Morgan, Donald

Narron, James

Yale University

Yale University EliScholar – A Digital Platform for Scholarly Publishing at Yale YPFS Documents (Series 1) Browse by Media Type 4-10-2015 Crisis Chronicles: The Panic of 1825 and the Most Fantastic Financial Swindle of All Time James Narron Donald Morgan Follow this and additional works at: https://elischolar.library.yale.edu/ypfs-documents Recommended Citation Narron, James and Morgan, Donald, "Crisis Chronicles: The Panic of 1825 and the Most Fantastic Financial Swindle of All Time" (2015). YPFS Documents (Series 1). 12731. https://elischolar.library.yale.edu/ypfs-documents/12731 This Document is brought to you for free and open access by the Browse by Media Type at EliScholar – A Digital Platform for Scholarly Publishing at Yale. It has been accepted for inclusion in YPFS Documents (Series 1) by an authorized administrator of EliScholar – A Digital Platform for Scholarly Publishing at Yale. For more information, please contact elischolar@yale.edu. Liberty Street EconomicsAPRIL 10, 2015Crisis Chronicles: The Panic of 1825 and the Most FantasticFinancial Swindle of All TimeDonald P. Morgan and James NarronCentered in London, the banking panic of 1825 has been called the first modern financial crisis, the firstLatin American crisis, and the first emerging market crisis. And while the panic displayed many of thekey elements of past crises we have covered—fluctuations in money growth, an investment bubble, astock market crash, and bank runs—this crisis had its own twists, including a Bank of England thathesitated before stepping in as lender of last resort. But it is perhaps best known for an infamous bondmarket swindle surrounding an entirely made-up Central American principality. In this edition of CrisisChronicles, we explore the Panic of 1825 and visit the mythical nation of Poyais.The BoomWith the end of the Napoleonic Wars in 1815, the Bank of England embarked on a tight monetary policyto resume specie convertibility at the pre-1797 parity (Neal 1998, Bordo 1998). The resulting deflation,apparently unanticipated, had its usual pernicious effect of increasing real debt burdens, but itnevertheless led to successful resumption of convertibility in May 1821. At that point, monetary policystarted to become more expansionary. In Neal’s telling, liquidity was flowing from three sources. First,the Treasury was conducting a version of market operations by issuing Exchequer bills to the Bank, thenusing credits at the Bank to retire high-interest long-term bonds held by the public. Second, the Bank,with plentiful gold reserves accumulated in the drive to convertibility, was running traditional open[]market operations by buying up war bonds from the public in exchange for cash. Lastly, with themonetary base increasing, country banks—small banks located outside of London—were issuing notes inthe hinterland to finance investment in infrastructure, such as gas lighting, canals, and railroads, as wellas stock market speculation (Bordo).The Latin American/Emerging Market ConnectionAs Spain lost control of its South American interests, several independent nations emerged, includingChile, Colombia, Argentina, Peru, Mexico, and Guatemala. These fledging nations were eager to developinfrastructure, as well as exploit their mineral resources, and their needs created a huge demand forfunds and technical expertise from the financial centers in Europe, particularly London, which hadreplaced Amsterdam as the financial capital of Europe. The sovereign bonds issued by these emergingnations, despite the nations’ lack of the tax structure needed to repay the debt, were all the rage in theearly 1820s. English mining firms entered the fray as well by forming joint stock companies devoted todeveloping South American mineral interests. The share price of one such company, Anglo Mexican, rosefrom £33 to £158 in a single month (The Economist).The underwriting of these emerging market securities was not always rigorous. Neal blames this oninvestors’ “reach for yield” after returns on safe British Consols declined substantially following the endof the war, and on the inherent difficulty of assessing risk at such long distances. Even with favorablewinds, a round trip from South America to London took six months, so new information was both slowand scarce.“New Securities Promiscuously Floated . . .” (Gayer, Rostow, and Schwartz 1953)As happens, the lax underwriting, poor information, andgeneral speculative fever invited fraud. The starkest examplewas Gregor MacGregor, a Scottish adventurer who had foughtfor Venezuela in its war of independence against Spain. Uponhis return to England, MacGregor toured the wealthiestdrawing rooms of London touting the vast resources, civilservice, and army of the entirely fictional Central Americanprincipality of Poyais (see map above). So convincing wasMacGregor that he was able to float a large bond issue on theLondon Stock Exchange in 1822. As evidence of theinformation gaps during the bubble, Neal notes that mythicalPoyais was able to borrow at yields barely higher than thosecharged real countries like Peru, Chile, and Colombia.The Bust and a Central Bank MisstepUnlike the Crisis of 1816, the London stock and bond market crash in April 1825 that brought on thepanic does not seem traceable to a single exogenous shock, such as a crop failure. Even in theirexhaustive, two-volume The Growth and Fluctuation of the British Economy 1790-1850, Gayer, Rostow,and Schwartz (1953, p. 171), merely state that “In the spring of 1825, a turning point came . . .” withoutsaying exactly what turned. Bordo notes that, in March, the Bank sold a considerable sum of Exchequerbills, which contracted the monetary base and may have contributed to the crash. Or perhaps, hesuggests, it was a sunspot. Whatever the precise trigger, the crash caused “commercial failures” (Bordo)and a “drop in collateral values” (Neal) that slowed activity over the ensuing months. By summer of thatyear, the price of Latin American bonds had fallen by half. Banks were highly exposed to such debt, sotheir nervous depositors began to withdraw. By December, there were outright runs, and as the panicspilled into 1826, fully 10 percent of the banks in Wales and England failed (The Economist). As themoney and credit supply contracted, bankruptcies and unemployment soared while production slumped.The crisis was aggravated by the Bank of England’s initial failure to act as lender of last resort. To ensurethat it would not have to suspend convertibility or risk profits, the Bank actually raised the discount ratein December 1825, in the midst of a bank run! Only after some large London banks failed, includingHenry Thornton’s, did the Bank finally begin increasing its advances to struggling City and countrybanks.Bagehot (1891) later chastised the Bank for initially “acting as unwisely as it is possible to act,” and usedits initial misstep as a case for what a lender of last resort should not do. However, he approvinglyquoted the statement by Jeremiah Harman, the Bank of England Director during the crisis, about theBank’s eventual decision to step up:We lent . . . by every means possible and in modes we had never adopted before; we tookstock on security, purchased Exchequer bills, we made advances on Exchequer bills, we notonly discounted outright, but we made advances on deposits of bills of exchange to animmense amount, in short, by every possible means consistent with the safety of the bank . . .Modern Parallels?It seems that the Bank eventually threw everything it had at the Panic of 1825. Does that sound familiar?The Term Auction Facility, the Commercial Paper Funding Facility, the Money Market Investor FundingFacility, and the Term Asset-Backed Securities Loan Facility are just a few of the liquidity programs thatthe Federal Reserve used to stem the Panic of 2008.This 2009 blog post draws some parallels between 1825 and 2008 based on the informationasymmetries that plagued the securities markets in both cases—bonds issued by far-off, fledging nationsin the former case and exotic asset-backed securities in the latter. Are there other parallels between thepanics of 1825 and 2008?  Let us know what you think.DisclaimerThe views expressed in this post are those of the authors and do not necessarily reflect the position of theFederal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are theresponsibility of the authors.Donald P. Morgan is an assistant vice president in the Federal Reserve Bank of New York’s Research andStatistics Group.James Narron is a senior vice president in the Federal Reserve Bank of San Francisco’s Cash ProductOffice.The comments to this entry are closed.

Crisis Chronicles: The Panic of 1825 and the Most Fantastic Financial Swindle of All Time

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Crisis Chronicles: The Panic of 1825 and the Most Fantastic Financial Swindle of All Time

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