 Panics
and Profits
Chris Mayer
The
Daily Reckoning
October 25, 2004
"To be
ignorant of what happened before you were born is to be ever
a child."
-Cicero
George Peabody
may not be a name familiar to you, but surely, you have heard
of J.P. Morgan. Well, there may never have been a Morgan if not
for George Peabody. What follows is a bit of his story, a small
study in the creation of wealth in 19th-century America. The
opportunity for Peabody emerged in the aftermath of the Panic
of 1837.
The Panic of
1837 itself is a great tale, not only because of its useful parallels
with today's markets, but also because it gives us an example
of the great truth about financial crises - they are midwives
of opportunity.
Generally,
the study of the bubbles and busts of the past should be a staple
in every investor's diet, because speculative manias and panics
are bound to be a part of every investor's experience. There
is much to be learned in mining these old experiences. The more
we know (so we hope), the better prepared and less surprised
we will be when things start to break.
Panics always
have their beginnings in the boom that precedes them. Just as
all hurricanes first develop over warm waters from pre-existing
conditions, financial storms are spawned by surging growth in
money, debt and speculation - the tres hombres of financial upheaval,
if you will.
From the perspective
of European investors, 1830s America was a booming emerging market
full of promise and potential, a lure for hungry European capital.
The cotton
industry was thriving, as the United States was a major global
exporter of cotton. Cotton prices were probably as important
as the price of oil is today for Middle Eastern countries like
Saudi Arabia.
In addition
to the cotton industry, there was a great surge in canal construction.
The Erie Canal was completed in 1824 and made a big impact on
trade. As Marc Faber reports in his excellent book Tomorrow's
Gold,
the Erie cut travel expenses by 90% on some routes. New canals
linking the St. Lawrence River to the Great Lakes allowed for
easier transportation of Midwestern grains to New York.
The canal was
like any of our recent technological marvels, in that it cut
costs and improved productivity. This should concern those investors
who are banking on productivity and breakthrough technologies
to make them rich, because the canal boom and bust is another
in a long line of examples (including airlines and automobiles)
in which investors lost boatloads of money betting on life-changing
technologies.
In any event,
the success of New York's canals helped make the state the financial
and commercial center of the young republic. It also inspired
numerous imitators, as other towns and cities sought to copy
its successes. New bubbles need a crowd of support to wreak havoc,
just as politicians need votes to get started.
The canal mania
also stimulated rampant speculation in land as speculators tried
to position themselves to profit from the growing canal boom.
Land prices soared, and properties were flipped like Internet
stocks.
Much of this
expansion - the cotton boom, the canal construction and the speculation
in land - was financed on credit. The banking business, too,
was a growth industry. The number of banks in the United States
rose from 330 in 1830 to 788 in 1837 - a 139% increase.
The Second
Bank of the United States (an embryonic Federal Reserve, which
was disbanded in 1836 after Andrew Jackson vetoed the bill to
renew its charter) and its coterie of state banks fueled a credit
binge that would have made Greenspan proud.
Total bank
loans and money supply more than doubled in the six years running
up to 1836. In short, there was a huge amount of money chasing
cotton plantations, canal projects and speculating on land.
Austrian business
cycle theory, as crafted by economists Ludwig von Mises and Murray
Rothbard, dictates that any bank credit inflation leads to the
boom-bust cycle. All that money and debt creation leads to malinvestments.
Malinvestments are investments that later prove to be unprofitable.
The word is perfect to express what happens in a boom - malinvestments
multiply. The 1830s boom would be no exception.
The immediate
causes of the bust were numerous, and all happened in 1837, precipitating
a period of tighter money in which the house of cards began to
collapse on itself.
But the immediate
causes of the Panic are not important. What is important to remember
is that massive borrowing and speculation put the economy on
the inevitable path of all bubbles. It also important to note
that as prosperous as America was to become, it was plagued in
its early stages with regular economic crises - in 1819, 1837,
1857, 1873, 1884 and 1893. Emerging market investors of today
take note (because as promising as China looks today, it will
not have a smooth ride, if history is any guide. In fact, I think
19th-century America is probably a good metaphor for China).
During the
ensuing depression, cotton prices would fall 70%, bankrupting
a number of speculators and plantation owners who had paid inflated
prices for their land. U.S. banks, facing the withdrawal of foreign
credit, began to shut their doors, unable to meet the redemption
demands of their depositors. U.S. bank shares fell to small fractions
of their previous highs.
Many of the
investments made in canal construction were based on unrealistic
high-growth assumptions and caused great losses for investors.
Many projects, starved for capital after the Panic, were never
finished and became worthless.
It was in this
maelstrom that George Peabody would build the fortune that founded
the House of Morgan. A Baltimore merchant, he opened a merchant
house in London in 1838, trading in dry goods and trade finance.
American securities had become a specialty of Peabody's, and
he sold many U.S. bonds to British investors. State governments
had become big debtors in the infrastructure boom - spending
money on canals and public works projects.
Peabody actually
saw what was coming, and in anticipation, he began to curtail
some of his operations, collecting debts he was due, selling
stock and getting into cash-building a kitty that would see his
business through the Panic and give Peabody some dry powder to
take advantage of inevitable new opportunities once the air finally
came out of the balloon.
Like contemporary
Russia or Brazil, the United States was the emerging market crisis
of that time. The state governments were the deadbeat debtors
of the day. As author Ron Chernow notes, "British investors
cursed America as a land of cheats, rascals and ingrates."
The stain of
default also tainted the federal government's credit standing.
When the United States sent Treasury representatives to meet
with the august James de Rothschild, he reportedly answered,
"Tell them you have seen the man who is at the head of the
finances of Europe and that he had told you that they cannot
borrow a dollar. Not a dollar."
Because of
U.S. debt troubles, Peabody became persona non grata around London
(after all, he had sold the Brits much of that debt). But that
did not deter him. He bought the depreciated state bonds when
they were trading for pennies on the dollar. When these bonds
paid interest again, in the late 1840s, Peabody reaped a fortune.
By 1848, American securities had come to be seen as something
of a safe haven as Europe was engulfed in the flames of revolution.
The American railroad boom was going strong too, and gold was
soon discovered in California.
The promise
of America once again won the hearts (and investment dollars)
of Europe's moneyed elite. Proof once again that investors of
all times and places have short memories.
Peabody's reputation
was restored, as America once again became the place to invest.
By the 1850s, he had amassed a fortune of some $20 million and
had an annual income exceeding $300,000. He was financing everything
from Chinese silk to iron rail exports to America.
Peabody, though,
was careful with his money. "My capital is ample,"
he wrote, "but I have passed too many money panics not to
have seen how often large capitals are swept away and that even
with my own I must use caution."
Junius Spencer
Morgan, J.P. Morgan's father, was invited to become Peabody's
partner in 1854. Fortunately for Morgan, Peabody had no heirs
or a spouse - not even a nephew to whom he could pass on his
vast fortune and thriving business. Not only that, he was determined
to find an American of good standing and talent to take the reins.
As Chernow writes, "This placed the Morgans in the exceedingly
nice position of inheriting somebody else's empire on a platter."
It was to Morgan
that such a fortune would fall when Peabody retired, although
Peabody broke their agreement by refusing to allow Morgan to
use the Peabody name (or perhaps the House of Morgan would have
become the House of Peabody). In September of 1864, George Peabody
& Co. became J.S. Morgan & Co.
The Morgan
family would prove to be good stewards of Peabody's empire. The
senior Morgan, whether you view him as villain or hero, was a
shrewd investor. Morgan and his partners were patient, taking
a long view of their investments and allowing their companies
to develop without panicking at short-term setbacks.
Long-term patience
like that is not a hallmark of today's institutional money. A
whole culture of meeting quarterly earnings estimates seems to
have vastly shortened investment horizons - to the detriment
of today's shareholders.
Taking the
lesson of past crashes and heeding the warnings about rampant
debt creation and widespread speculation, let's look at today's
market for areas that might be potential panic spots for 2005
and beyond.
It is hard
to look at today's market and not see housing as a potential
panic spot. It is like looking at a normal-sized man with elephant
ears: It's hard not to notice. The housing market has all the
makings of a bubble - lots of debt (mortgages), artificial government
stimulation, incredible price increases and a belief that housing
is always a good investment. As Grant's Interest Rate Observer
notes, "Since the stock market peaked, Americans have shifted
their hopes for capital appreciation to the roofs over their
heads, net of the mortgages on their backs."
The United
States has not seen such a long bull market in housing since
at least the 1950s.
In some parts
of the country, the gains have been staggering. Since 2000, in
the Washington, D.C., area market, where I live, prices have
gained 70%. Housing prices do decline, lest we forget. According
to research by HSBC, "Declines occurred in 1975, 1979-82
and 1989-94, using the OFHEO House Price Index. In the past 116
quarters that we have data for (1975Q2-2004Q1), real prices rose
73 times and fell 41 times and were flat twice. In other words,
real prices declined 35% of the time." This time, the run-up
in prices was unprecedented. Will we soon be able to add housing
to the long list of great bubbles in American history - along
with canals, railroads and all the rest?
In short, the
housing bubble is stretching itself awfully thin. Take this story
to heart and become more knowledgeable about risks, and learn
to appreciate the timeless qualities of financial cycles. Like
Peabody, let's heed the warnings and keep our capital safe.
Regards,
Chris Mayer
for The
Daily Reckoning
TDR Editor's
Note: Christopher W. Mayer is a veteran of the banking industry,
specifically in the area of corporate lending. A financial writer
since 1998, Christopher's essays have appeared in a wide variety
of publications, from the Mises.org Daily Article series to The
Daily Reckoning. He is also the editor of The Fleet Street Letter.
He is also the author of "Capital
and Crisis," a
recently-launched investment advisory for contrarian-minded financial
observers. For details, see:
Capital and
Crisis
http://www.capitalandcrisis.net/
As Mr. Mayer
writes above, it is inevitable that the housing bubble will burst.
When will it happen...and how will it affect American investors?
Fleet Street
Letter - at $59 for an annual subscription - has the
details...
321gold Inc
|
