Wednesday, August 15, 2012

How an Act of Congress Killed the US Gold Market

A view inside the New York Gold Room from Harper's Weekly, October 1869.
 Thanks to our friends at Bloomberg Echoes for  first running this post last week on August 2, 2012.

When President Abraham Lincoln acted in December 1861 to suspend the national gold standard -- the legal right to convert paper money into gold coin or “specie” -- he wasn’t trying to start a fight with financial speculators in New York.

Lincoln had a bigger headache at that moment: trying to finance his rapidly growing Union Army in its fight against the South.

Within three years, though, Lincoln’s decision would bring a defining moment that would shape the federal government’s relationship with Wall Street. It came in June 1864 when Congress passed the Gold Act -- the single time in U.S. history that Congress used its power to directly close a major financial market in the middle of active trading. It was such a failure that Congress never tried again.

The Gold Act was Washington’s response to a case of extreme profiteering during one of the bloodiest periods of the Civil War. After Lincoln had suspended the gold standard in 1861, he immediately asked Congress to float about $450 million in paper currency for the government to pay its bills. These steps created a temporary dual-currency system: paper “greenbacks” as legal tender for domestic debts, and gold coin as the currency of the world, needed for foreign trade, tariffs and custom duties.

Confederate Victories

Without government backing, the value of paper floated freely against gold. Within a few weeks, there was a brisk market on Wall Street for trading between gold and dollars. Each Confederate military victory sent gold prices soaring.

Speculators, stock traders, rebel and Union sympathizers, and government officials soon dominated the market, far outnumbering the bankers, exporters, importers and other commercial gold users. Daily price fluctuations affected the national war effort because rising gold prices directly eroded the value of the federal Treasury.

A Philadelphia banker, Jay Cooke, called the New York gold traders “General Lee’s left flank.” The New York Stock Exchange agreed; it considered gold trading disloyal and refused to allow it under its roof. This forced gold speculators to form a separate Gold Exchange on nearby William Street.

Gold prices spiked in June 1864 to $200 in paper -- a 50 percent devaluation of the nation’s paper currency. That spring marked the culmination of General Ulysses Grant’s “Wilderness campaign,” a particularly bloody set of encounters as the Army of the Potomac pursued Confederate General Robert E. Lee across Virginia toward the Confederate capital of Richmond. Casualties on both sides were enormous, about 40,000 killed and wounded for the Union and another 70,000 for the Confederacy.

Gold prices peaked just as Grant’s army reached Petersburg, Virginia, to begin a desperate seven-month siege. The spectacle of New York financiers profiting from this carnage particularly outraged the public, and Congress decided it had to act.

The result was the Gold Act, passed with little debate on June 17, 1864. It was designed to close the Gold Exchange immediately and thereby end the speculative bubble in prices. To the surprise of senators and Treasury officials, however, it did nothing of the kind.

In fact, closing the Gold Exchange only made matters worse, by encouraging hoarders and fueling a panic. Kinahan Cornwallis, a British-born writer working in New York during the war as a reporter for the New York Herald, described how “the real holders of gold were thus isolated,… and purchasers had to run from office to office, inquiring the price at which holders were willing to sell … The whole country was alarmed by the rocket- like ascent of the [gold] premium, including Congress, amazed and rebuked by the advance.” Finally, he wrote, “Leading merchants and bankers, who had urged upon Congress this prohibitory legislation, now wrote and telegraphed to Washington, imploring the repeal of the Gold bill.”

Price Spikes

Gold prices would touch almost $300 before Congress would finally reverse course, repeal the Gold Act, and reopen the Exchange on July 2 -- barely two weeks after the law was passed. Even after the Gold Room reopened, chaos continued with further corners and price spikes. Only the capture of Atlanta by General William T. Sherman in August 1864 finally broke the bull market in gold. By the time Lee surrendered to Grant at Appomattox Courthouse on April 9, 1865, the gold price was $144, less than half its wartime high.

In the 148 years since the Gold Act, Congress has developed extensive systems to regulate Wall Street --including the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Reserve, and the latest additions under the Dodd-Frank law, the Consumer Financial Protection Bureau and Financial Stability Oversight Council -- but never again has it shut an actively trading market. Closing a market can turn excitement into fear and transform a bubble into a panic.

The Gold Act episode taught a simple lesson. In a crisis, politicians and financial regulators should follow the same rule as physicians: First, do no harm.

For Kinehan Cornwallis's full story of the of the 1864 Gold Act episode, see the new reissue of his classic account -- The NEW YORK GOLD ROOM: Wall Street's Big Gamble on the Civil War.

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