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How Does The United States Federal Government Deal With Financial Crises?

Faisal ALQadheeb
History
23th of July, 2015

How Does The United States Federal Government Deal With Financial Crises?
Introduction
As much as the US Federal Government operates the most robust financial system in the
world, it has had to grapple with five major periods of acute economic depression the first being
the economic crisis of 1792 and the most recent being the financial crisis of 2007-2009. It is
important to note that these experiences that the US federal government has had with these major
economic depression have helped legislators and regulators to institute measures that have
resulted in the US being the global economic and financial powerhouse.
The US federal government has had to institute different measures to deal with each case
of economic depression it has experienced. One has to look into the historical context of
economic depression in US history to critically understand how it deals with the financial crisis.
Economic depression is a period where a countrys economy suffers a prolonged and severe
decline in economic activity that tends to go on for two years or longer1. An economic
depression involves a situation which is characterized by economic factors like rising
unemployment rates, lack credit facilities, declining economic output levels, debt defaults,
decline in commerce and trade, and continued unpredictability in the valuation of a countrys
currency. Economic depression causes pain, anger, reduced investor, and consumer confidence
further dilapidating economic activity. This research paper seeks to look into means with which
the US Federal Government has dealt with periods of economic depression from the first
financial crash of 1792 to the most recent mortgage crisis of 2007-2009.

Rousseau Peter L and Richard Sylla, "Emerging financial markets and early US growth."
Explorations in Economic History 42, no. 1 (2005) 12.

The Economic Depression of 1792

Americas first Chief Financial Officer was Alexander Hamilton. As the countrys first
national Treasury Secretary, he sought to have the US government establish a central bank that
could rival the central banks in Europe more so in the Netherlands and Britain2. He sought to
have the young US government realize the creation of a robust financial system, where a federal
debt could amass the IOU of all federal states so that the new American bonds could be
purchased or sold in open markets enabling the federal government to access inexpensive
borrowing protocols. He also envisioned the creation of a publicly owned American central bank.
American investors well received news on the proposed establishment of an American
central bank. The First Bank of America (BUS) offered a total of 10 million dollars worth of
shares of which 80% were to be offered to investors. The first auction was held in July of 1791
and was oversubscribed in just over one hour3. As Hamiltons vision came to fruition, he was
able to have both debt required and the central bank. These two had been designed to relate to
each other symbiotically. As such, for an investor to receive a share of the BUS valued at 400
dollars, he was required to purchase a single share certificate also known as scrip for 25 dollars
and the remaining three-quarters of federal bonds4. This plan ensured that investors would
increase the demand for the US federal governments debt and allow the bank to realize a
substantial wedge of secure assets. The plan was quite appealing on paper, but in the real market

Cowen David J, "The First Bank of the United States and the securities market crash of
1792," The Journal of Economic History 60, no. 04 (2000): 1043.
3
4

Ibid., 1046
Ibid., 1048

situation, the price of share certificates driven by high demand rose to more than 30 dollars by
August 1791. By December 1791, the First Bank of the United States was operational.
However, two main issues put Hamiltons blueprint for a strong federal financial system
in jeopardy. For starters, the BUS instantaneously dwarfed all other banks and as such in two
months had offered investors over 2.7 million dollars in credit facilities, more specifically, new
loans5. The huge amount of credit in the major American cities of Philadelphia and New York led
to increased speculative fears such that the futures and short sales contracts blossomed.
However, March 1792 saw the BUS begin experiencing a shortfall in hard currency, vital
for paper notes to remain stable6. It, therefore, had to hold back from supplying more credit
facilities rather too abruptly, leading to a fall in new credit facilities dropping by 25% in just
under two months.
Another risk to Hamilton in the envisioned financial system for the US federal
government was a man by the name of William Duer7. He was Hamiltons close associate and as
such used this position to make the most out of the investors need for federal bonds. He
borrowed funds from other wealthy associates and issued personal IOUs from the American
public as well as embezzling his companies. Duer began facing challenges in borrowing more
funds from his friends as the BUS instituted credit-tightening measures, sending the American
financial markets into a spin. Duer had become accustomed to borrowing funds to pay off his
existing loans, and as the credit facilities became difficult to access, the American public grew
increasingly discontented. Government debt prices, stocks, and BUS shares dipped by 25% in
just two weeks. Duer was quickly imprisoned, and soon after, businesses began failing.
5
6
7

Ibid., 1048
Ibid.,1049
Ibid.,1049

Hamilton understood that the financial crisis America was facing could cost him his
legacy and could also lead to the dissolution of the financial system and the institution he had
founded. He responded to the desperate situation by allowing for Americas very first bailout
plan for the nation8. As such, the Treasury Secretary employed public funds to purchase federal
funds as well as invigorate their prices. This very noble cause towards enabling speculators and
banks had earlier bought the bonds at exorbitant prices. Thus, they remained protected from the
negative effects of the financial crash. Funds were channeled to distressed lenders, and banks
with a comfortable degree of collateral were allowed to borrow as much as was needed at a 7%
penalty rate or usury ceiling.
These measures began arresting the situation, but also elicited great debates discussing on
how future economic slumps could avoid. The general American public concluded that most
people in the financial sector were amateurs, and as such, the government had to exert extra
effort towards protecting nave investors. Likewise, legislators passed rules in April of 1972 that
put a ban on public trading of futures contracts9. This harsh regulation led to the creation of a
private trading club in Wall Street, New York, which became the precursor of todays New York
Stock Exchange.
The bailout plan worked well and restored confidence in the US federal governments
financial system and institutions as well of other business operating in the country. New banks
were established, and the markets grew, and so did the GDP. By bailing out banks and other
financial institutions, Hamilton set up a forbearing precedent such that in all subsequent financial

8
9

Ibid., 1054
Ibid.,1059

crisis. State support was deemed as the only way to rescue the society from the adverse effects of
economic depression and as such turn the economy back onto a path of positive growth10.
The Financial Crisis of 1819
In 1816, a charter by the US Federal Government created the Second Bank of America
after the BUS had lost its charter in 1811. It was formed to arrest the high inflation in the US as
well as to finance the military operations of the War of 181211. The war left the countrys
government in great debt though it still experienced an economic boom as Europe had suffered
greatly because of the Napoleonic wars. The US thus had an opportunity to invest in agriculture
with Europe being a chief export market. This allowed the US agricultural sector to develop at a
high rate, enabling the Second Bank of the United States to offer loans to the agricultural sector
for more expansion. This led to a speculation in land price that resulted in land being purchased
at even 3 times the actual market value. By 1819, land sales had reached a staggering 55 million
acres12. Unfortunately, the land boom encouraged many officials at the Second Bank of the
United States to engage in fraudulent practices and more so created an economic bubble. In
1818, the banks senior officials noticed the anomalies associated with its enormous
overextension and thus instituted contraction measures as well as calling in of disbursed loans.
This led to a sharp decline in land sales and consequently slowed down the production boom
since Europe was also experiencing a period of economic recovery at the time.
The Financial Crisis of 1837-1842
10

11

Ibid., 1057

Rousseau Peter L and Richard Sylla "Emerging financial markets and early

US growth." Explorations in Economic History 42, no. 1 (2005): 7.

12

Ibid., 9

During the 1830s, the then president was Andrew Jackson, who openly voiced his
discontent with the Second Bank of the United States for its high corruption and fraud. He opted
not to renew the Second Bank of the United States, as he believed special privileges accorded to
banks tended to fuel inflation as well as other economic evils. President Jackson also believed
that silver and gold were the real forms of money and more so he greatly disliked the American
banking system in totality13.
The Second Bank of the United States received all the tax revenues collected by the
federal government and as such the bank began experiencing significant challenges after
President Jackson issued an order to the Treasury Secretary. Roger B. Taney to have federal tax
collections deposited with state banks in 183314. In response, the banks chairman, Nicholas
Biddle, to rescue his bank from bankruptcy opted to call in all outstanding loans and disallowed
any issuance of new loans. The banks clients were angry at Biddles directive, and, as a result,
this led to the Biddle panic.
In 1836, the federal government allowed the banks charter to expire, leading to its
closure five years later. President Martin Van Buren was elected to office in 1837 about 40 days
prior to the beginning of the period of economic depression under discussion15. The American
public blamed him for the extended period of depression as he failed to involve the government
through policies meant to assist the economy get back on its feet. Jacksonian politicians, on the

13

Wallis John Joseph, Richard E. Sylla and Arthur Grinath III, Sovereign Debt and Repudiation:
The Emerging-Market Debt Crisis in the US States, 1839-1843. No. w10753. National Bureau
of Economic Research, 2004.
14

Wallis, Richard and Arthur, Sovereign Debt and Repudiation: The Emerging-Market Debt
Crisis in the US States, 1839-1843.
15
Wallis, Richard and Arthur, Sovereign Debt and Repudiation: The Emerging-Market Debt
Crisis in the US States, 1839-1843.

other hand, blamed the Second Bank of the United States as it used paper money that was not
accurately matched by its bullion reserves.
The American economy began recovering from this extended depression in 1842 because
of the establishment of the Tariff of 1942. The Tariff allowed for an upward revision, which
enables the average rates to attain the 1833 levels16. The support for these high tariffs was
championed and supported by states that relied heavily on manufacturing industries, thus
allowing cheap imports to be kept away in support of domestically produced goods. As such, the
agricultural sector benefitted greatly from trading with states reliant on manufacturing as
opposed to exporting products to Europe. Secondly, the tariff enabled the federal government to
access greater funds to support further the operation of the national government.
The Economic Depression of 1873
This economic crisis was chiefly blamed on the international capital markets. As a result,
the huge boom witnessed in Europe at the time translated into a situation where the US received
decreasing the supply of the vital European capital17. For instance, prior to 1873, the US attracted
imports from Europe worth 1.1 billion in the capital as European investors sought to purchase the
federal government securities as well as those of the American railway companies. The net
liabilities of the US to European investors stood at 1.8 billion dollars.
During this time, the railroad industry was the most significant employer in the US, and
the operations of this industry not only required massive amounts of capital but also were highly
risky. Investors infused huge amounts of capital into the industry, leading to abnormal growth
16

Wallis, Richard and Arthur, Sovereign Debt and Repudiation: The Emerging-Market Debt
Crisis in the US States, 1839-1843.
17
Kehoe Timothy J and Edward C Prescott, "Great depressions of the 20th century." Review
of Economic Dynamics 5, no. 1 (2002): 5.

such that the railroad network in the US doubled in less than eight years. One investment bank
under Jay Cooke sought to invest heavily in the industry and finance the Northern Pacific
Railway18. The bank failed in September of 1873 causing a panic in the US financial sector. The
government was blamed for not taking an interest in the situation as it sought to have gold as the
standard conversion rate for the dollar.
The Financial Crisis of 1907
From 1897 to 1906, the US registers very strong economic and industrial growth leading
to many acquisitions and mergers in the corporate world. However, the Roosevelt-led
government did not favor the prevalence of huge corporations. More so, the earthquake that
struck San Francisco in 1906 created significant shocks to the international markets as well as
Eastern US markets19. Trust companies blossomed at the time, though a fall in a copper
processing firms stock led to a panic in which these trust firms were heavily implicated. The
actions of JP Morgan, who used his powerful influence to bail out failing banks, arrested the
situation. Later, Congress assented to the Aldrich-Vreeland Act, which allowed for the issuance
of emergency currency during instances of financial panic. This enabled the US to realize
economic stability when World War I began. The National Monetary Commission was also
established under the act allowing for the passing of the Federal Reserve Act in 1913 that
resulted in the creation of the Federal Reserve as the US central bank.
Conclusion
Economic depressions have only served to strengthen the US financial systems
throughout its history. However, out of all economic depressions looked into in this paper, one
18
19

Ibid., 9
Bid., 10

can come to the conclusion the Alexander Hamilton offered the US economy with the best means
through which to arrest economic inactivity and once again spur growth. The same measures
were employed in the 1907 panic though from a different perspective. As such, in the 2007-2009
financial crises, the financial institutions in the US survived only because of the massive bailout
schemes instituted by the Federal Reserve Bank.

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