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Bill Brown

A complicated man.

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I read an article on the parallels between today's financial crisis and the Panic of 1873 with considerable interest. I got my bachelor's in history and am halfway through a master's degree with an emphasis on business history and the post-Civil War American Industrial Revolution. And two of my personal side interests are in banking and railroad history. But I'm pretty out of practice, having set aside plans for my master's and doctorate to raise my children and work in software, so I read that article uncritically.

I reconsidered the subject when I read this New York Times blog entry following up on the earlier article. Suddenly memories of my research on the Great Depression flooded back into my consciousness and I realized, as usual, that only half the story was being told—perhaps completing the parallels to today's situation.

Scott Reynolds Nelson (tellingly) never mentions the Northern Pacific by name and only casually refers to Jay Cooke, instead laying the blame for the panic on rampant European mortgages, a bubble that depended on ever-increasing land valuations. Bank failures there spread across the Atlantic where investors lost confidence (inexplicably) in complex railroad bonds and the stock market crashed, he alleges. It's all very tidy and one is left in awe at Santayana's maxim, tut-tutting how we never learn.

Jennifer 8. Lee (aside, what's the story with the number for a middle initial) doesn't have the luxury of omitting the Northern Pacific since she's looking through contemporaneous newspaper accounts—where the railroad and Jay Cooke were demonized. She breezed over the issues in Europe, again because the Times wouldn't have particularly covered them at the time.

But both omit the underlying accelerant in the panic: government subsidy of the railroads on a scale unprecedented in American history. I don't know anything about European economic history of the nineteenth century except to note that there's a reason everyone over there was migrating over here—it was pretty dismal except for the landed. Moreover, I know that no- to low-down payment mortgages are a very recent phenomenon: any mortgage of that day would have a substantial equity component that would make it difficult to lose money on a foreclosure.

The transcontinental railroad race was wholly the creation of the federal government, which wanted at least three lines built to link the east to the west as quickly as possible. It meted out cash payments, enormous land grants, and generous loans over the course of nearly 20 years. Despite its best efforts and oversight, each of the transcontinental lines was rocked by financial scandal, bankruptcy, and bribery. But the federal government had a mission and was prepared to spend handily to achieve it.

Each of the railroads, and especially the Northern Pacific, were paid based on how much track was laid. So the main line took precedence and quality of track was of minor importance; this meant that the railroad couldn't be viable unless goods were transported to stations built on that main line. After the quick buck, which was right in line with the government's desires, railroad builders of the time spurned branch lines to mines, farming centers, and manufacturers and sited their lines along the easiest grades as straight as possible.

But even doing business that way proved too capital-intensive for the companies so they issued copious quantities of bonds to get the money for building. These bonds, far from the unfathomable financial instruments Nelson would have you believe, were straightforward and relatively short-term. The railroads hoped to complete sections of track in time to pay the interest portions of the bonds and thus stay one step ahead of receivership. Sometimes they made it; sometimes they didn't.

The country had invested a lot of its hope in the railroads, for they were truly the most modern and mammoth institution America had ever seen. The race across the frontier was followed by everyone in every town across the east. They eagerly bought railroad bonds because they seemed like a prudent investment—the railroads weren't going anywhere and the government was backing the whole enterprise.

The whole thing was a house of cards. Once the main line track was completed, there were operating expenses of an unprecedented scale and very little freight to generate revenue. With the 1872 Crédit Mobilier scandal fresh in the public's memory, the bankruptcy of the Northern Pacific in 1873 brought everything crashing down.

Jay Cooke prophetically said in 1869: "Why should this Grand and Glorious country be stunted and dwarfed—its activities chilled and its very life blood curdled by these miserable 'hard coin' theories—the musty theories of a bygone age. These men who are urging on premature resumption know nothing of the great and growing west which would grow twice as fast if it was not cramped for the means." (Murray Rothbard, The Mystery of Banking, p. 231-2) Four years later, his bond bubble would result in chilled activities and a stunted country.

The problem at its root was the distortion and perverse incentives of government subsidy. As Ayn Rand put it:

It is not a matter of accidental personalities, of "dishonest businessmen" or "dishonest legislators." The dishonesty is inherent in and created by the system. So long as a government holds the power of economic control, it will necessarily create a special "elite," an "aristocracy of pull," it will attract the corrupt type of politician to the legislature, it will work to the advantage of the dishonest businessman, and will penalize and, eventually, destroy the honest and the able. "Notes on the History of American Free Enterprise" from Capitalism: The Unknown Ideal

It is convenient to blame the Jay Cookes and mortgage brokers of then and now, but getting rid of them while leaving the underlying system untouched will not address the problem. The well-run and well-planned railroads of the day, like James J. Hill's Great Northern Railway, did not need government assistance and financed their trek across the United States slowly but safely. The well-run banks of today, like BB&T or Wells Fargo, did not drink from the subprime trough and they're still around, as viable as ever.

The government needed to get out of the railroad financing business then and it needs to get out of the mortgage finance business now. For starters.