Are We Repeating the Biggest Mistake of 1873?

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2:15Welcome to Merrin Dorks Money, the podcasting with people who know the markets, explain the markets. I'm Merit Homsett-Webb. This week, I'm speaking with Pulitzer Prize-winning author Leocard Arbant about his new book, 1873, The First Great Depression and the Making of the Modern World. It's a great read. You can take it to the beach. I promise you you'll like it just as much as all the romances you were planning to read there. It covers the 1873 crash, which is particularly interesting because it was the first global crash across bond markets and stock markets. It also had an extraordinary amount of fallout, some of which you could argue is still with us today.

2:51In our conversation, we reflect on the parallels between then and now and the lessons that we can take from those early crashes. I loved this book. Do you know why I loved this book? Oh, thank you. It's basically property porn, right? You know, I did an event in Newport, Rhode Island, and they wanted to compare the Vanderbilt mansions with Rothschild's mansions. And basically the Rothschild's mansions beat them down. I mean, this is the best bit about it. I start off when I'm looking at money supply and gold droughts and market crashes, valuations, railways, capex, comparing capex numbers. But actually, I'm frantically turning the pages so I can find out about the next guy's great house.

3:42You know, what happens, you know, Jim Fisk and Jay Gould, they put an opera house. What was their actual house like? So that's really what I enjoy most about the book. Right, yeah. But I know that's not the point. So why don't we, why don't we now? Well, no, it is hardly the point because I think livens it up. Absolutely. A lot of it reads like fiction. You know, it reads like a great novel. It gallops along as you move from grand party to grand party. And also, I'll tell you what is missing. I'll tell you what is missing. I'd like more pictures. I want to see the dresses at the exhibition with all the mud.

4:19And I want to see what everyone's wearing when 3 ,000 people go to the ball for the opening of the Suez Canal. And what the emperor's daughter is wearing when she gets married in Vienna as the stock market crashes. Right. Okay. That's actually great advice. I will push that. All right. Brilliant. Thank you. So that's all to look forward to. So most of you should immediately go out and buy the hard copy of this wonderful book. And the clue of what it's about is in the title, 1873. But if you want pictures of people in ball gowns, wait for the paperback. Is that fair? Yeah, that's... Brilliant. I can't promise.

4:58Can't promise. So let's talk about what this is actually about. But 1873, it's called 1873, the first Great Depression and the making of the modern world. I mean, it is fascinating because you make the case in the book that pretty much everything that happened in the following hundred years came from this one crash, this first global crash. So what I would like to do, if you don't mind, is to start with a run up to how we got to 1873. In fact, not as far as 1873. It's kind of up to 1870 before it turns into a speculative boom, isn't it? Up until then, it's really, really strong economic growth, globalization, lots of really fantastic things happening, amazing revolutions in transportation, in communication, the railway boom.

5:46So many exciting things happened. And of course, back to how amazingly you write and you bring out all these wonderful little things. We're talking about the railways. We're talking about the Suez Canal. And then you remind us that this is where Jules Wayne got the idea for Around the World in 80 Days. Right, exactly. Where did we get to the point where we were having 8 % to 10 % GDP growth across the world? What started it was the gold rush. Because Europe, which was the center of the world, went through a terrible depression in the 1840s, fueled by bad harvests and by revolution. I mean, they actually thought every government in Europe was going to fall, and we'd have the equivalent of the Russian Revolution across Europe.

6:31And that didn't happen. But at the same time, they discovered gold in the United States. And that provided the fuel to get the global economy going. And you had bankers like the Rothschild, who had made a ton of money in the early part of the 19th century lending to governments, who jumped on the bandwagon and started lending for infrastructure, and particularly the railroads, but to the private sector. And you got a massive boom in lending. And it was a boom based on the bond market. Now, everyone thinks the bond market is a sleepy place where who don't want to take risks put their money. But it was essentially that which provided the impetus to the growth.

7:30So the bond market grew by five times in the two decades from 1850 to 1870. And all of it went into big projects like the railroads, like the Suez Canal, like the Trans-Cross-India Rail Link, which set the scene for that wonderful article which a French newspaper wrote in 1870 saying, Now you can go across the world in 80 days. And Jules Verne, who was a young adventure novelist based in France, stumbled across this article because the article even gave an itinerary for what a journey like this would look like. So he didn't even think of any of this himself. Nicked it all out of a newspaper article.

8:26He probably didn't realize it would make a great movie as well. And that we'd still be having television shows based on it today. Fascinating. Right. And one of the interesting things about this great bond boom was that a lot of this was retail money. So this is one of the first times where suddenly we're gathering the savings of ordinary people across the world and shoveling it through middleman vehicles into huge infrastructure projects. I mean, that's a huge change. Right. And, of course, the basis of the investment trust industry in the UK, which we come back to another time, but fascinating.

8:56Yeah, not so much ordinary people, but upper middle class people. Sort of ordinary people. We were all high net worth individuals. The average man in the street wasn't buying bonds, which actually would prove to be part of the savior when the whole thing went south, because the people who lost money could actually afford to lose money. But yes, you're right. I mean, it was retail. It was not institutional. and the institutional came later, as you mentioned, with investment trusts. Okay. I mean, it wasn't seamless all the way through the early part of the 19th century. Of course, there were two other crashes, one in the 30s, one in the 50s, right?

9:40But they were sort of quickly dealt with or not really dealt with. They fixed themselves. Yeah. And they were, to some degree, more localized and they were less global. I mean, In the 1830s, the canal boom ended in the US, and that caused a whole lot of repercussions in the UK. Most of Europe wasn't involved, so it was primarily an Anglo-Saxon thing. There were many crashes during the 1860s. The first was when Jay Gould tried to corner the gold supply of the United States. I enjoyed that bit very much. Indeed, this is just after he bought the Opera House, right? Right. Yeah. And bribed the president's brother-in-law.

10:26Which is when it all came crashing down. That was his mistake, overreach. Right. And there was another crash in Britain when a discount house, the first one of the big discount houses went under. But they were all localized. And there were even wars. There was a civil war in the United States. There was the Crimean War. There was Prussia versus Austria. where the economy was surprisingly resilient despite these little hiccups. Yeah, and that's interesting. We'll come on to that about whether economies are incredibly resilient and maybe the best things to do is just leave them alone. Because when we get to 1873, of course, we find out that everyone decided to just not leave it alone.

11:11They succumbed, didn't they, to what we call something-must-be-done-ism. And that's when things started to get nasty. But the pivotal bit is this war between Prussia and France that starts 1970, right? And it's a short war. Yeah, 1870. Sorry, 1870. It's a short war, but it has enormous repercussions because France is obliged to pay enormous reparations to Germany to the tune of how much? Around a billion dollars. A billion dollars, which would be equivalent to$1.2,$1.3 trillion today. Yeah. And so Prussia thought that this is fine because that's so much money is going to take France forever to pay that off.

11:54So this is going to keep them down, down, down, out of our way. We've dealt with this enemy indefinitely. Instead of which, they somehow managed to go out and get the bond markets to give them a billion bucks over two years. And it was the Rothschilds who were the centerpiece of that because they had an incredible reach. They raised two bond issues, which raised a billion dollars. But the most important thing was they were, in one case, three times oversubscribed and the other case, 12 times oversubscribed. And where was that money coming from? Well, that was the astounding thing. People suddenly realize that there's all this money that's been in the woodwork and is just looking for a, if you can only provide it with a return, will come out of the woodwork.

12:47Because until then, government bond yields had gone down to 3 % in the UK, 4 % in France. The sort of revelation that you could raise$12 billion from the bond issue just got everyone so excited. The London Stock Exchange went crazy. Well, because everyone who didn't get into this bond issue, the money is still out there. Exactly. And also in the U.S., railroads were, it was a perfectly rational boom until then. And then suddenly railroad bond issuance doubled. So we suddenly went up to$500 million a year in an economy that's roughly 5 % of their GDP, which, you know, today would be$1.5 trillion in the U.S.

13:41So that$1.5 trillion that went into SpaceX is what went into the railroads. Yeah, fascinating. And then, of course, that billion dollars went to Germany in a two-year period. Yes. And they then had 25 % of GDP to play within cash. Right. And that was totally mismanaged. They could have fed it into the economy at a slower pace, but injecting 25 % of GDP in liquid cash into an economy that was relatively unsophisticated, where everyone who owned government bonds found their government bonds paid off, paid off meaning redeemed, suddenly sort of looked around and said, what do I do with this money?

14:35and was looking around for opportunities. And lo and behold, a whole lot of charlatans appeared on the scene to try to liberate them of their money. It was not only a stock market boom, but it was a giant IPO boom. And the stock market, which had maybe 30 or 40 companies listed, suddenly ballooned to 500, 600 companies. And these companies, a lot of them were banks, a lot of them were real estate, a lot of them were railroad companies. But they were also all sorts of things, you know, setting up companies to explore the northern regions of Europe. Companies to, you know, I don't know, look for banana plantations in West Africa.

15:29So it was a crazy time. And a lot of fraud in there. Is this around the same time? I might be getting my timing wrong, but around the same time as the diving bell bubble in the UK, where there were loads of small companies were set up to invest in diving bell technology to go and explore for shipwrecks. Oh, okay. And of course, the same thing, lots of kind of pointless shells and endless fraud. So in these last years, 1872, 73, we're moving into what Galbraith called the bezel bit, when there's lots of fraud and the fraudsters are still riding high and the investors haven't yet realized that it's a fraud.

16:04So it's a great time. It's a wonderful time. Everyone's happy. Everyone thinks they're richer, both the fraudsters and the people who've had their money embezzled. So yes, it is a great time. And then? Well, and then, like all great times, it comes to an end. The first sign is in Vienna, which was an ancillary of the German stock market. And that had gone up 300%. And suddenly, in the beginning of 1873, investors began to question whether all these new companies had a business plan. And for a while, the markets stayed up at the highs and didn't realize, a little bit like these roadrunner cartoons, that didn't realize the floor had been taken away from it.

17:01And then in May of 1873, crashes and bank stocks fell by 45 % in one day. And you had this surreal scene where the emperor's daughter was getting married and every major royal family from Europe had collected in Vienna. So the Prince of Wales and all of the major princes, the crown prince of Russia, and they were all having these magnificent balls and dancing to the music of johann strauss this is what we need pictures of well but meanwhile just down the road because the stock market was next to the palace the stock market was crashing you got the first wave of people committing suicide because they'd lost money although even those suicides were frauds because people had bought equities on margin and realized that the way to escape their creditors was to go to the canal, pile their clothes at the side of the canal, jump into the canal, swim to the other side, and disappear.

18:22That really is a fitting end to the bezel, isn't it? Yeah. And this was the same time. Did I read in the right order that the Vienna exhibition was at the same time? Yeah, and the exhibition was going on, and that proved to be a total failure. So they'd expected 19 million people to turn up. 19 million? Oh, these great exhibitions were giant affairs. I mean, they started out with the UK in the 1850s, but there'd been one in Paris and then another one in the UK. And this was Vienna's attempt to say, we're a serious country and we're a serious city. They'd expected 19 million. They'd torn down half the palace gardens and established pavilions, and only 7 million people turned up.

19:12So it was a series of minor disasters, a cholera outbreak, and the cab drivers of Vienna decided to go out on strike. Of course they did. Standard stuff. Nothing ever changes, does it? One of the little tidbits in this bit that I really enjoyed was a little bit you wrote about Karl Marx and the crash and how he was exactly the kind of person who predicts crashes all the time and he'd been at it for ages and was finally right. And he'd just become famous because he'd finally got some traction with Das Kapital because first edition, pretty much no one read it. And then he managed to get it printed in Russia and it kind of squeezed through the Tsarist censors because they figured it was so long, so boring and so complicated, no one ever read it.

19:55But they did. And suddenly he's quite famous, predicts the crash and now he's more famous. Yeah. And as you said, throughout the 1850s and 60s, he'd been saying, oh, this is it. A crash is coming. And I mean, it got to a stage where even his friends started pulling his leg, which he didn't react well to. I bet he didn't. And this is possibly the only area in which Marx and I have something in common. That you're always predicting crashes? Constantly predicting crashes. At the wrong time. Okay, so a crash starts in Vienna, but then because there has been a global boom and it has been a global bubble, it spreads.

20:39There is contagion across the world, right? Yes. And actually, you get this sort of false period of calm. So it crashes in Vienna, and everyone says there's going to be a global disaster, and then suddenly nothing happens. and you get a period of three, four months where nothing happens. So they said, okay, maybe Vienna was just overpriced and it was a local incident. And everywhere else the earnings will rise to match the price. It'll be fine. But meanwhile, Jay Cook, who is the premier investment banker, had raised$2 billion for the union government during the Civil War, suddenly finds that because of the disruptions in Europe, he's not able to raise capital.

21:28And he runs out of capital in the middle of constructing the second transcontinental railroad. And it was a little bit like the Lehman Brothers story. He started injecting his own bank's money into the project. He's not able to complete it. And when he announces that I cannot raise the capital, there is total panic, the sort of psychological panic that happened after Lehman. People said, look, if Jay Cook, who's a friend of the president's, is the most well-connected banker in the United States, can't raise$100 million, then what hope do we have? And every railroad stops construction. So there were 500 railroad companies in the United States.

22:20By the end of the year, a third of them had stopped paying dividends. By the end of five years, half of them had defaulted. Everything comes crashing down. Everything comes crashing down. And at the same time, everything's still going horribly in Europe. 70 % of the banks in Vienna have gone bust, etc. It's global carnage. Yes. Okay. So then we get to the bit where things start to go wrong in a monetary sense. And one of the things that I think you, when you look at all the books you write, this is just like a book I never do, is was there a big mistake? Was there a big mistake? Was there a pivotal point when everybody did something completely wrong?

23:00And this is the bit of that story. Yes. So in a crisis, everyone scrambles for a safe asset. And in those days, the two safe assets were gold and silver. But in 1873, Bismarck, having defeated France on the battlefield, decides to double down and try to destroy France financially. And he takes the billion dollars that he received from France and uses it to convert all the silver that he had in the central bank into gold. So silver prices plunge. That causes every bank in Europe to panic and dump their silver, which causes silver prices to go down even further. one of the two safe assets that everyone had relied on, which was silver, suddenly is plunging in price.

24:03So they all scrambled into gold. Now, if everyone in the world is scrambling into gold, what does it cause? It causes a giant shortage of liquidity. So the world might have been able to cope with a shift from a system based on both silver and gold into gold under normal circumstances. But trying to do it in the middle of a financial crisis just didn't work. So as a consequence, you got this tightening of credit. Wholesale prices in 1873 over the following year declined by 30%. The worst thing was they kept going because there was this shortage of gold and everyone wanted to get out of silver. And you've got a 20-year period where prices declined relentlessly for 20 years, ending up 40 % to 50 % below where they started.

25:09So long-term deflation until there were more gold finds and suddenly there's a higher supply of gold. Exactly. Central banks didn't really have discretion at the time. So the thing that determined what central banks could do was the amount of gold they could find. Ironically, when everyone moved to gold, there was a gold drought. And there were very few discoveries of gold from 1870 until 1890. Yeah, yeah. Fascinating. And the problem with deflation to a generation used to rising prices, it sounds pretty good if we could get falling prices, but it causes terrible problems for people who borrowed money.

25:59Yeah, if you owe money, you're in trouble. Yeah. If you have a mortgage, you suddenly discover that your house is worth less, but your mortgage just continues to weigh on you. And there's nothing that damages confidence more than having this overhang of debts that keeps on rising. And absolutely horrible for farmers and landowners, right? Because that has an effect on the price of land. And most farmers will have debt of some kind. So land prices fall a lot. You have a lot of trouble in that area. And then, of course, back to property porn. Then it leads directly into the trend in the UK for posh British landowners to marry rich American heiresses.

26:47Which, of course, brings us all the way up to Winston Churchill. Yeah, and to Downton Abbey. Exactly.

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28:36There's a lot of things I could pick up on here and a lot of things I'd like to talk about. And I do think that this deflationary impulse and the way that affects society is fascinating. But I think that what I'd like to do now, if you don't mind, is bring it back to where we are now. Because there's so much that you talk about in the book that resonates with where we are now. We talk about, for example, the equivalent of$500 billion in CapEx going into railways. We've surpassed that now with CapEx into data centers and AI, etc. But nonetheless, it's a similar dynamic. And certainly in stock markets in those early days before the speculative froth really kicked in, 72, 73, there was a perfectly reasonable justification for markets going up 50 % here, 40 % there, 30 % here, because everything's going so well and the earnings will rise and you can pay for your growth in advance and you'll get it later.

29:26And this all makes perfect sense, which of course resonates very well with where we are in markets today. Great. And I think that's what everyone has latched onto. I mean, they've latched onto the boom portion rather than what comes when the boom ends. Now, what caused the boom to end? I think two things. One is that everyone trying to build railroads at the same time, just they started competing against each other. And the profitability of the railroad started declining. So the equivalent today, if all of the hyperscalers start trying to build AI infrastructure and the price of tokens starts collapsing, which by the way, it is already started collapsing.

30:20It changes sort of the economics of their investment. So that started happening. At the same time, because of the disruptions in Europe because of the war, the price of the capital starts rising. And there's some signs that that's happening now. Until recently, we reassured ourselves that we could finance this boom from the profits of the giant technology companies. But that has even proved to be inadequate, and they're now going out and borrowing. So the combination of declining profitability and rising cost of capital at some point causes a crunch. In the US case, when Jay Cook announced that he couldn't complete is railroad, that would be the equivalent of, let's say, open AI declaring, actually, I think we've miscalculated and we are not going to be able to complete a whole model and we're going to have to sell to Microsoft.

31:36Can you imagine the panic that will occur in the market for AI infrastructure? Yes. Yes, it can. So, it would all be fascinating, everyone having to sell their houses and that kind of thing. We'd get to look at everyone else's houses and the brochures would be great. Right. It would be the silver lining anyway. Right, yeah. So, that's the relevance, I think, for today. As this all came to an end, the 1873 crash and the consequences, in the late 70s you talk about literally everyone setting up a committee because you know even in the 1800s people were super keen on committees and working groups etc everyone set up a committee to look at it and try and find the cause of what had happened and the US committee came up with 180 different reasons which I enjoyed a lot one of which was people drinking too much that was that came from the temperance movement.

32:37But the main cause was too much money. Yeah. The cause of the boom was too much money, and the cause of the crash was not enough money. The cause of the depression afterwards was not enough money. It is that simple. Yes, it is. But unfortunately, these booms and bust cycles are not simply driven by sort of getting the dials right in the central bank. They are driven by human psychology and that in the boom, you have too much money, but it's driven by over-optimism, which then causes bankers to lend too much, which then provides the fuel for a boom. And in a bust, it's not enough money as people suddenly hunker down, start hoarding, bankers cut their lending, and you get the whole thing going into reverse.

33:38Yeah. The one thing we haven't talked about, and I would love to very briefly, is the way that this changed things politically in that you get as a direct result of all of this, this sense of injustice, this sense of people being hard done by. And that led to a shift in politics in the US. The Democrats back on top, well, not quite on top, but better than they had previously. So it's a return to the kind of ideals of socialism and also the rise of anti-Semitism. Yeah. I mean, look, when you have a financial cataclysm, people look around for someone to blame. Think back upon 2008. The Obama administration probably did the right thing in trying to save the financial system, but they didn't bail out homeowners.

34:26homeowners, you got a wave of defaults on mortgages, and homeowners looked around and said, this system does not work. That if you're an insider and you're a banker, you get bailed out. If you're just an average person, you don't. And you get a wave of populism and a sense of the injustice of the system. And that's what you had in the 1870s. In some ways, you know, there was a catastrophic mistake after 1873 with going to gold and leaving something behind the end of bimetallism. And that caused this horrible depression, which again had winners and losers. So maybe we could look at it and we could say, well, the QE period globally was in some ways a catastrophic mistake in the same way, perhaps in its length and duration and wealth redistribution impact.

35:17And that gave us this sense of injustice and unfairness that people still have today. I think there's some truth to that, that the QE period led to rising asset prices. So if you were wealthy and you owned something, you did very well. And if you didn't own something, you felt aggrieved. So how this comes to an end, I haven't a clue. What do central bankers do? We've now got a period where you've got rising inflation. Do they tighten? If that causes a disruption in the equity market, does that spook them? There are all sorts of questions you can raise. I think the one thing that makes the current period really scary is the size of the equity market relative to the rest of the economy.

36:17The U.S. equity market, if you take public and private equities, you're talking about something that is 300 % of GDP. So GDP is$30 trillion in the U.S. Public and private equities are$90 trillion. A minor stumble in the equity market could cause massive disruptions in spending. Very, very dangerous. So, given that that risk is out there and the risks we've talked about in AI, should we just do what they did back then and just go hoard gold? Right. Or maybe silver as well. Hoard silver, you think? What are you hoarding?

37:12Fixed income. Are you? Yeah. Bonds are due for their turn. Okay. I'm going to stick with hoarding gold, I think. You're still? Okay. Bitcoin? Would you hoard Bitcoin? No. We've had a rolling sequence of speculative bubbles. We had NFTs or whatever they were called, then meme coins, then meme stocks. Then we had crypto, which has come crashing down. So you get this rolling effect of one speculative asset after another. So I think equities, it's the turn of equities to have their comeuppance. Have their comeuppance. And in that environment, we won't be worrying about inflation. We'll all be fleeing fixed income.

38:00Right. Yeah. Okay. Brilliant. Thank you so much. Can I ask you one final question? One final question. You're a great writer. As I say, I love this book in so many ways. But what are you reading? What are you going to take to the beach with you? I just finished Whistler by Ann Patchett. Whistler by Ann Patchett. Okay. Crime novel? It's a family saga of a woman meeting her stepfather accidentally from her stepfather from 30, 40 years ago. and the blossoming of a friendship between her ex-stepfather and her. And it's very touching. Is there a nice house? Not really. It's apartments in New York City.

38:51Oh, I like those too. Thank you so much for joining us today. This was great fun. Okay. Thanks.

39:05Thanks for listening to this week's Merrin Talks Money. If you like our show, rate, review and subscribe wherever you listen to your podcasts. And keep sending your questions or comments to merrinmoney at bloomberg.net. You can also follow me and John on Twitter or X. I'm at MerrinoseW and John is John underscore Stepek. This episode was hosted by me, Merrin Somerset-Webb. It was produced by Samasadi and Moses Ander. Special thanks, of course, to Leokhard Ahmed.

39:52We'll see you next time. Tom Keen for smart conversations that help you make better financial decisions. Subscribe to Bloomberg Money on Apple, Spotify, or wherever you listen.