a trip down memory lane to previous crashes, booms and busts to see the similarities to what’s happening today — there’s nothing new under the sun.
The Canal boom (& bust)
In the 1830s, Andrew Jackson criticized the Central Bank of the United States, claiming that it was helping the rich get richer. The United States had incorporated a ‘central bank’ in 1791 by direction of Alexander Hamilton, the then treasury secretary. The bank though had a limited charter and when time for renewing it came up, Andrew Jackson, the then president elect, campaigned hard against it claiming that its policies was helping the merchant class over the working class (sound familiar?).
During the early 1830s, after his election, Jackson shut down the bank and redistributed the funds from the Central Bank to state banks (of his own choosing — Cantillon effect anyone?). These banks, now flush with credit, did what banks do when they have credit and distributed it in order to earn a return on investment.
However, as new funds flooded the system, they were invested in poor quality projects.
The Erie Canal, completed in 1825 had set off a boom of interest in infrastructure. Railroads and the entire expansion westward were also getting underway.
There was no shortage of bad projects to throw money at.
Adding fuel into the liquidity surplus fire were two additional policy actions:
As the government approached paying off its debt and entering surplus, funds were once again sent to state banks. The coinage act of 1834 added more liquidity.
Liquidity leads to speculation, and in this case it went to land. The federal government earned ~$2 million each year from land sales in the 1820s. This number increased to about $5 million in 1834, $15 million in 1835, and $25 million in 1836–10x
Fueling the growth was re-hypothecated collateral.
Banks, being the shrewd operators that they were, started allowing land deeds to be used as collateral to receive paper money to buy yet more land. This gave speculators exactly what they needed: an asset that could be bought and then re-hypothecated to buy more, which could then be used as collateral to buy more.
Infuriated by speculators, their lacking morals and soaring land prices, especially the best plots, Jackson instituted the Specie Circular in 1836: land could only be bought with hard currency, gold.
The result? gold flooded west from the financial centers on the east cost of the USA. The drawdown in hard money left the eastern seaboard lacking the resilience and reserves needed to withstand a financial contraction.
Just one year later, in 1837, financial conditions worsened — not only in the USA but rather global macro conditions caused a contraction in the East coast financial centers. Banks didn’t have the capital and reserves to lend out, leading to failures and further credit contraction. A problem which only worsened as faith in paper money deteriorated as gold fled. Credit evaporated, cash flows seized and companies went bankrupt.
The result?
194 of the 729 banks with state charters collapsed and closed their doors. Farmers suffered from price deflation in crops which led to their own debt-default spirals. By the summer of 1842, eight states and the Florida territory had defaulted on their debts, which further outraged international investors and hurt the reputation of the United States as a legitimate place to do business and lend money to. A faith that would only be restored twenty years later by J.P Morgan (the elder).
Sound familiar?
