Economic meltdowns may come with warnings but they are often obvious only in hindsight. In the late 1830s, the American economy was beset by two financial crises in close succession. The first of these could have motivated the overextended, governments included, to improve their financial position but, in the aftermath of the Panic of 1837, the wise choice was not taken. When a second panic commenced a couple of years later, it brought far greater destruction than the first and this time the vulnerable were in even weaker condition than before. Despite the agricultural depression and bank failures of the era, the most remembered effect of the crisis was the default of several American state governments.
Before the Panic
The United States’ agrarian economy benefited from an increase in trade and rising prices, most notably for cotton, in the years before the crisis. The price of agricultural commodities was the single most important economic fact for large swaths of the country. Two of the most important commodity trades were the growing exports of southern cotton to Britain and the extensive internal trade in various other agricultural commodities, much of it from the growing Midwest.
The least agrarian part of the country, the northeast, was also benefiting from growing commerce and the early stages of its industrialization, aided by infrastructure investments. States, especially in the northeast and northwest, financed the construction of various internal improvements, from roads to canals. To make this happen, state governments borrowed more than $200 million at home and abroad; this was nearly double the record level of federal government debt up to that point.
Another driver of economic growth in the 1830s was the sale of formerly federal government owned lands in the ‘old west’ states, such as Ohio and Indiana. The transfer of tens of millions of acres into private hands provided a windfall to state governments because, after a five-year period following the sale, the land became taxable.
Credit was readily available to those purchasing land, the product of growing local banks and foreign capital inflows from Britain. American foreign indebtedness tripled between 1830 and 1837. Buyers were able to purchase federal lands with banknotes as well as with precious metal specie. Because of this, and the fact that land prices were rising, planters were able to easily borrow money from banks with which to acquire more land.
The economic boom had a profound fiscal effect on American states, which were more involved in the day-to-day economic life of the country than the federal government. Most notably, the prosperity changed the composition of state government revenues. The boom years enabled many states to altogether abolish property taxes, which had previously served as a key source of funding for many. Now, governments were able to rely instead on strong revenues from infrastructure projects, taxes on businesses, and investments made by state governments in the banking system.
The crisis that changed all this came in two parts. First, in 1836, the federal government required that purchases of western lands be made in specie alone, and not in banknotes. This helped arrest the rush to buy land as buyers could not accumulate the metal needed to make purchases as easily as they could using more plentiful banknotes. This was significant; to understand the earlier scale of the land sales, it is worth noting that the proceeds from the sales were the largest source of federal government revenues in 1836.
That same year, the Bank of England began to restrict the terms on which it advanced cash on commercial bills. The bank raised interest rates from 4% to 5% in 1836, triggering pain in 1837, but soon reversed course. In the meantime though, many banks in America were forced to suspend the convertibility of banknotes into specie. The requirement that land purchases be made in specie, rather than in banknotes, likely exacerbated the drain on bank reserves as buyers cobbled together the required money with which to make purchases.
Economic and financial conditions recovered in 1838 and 1839. Overall, this first crisis had little fiscal effect on state governments besides causing some to increase borrowing still further. State governments borrowed more during these years of crisis and recovery than they had during the preceding prosperity. The amount of state debts outstanding rose from $81 million in 1835 to $198 million in 1841.
In 1839 though, the Bank of England repeated its earlier move and raised interest rates once more. At the same time, poor harvests in Britain caused incomes to fall and depressed British demand for cotton goods. The price of cotton fell, eventually reaching a low in 1842 that was just half of its 1836 level. An agricultural depression got underway and land values fell. American banks again suspended convertibility and many closed their doors entirely. One quarter of American banks failed as debts secured by cotton plantations and other agricultural assets became unsellable.
Unlike the first one, the second of the twin banking crises particularly damaged the finances of American states, now more indebted than ever. Several state governments were quite intertwined with the banking system now in distress. Many had encouraged the development of banks by purchasing shares in them using the proceeds of state bond issues. The expected dividends on the bank stock were allocated to meet repayment of the bonds; now these banks were failing.
The crisis was so dire that even what was essentially the country’s former central bank, the Second Bank of the United States, failed in 1841 having by then lost its official role. Indeed, many of the banks being founded with state assistance were intended to replace the dwindling presence of the Second Bank of the United States which had closed branches across the country after its federal banking charter was withdrawn in 1836. In addition to investing in banks, some states borrowed from them, a source of financing no longer available after the banking panics.
Of course, states also borrowed to fund infrastructure projects, particularly toll roads, railroads, and canals. Much of this debt was sold in Britain during the boom years when investors there sought American securities. However, these improvements would take still more years to complete and any associated revenue would be at least somewhat uncertain until then. Unable to finance continued work on speculative construction, projects were put on hold. The stoppage forced by the drying up of financing accelerated the economic decline.
The crisis that followed the Panics of 1837 and 1839 made states unable to service their debts with existing revenues. The problem was then compounded by an unwillingness to levy new taxes. During the economic expansion, many states had abolished taxes that could now be reintroduced but governments were reluctant to raise taxes in the midst of an economic crisis. States were also unwilling to pay higher interest rates; selling bonds into the market at more distressed prices, below par value, seemed anathema to some. In this period of fiscal pressure, default was turned to. Eight states and the territory of Florida defaulted on their debts, starting with Indiana and Florida in January 1841 and ending with Louisiana in February 1843.
More astoundingly still, most of these states outright repudiated at least some portion of their debts, refusing to make further payments altogether. This occurred mostly in southern states where bonds were sold to raise money for state-supported banks. The bankrupt states argued that these were really obligations of the failed banks and that creditors must turn to the banks’ mortgage portfolios first. In some cases, the states pointed to violations of banks’ charters as justification for not making good on bonds that really benefited the banks. Faced with their neighbors’ bankruptcy and repudiation of debts, even those states that did not default were unable to raise more capital at home or abroad.
Data on bond prices and yields survive to this day. The bonds of American states were often traded in Philadelphia, New York, and London, in addition to in their home market (e.g. Boston in the case of Massachusetts bonds and Baltimore in the case of Maryland). Throughout the crisis, London was always one step behind, with bond prices moving in New York two months before equivalent moves were registered in London, making the domestic bond markets the best place to measure the effects of the most current news. In these markets, as in London, the bonds of New York, Ohio, and Pennsylvania were the most actively traded and this selection alone already allows for a comparison between defaulting and non-defaulting states.
The yields on New York and Ohio bonds rose sharply during the period, from below 3% for New York issues and below 4% for Ohio issues before 1836 to almost 10% and 13% for New York and Ohio respectively at their peaks in early 1842, and these were two states that did not default. The state of Pennsylvania did default. Yields on that state’s bonds rose from below 4% prior to 1836 to a peak of over 23% in the third quarter of 1842. Though less frequently traded, prices for defaulted Illinois and Indiana bonds are also available and their yields rose to even higher levels. Bond prices move inversely to yields, with the later rising as prices fall.
Despite the panic, investors were able to discern the riskiness of different issuers. Some states were largely immune to the crisis. Many states had no indebtedness at all but others, though indebted, had well managed finances. For example, the bond yields of Massachusetts, one of the more fiscally sound states, rose to 5% but strayed not much higher even through the worst moments of the entire crisis.
The fiscal crisis never spilled over into higher levels of government. As a result, there were proposals floated for the federal government to guarantee the debts of American states. Though a means of resolving the crisis then underway, this was politically controversial. The Democratic Party was not as open to the idea of a guarantee as the Whigs, fearing it would lead to greater federal control over states. Direct payments to state governments were also proposed. However, though the federal government was in much better financial condition, having retired its debt in 1835, the economic crisis nonetheless curtailed its customs revenues and even the federal government may have had difficulty financing any new deficits.
In any case, after more-or-less three years in default, the public finances of some states began to improve. New property taxes were introduced, including by many states that had abandoned such taxes during the boom years. As examples, Maryland introduced a property tax in 1841 and Pennsylvania and New York in 1842, though the later had not defaulted. To avoid future fiscal crises, some governments had also passed constitutional amendments that limited new borrowing. In virtually all states, public sector involvement in private ventures, from banking to railroads, would be increasingly scrutinized.
The recovery is apparent in the movement of bond prices. Yields for state bonds trading in London and in America began to come down in 1842 and 1843. By 1848, the American federal government was able to successfully market new bonds in Europe, bonds that funded its war against Mexico. That same year also saw revolutions in Europe that led many investors there to once again consider, and perhaps favor, American securities. It was a sure sign that the country’s reputation as a borrower had recovered.
The 1830s and 1840s produced among the most miserable years in American economic history. The events affected every corner of the country and reversed years of progress and prosperity in several industries. For the most indebted of the nation’s states, it meant bankruptcy. Yet, the cause of the trouble varied by state and the full range of possible outcomes were on display. Some had no debts at all and others were manageable. Some defaulted and many of the bankrupts outright refused to recognize at least some of their earlier debts. What they all had in common was debt-financed investment in speculative projects, whether for bank formation or road and canal construction.
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Though still an independent country, Texas was also affected by poor economic and financial conditions after the Panic of 1837; it too defaulted. Also, consider subscribing to this blog’s newsletter here.
1. English, William B. “Understanding the Costs of Sovereign Default: American State Debts in the 1840’s.” The American Economic Review, vol. 86, no. 1, Mar. 1996, pp. 259–275.
2. Kim, Namsuk, and John Joseph Wallis. “The Market for American State Government Bonds in Britain and the United States, 1830-1843.” 2003.
3. Roberts, Alasdair. “‘An Ungovernable Anarchy’: The United States’ Response to Depression and Default, 1837–1848.” Intereconomics, vol. 45, no. 4, 2010, pp. 196–202.
4. Wallis, John Joseph, et al. “Sovereign Debt and Repudiation: The Emerging-Market Debt Crisis in the U.S. States, 1839-1843.” NBER Working Papers, Sept. 2004.