From Liberty Street Economics

— this post authored by Thomas Klitgaard and James Narron

It always seemed to come down to railroads in the 1800s. Railroads fueled much of the economic growth in the United States at that time, but they required that a great deal of upfront capital be devoted to risky projects. The panics of 1837 and 1857 can both be pinned on railroad investments that went awry, creating enough doubt about the banking system to cause pervasive bank runs.

The fatal spark for the Panic of 1873 was also tied to railroad investments – a major bank financing a railroad venture announced that it would suspend withdrawals. As other banks started failing, consumers and businesses pulled back and America entered what is recorded as the country’s longest depression.

Westward Ho!

Formed in 1861, Jay Cooke & Co. was a bank that achieved fame and fortune by aggressively marketing government bonds during the Civil War. By 1869, it had expanded into financing railroads, specifically the Northern Pacific Railway that would link Duluth to Seattle. The line would be part of a transcontinental system that would carry goods from the Pacific Coast to the Great Lakes and then to Europe. Unfortunately, the project was plagued by mismanagement and construction challenges, and a growing funding gap made more challenging by the Credit Mobilier scandal.

In that case, the Union Pacific Railroad got caught using a shell company, Credit Mobilier, to inflate costs to maximize government subsidies for building the line. The revelation of this deception in 1872 damaged investor confidence in railroads and made Congress much less willing to support new railroad construction, including by the Northern Pacific.

Jay Cooke & Co. knew it was sinking at least a year before it suspended payments. “In the fall of 1872, the London partner Fahnestock observed that it was cruel to the depositors to use their money to support Northern Pacific bonds, and that the railroad should go to the market to borrow at any prices. The near panic in September 1872 made this impossible.” (Kindleburger in Crashes and Panics, p. 80)