Commentary

By Snowden, Kenneth A. | Federal Reserve Bank of St. Louis Review, May-June 1998 | Go to article overview

Commentary


Snowden, Kenneth A., Federal Reserve Bank of St. Louis Review


England's stock market crash and banking panic of 1825 provide a fascinating story that is considerably relevant to today's policy issues. The story has resonance for three reasons: (1) The crisis was probably the first example of an emerging market-induced financial crisis. (2) It offers an early lesson on the importance of timely lender-of-last-resort intervention by the monetary authorities. (3) It provides valuable insights on the role of information in credit markets, as Larry Neal emphasizes in his paper.

WHAT HAPPENED IN 1815?

At the end of the Napoleonic wars in 1815, the Bank of England began following the deflationary policies required to restore specie convertibility at the pre-1797 suspension parity, leading to successful resumption in 1821. Following resumption, the British economy began a period of rapid expansion, characterized by both an export boom and an investment boom. The opening up of the newly independent states of Latin America stimulated a boom in exports. At the same time, important infrastructure projects (e.g., gas lighting, canals, and railroads) stimulated investment expenditures. The sale of stocks to finance these ventures, in addition to gold and silver mines (some real, some fictitious) in Latin America, and sovereign government debt (initially European and later Latin American) propelled a stock market boom. The Bank of England's easy monetary policy fueled the stock market boom and economic expansion. The Bank was also flush with high gold reserves amassed in the drive to resumption. These aided the British government in servicing and converting some of its debt to lower yield issues. The increase in the Bank of England notes and deposits in turn served to increase the British monetary base. The country banks then freely issued notes to finance both economic activity and stock market speculation. The stock market boom became a bubble as investors bid up the prices of real and imaginary stocks (e.g., bonds from the imaginary South American Republic of Poyais). Asymmetric information led to adverse selection, and legitimate firms found it more difficult to obtain finance, except at premium rates. Banks infected with the euphoria let down their guard and made risky loans.

As always happens, the bubble burst. It is unclear what caused the April 1825 collapse, but the Bank of England had in March sold a very large block of Exchequer bills, presumably to "contract the circulation" (Clapham 1945). The Bank in succeeding months continued to follow a cautious policy. The collapse of stock prices triggered commercial failures. By autumn (a season of normal financial stress), a number of country banks also failed. When several important London banks failed (e.g., Henry Thornton's bank), a full-fledged panic ensued in early December. The Bank of England then reversed its discount policy and began acting as a lender of last resort. The Bank was saved at the last minute from suspension of convertibility by gold flows from France. However, although the Bank's discount policies were very liberal, it acted too late to prevent massive bank failures, contraction of loans, and a serious recession in early 1826. The English crisis then spread to Europe and also to Latin America, prompting a general default on its sovereign debt.

In the aftermath of the crisis, blame was placed on the country banks for fueling the stock market boom and on the Bank of England for not policing them. Neal views several institutional changes that began in 1826 (e.g., creating branches for the Bank of England, permitting joint stock banks of issue beyond a 65-mile radius of London, and prohibiting small-denomination country banknotes) as setting the stage for a new financial order in the nineteenth century.

Neal's presentation of the tale, which differs somewhat from my rendition, is convincing, but parts of his story are not clear. Neal views the deflation of 1815-20 as unnecessary. To back up this view, he would need to make the type of purchasing power parity calculations that Officer (1981) did for the United States after the Civil War. …

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