Banks and banking - History ; Banks and banking - Great Britain ; Great Britain ; Financial crises - Great Britain

Michael D. Bordo

English

Research Papers in Economics

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Commentary
Michael D. Bordo
E
ngland’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 valu-
able 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 follow-
ing the deﬂationary policies required to
restore specie convertibility at the pre-1797
suspension parity, leading to successful
resumption in 1821.  Following resump-
tion, 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 Ameri-
can) propelled a stock market boom.  The
Bank of England’s easy monetary policy
fueled the stock market boom and econo-
mic expansion.  The Bank was also ﬂush
with high gold reserves amassed in the drive
to resumption.  These aided the British gov-
ernment 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 Bri-
tish monetary base.  The country banks
then freely issued notes to ﬁnance both
economic activity and stock market specu-
lation.  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 Exche-
quer 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 Decem-
ber.  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 converti-
bility by gold ﬂows from France.  However,
although the Bank’s discount policies were
very liberal, it acted too late to prevent mas-
sive bank failures, contraction of loans, and
a serious recession in early 1826.  The Eng-
lish 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 fuel-
ing 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
Michael D. Bordo is a professor of economics at Rutgers University and a research associate at the National Bureau of Economic Research.FEDERAL  RESERVE  BANK  OF  ST. LOUIS
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MAY/JUNE  1998
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 con-
vincing, but parts of his story are not clear.
Neal views the deﬂation of 1815-20 as unne-
cessary.  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.
Also, it is not clear from Neal’s narrative
exactly what triggered the crash.  Neal’s ren-
dition of the story is similar to the Minsky
(1977) and Kindleberger (1978) version or
the Diamond and Dybvig (1983) view,
which asserts that no identiﬁable trigger
exists, and the crash may have been a ran-
dom event such as a sunspot.  It is also 
not clear why Neal devotes several pages
to co-integration tests on the yields of the
three funds traded on the London market.
Does the break in co-integration shown
between consols, East Indian, and Bank of
England stock tell us that the environment
for private sector enterprises has become
more risky?  Finally, his emphasis on the
legislation that followed the crisis may be
only a sideshow.  I believe 1825 was just a
preview for a number of other crises to
occur in the next 40 years.
NEAL’S LIST OF “USUAL
SUSPECTS”   
Neal discusses at great length the list
of “usual suspects” as possible causes of
the crisis: Latin American debt issues,
country banknote issues, and the Bank of
England.  He dismisses the ﬁrst two as
causal factors and attaches more weight to
the third factor.  
Speculation in Latin American debt
cannot explain the collapse of the stock
market bubble because, Neal argues, “the
sums risked were relatively small and the
risks generally appreciated even by an
inexperienced British public.”  Neal bases
this conclusion on the experience of the
Rothchilds and the Barings.  However, if
these key players were not unduly exposed,
surely others were because they bought the
stock on the expectation of further appreci-
ation and had less accurate information
than did the Barings and Rothchilds.  The
highly speculative Latin mining stocks and
sovereign bonds made up a very signiﬁcant
fraction of the shares issued.
The country banks also could not be
blamed, Neal argues.  Data from two failed
banks show that note holders were willing
to hold onto their notes for long periods
and were eventually largely compensated
for their losses.  These facts suggest that
country banks were victims of circum-
stances and not contributors to the crisis.
I agree with Neal when he proposes that
the country banks could not have issued
their notes in a vacuum, and that the key
determinant of the growth of their liabili-
ties was rapid expansion of the monetary
base.  But the country banks were surely 
an exacerbating factor because of their
inherent weak structure, which in turn was
related to the regulations that governed
their operations.  The prohibition on joint
stock banking outside of London, the
limit of six on the number of bank part-
ners, and their unit banking character
constrained the size of country banks.
Also, their ability to diversify risk made
country banks prone to easy failure in 
the face of big shocks.
Neal is correct that the Bank of Eng-
land is the main culprit.  Expansionary
monetary policy fueled the boom, tight
money ended it, and the Bank acted as
lender of last resort too late to prevent
massive bank failures from creating real
economic distress.
The value added of this paper is not so
much the retelling of the sordid (thrilling)
tale but the author’s emphasis on the role
of information at every stage of the cycle.
The lending boom in the upswing was rife
with poor information, adverse selection,
and careless surveillance, as is the case
today in Latin America and Southeast Asia.
More information on why some country
banks were sound and others were not
would be of value, as would informationFEDERAL  RESERVE  BANK  OF  ST. LOUIS
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on the role of the Bank of England in sur-
veillance and supervision.
TWO RELATED THEMES
I conclude my comments by focusing
on two themes that underlie the paper but
that Neal does not analyze: the macroeco-
nomic background and generality of the
crisis, and the lessons for the lender-of-
last-resort function.
The Macroeconomic Background
The 1825 crisis is of more than anti-
quarian interest because it was a global
event, and because it contained many ele-
ments of the crises that occurred during
the subsequent century.
The crisis contained three unifying forces
that occurred in most of the historic crises:
(1) monetary shocks; (2) price-level varia-
bility and ﬁnancial distress; (3) real shocks.
Money.  Expansionary monetary policy
fueled the boom and created the 1825 crash,
as shown in Figure 1.  As Neal argues, the
Bank followed a liberal policy to accommo-
date the government’s ﬁscal demands.  The
expansion in the monetary base (notes
shown  in Figure 1 and deposits in the Bank
shown in Figure 2) created the conditions
that allowed country banks to expand their
note issues.
At the same time, expansionary mone-
tary policy in the gold standard environ-
ment was creating the seeds of its own
reversal, as rising domestic prices (Figure 3)
led to a trade deﬁcit (Figure 4); an external
drain of specie, as manifest in a decline in
the Bank’s bullion reserves (Figure 5); and a
decline in the price of Paris Bills on London
(Figure 6).  The Bank began tightening early
in 1825 (Figure 1), and the stock market
(including mining stocks) peaked in January
(Figure 7).  All other stocks peaked in April.
Price-Level Variability and Financial
Distress.  Price-level instability is closely
related to banking instability.  According to
one hypothesis (Schwartz 1988), rising
prices may contribute to banking instability
by increasing misperceptions about current
and prospective real returns and possibly by
creating an environment in which misman-
agement and fraud are more likely to persist.
Unexpected disinﬂation promotes ﬁnancial
instability by adversely affecting ﬁnancial
intermediaries’ balance sheets.  As a result of
unanticipated disinﬂation, the real value of
nominal debt rises and, without complete
contracts, can lead to an increase in bank-
ruptcy and banking distress.  Figure 8 shows
the U.K. annual inﬂation rate from 1821 
to 1991.  As can be seen by the arrows 
in Figure 8, virtually all banking panics
occurred at inﬂection points of the inﬂation
rate.  The ﬁrst arrow points to the crisis of
1825.  The panics ceased after 1866 when
the Bank of England learned to act as a
proper lender of last resort.
Figure 2
M
i
l
l
i
o
n
s
 
o
f
 
p
o
u
n
d
s
Quarterly
12
11
10
9
8
7
6
5
4
3
2
1
Government
Total
Private
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 146.
Deposits in the Bank of England
1822  1823  1824  1825  1826  1827
Figure 1
M
i
l
l
i
o
n
s
 
o
f
 
p
o
u
n
d
s
Monthly
26
24
22
20
18
16
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 135.
Bank of England Notes in Circulation
1822 1823 1824 1825 1826FEDERAL  RESERVE  BANK  OF  ST. LOUIS
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MAY/JUNE  1998
Real Shocks.  The background to the
crisis of 1825 was not strictly monetary,
however.  Big real shocks or displacements,
as Irving Fisher (1932) termed them, also
occurred.  These shocks included the mas-
sive investment in infrastructure, consolida-
tion of the industrial revolution in England
after the upheavals of the Napoleonic wars,
opening up of trade, and foreign investment
(ﬁrst with the continent of Europe and then
with the newly emerging countries of Latin
America).  Gayer, Rostow, and Schwartz
(1953, Chapter IV) describe some of the
details of the investment boom.  These
investments in turn required ﬁnance and
monetary accommodation.
The Role of the Bank of England 
as Lender of Last Resort 
The Bank of England in 1825 was a
public bank, not a central bank.  The Bank
had three loyalties: its shareholders, the
British government, and its correspondent
commercial bankers.  In the ﬁrst half of
the nineteenth century, the Bank of Eng-
land was learning to balance these three
roles.  During the suspension period, the
Bank made considerable proﬁts from its
issue of inconvertible banknotes.  With
resumption, proﬁts declined; hence there
was less incentive to discount freely on
unproﬁtable paper.  Indeed, the Bank had
not yet adopted Bagehot’s (1873) “Respon-
sibility Doctrine” of acting in the public
interest ﬁrst to allay a banking panic or to
prevent a stock market crash from spilling
over into the monetary system.  Henry
Thornton basically laid down all the stric-
tures for proper lender-of-last-resort action
in 1802 (Humphrey 1989), but the Bank of
England did not really “get it” until after
the Overend Gurney crisis of 1866
(Schwartz 1986).  Also, by following easy
money to aid the government in its debt ser-
vice and loan conversions, the Bank had not
yet established the independence needed to
follow a stable monetary policy.
Thus, 1825 was just one of a series of
crises—1837, 1847, 1857, and 1866—in
which the Bank of England did not act prop-
erly as a lender of last resort.  As Neal tells it,
Figure 3
I
n
d
e
x
 
1
8
2
1
-
2
5
 
=
 
1
0
0
Domestic commodities, monthly
120
115
110
105
100
95
90
85
80
75
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 40.
Wholesale Price Index
1822  1823  1824  1825  1826
Figure 4
M
i
l
l
i
o
n
s
 
o
f
 
p
o
u
n
d
s
Annual
20
10
0
-10
-20
-30
-40
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 114.
The Trade Balance
1816  1818  1820  1822  1824  1826  1828  1830
Figure 5
M
i
l
l
i
o
n
s
 
o
f
 
p
o
u
n
d
s
Monthly
16
14
12
10
8
6
4
2
0
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 154.
Bullion in the Bank of England
1822 1823 1824 1825 1826FEDERAL  RESERVE  BANK  OF  ST. LOUIS
81
the Bank’s reluctance to lend early in 1825—
when signs of stress were looming, mer-
chants in the Latin American trade were
failing, and the Bank raised the discount 
rate and cut back on advances later in the
summer—likely exacerbated the crisis.
Therefore, when the Bank ﬁnally did act in
December, it was much too late to prevent a
large number of banks from failing.  True,
the Bank did not have to suspend specie pay-
ments.  Gold from the Banque de France
saved the Bank of England.  But had the
Bank of England lent earlier and prevented
the bank failures, it would also have pre-
vented a serious recession.  The Bank
would likely have received permission
from the government to temporarily
suspend payments.  The Bank Act of 1844
later institutionalized the practice of the
Bank’s requesting a letter from the Treasury
granting permission to suspend payments,
which the Bank did in later crises, e.g., 1847
(Dornbusch and Frenkel 1984).  The les-
son that central banks have learned since
Bagehot (1873) is to lend freely, in a timely
manner, and on the basis of any acceptable
collateral, but to lend at a penalty rate.  The
Bank apparently followed the penalty rate
part of the rule (seen in a rise from 4 percent
to 5 percent in December 1825) but did not
lend freely nor in a timely manner. Today,
most central banks have learned Bagehot’s
rule, and they do not make the mistake the
Bank of England made in 1825 (e.g., the
Federal Reserve’s response to the 1987 stock
market crash).  The problem today is that
many central banks have learned the lesson
too well and now follow the “too big to fail”
doctrine, which leads to new problems
under the rubric of moral hazard.  For
emerging countries today, however, the 1825
crisis still has resonance.  The problems of
adverse selection during lending booms echo
the story Neal tells.  Structural problems in
the banking system, poor oversight and reg-
ulation (papered over by rising prices), and
proﬁts taken during the boom are revealed
when the crash occurs.
MAY/JUNE  1998
Figure 6
F
r
a
n
c
s
 
p
e
r
 
p
o
u
n
d
Monthly
26.2
26
25.8
25.6
25.4
25.2
25
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 194.
Price of Paris Bills on London
1822  1823  1824  1825  1826
Figure 7
J
u
n
e
 
1
8
4
0
 
=
 
1
0
0
Monthly
440
380
320
260
200
140
80
SOURCE:  Gayer, Rostow, and Schwartz (1953), Table 9.
Total Index of Share Prices
1822  1823  1824  1825  1826
Figure 8
Percent
20
15
10
5
0
-5
-10
SOURCES:  For 1821-79: Mitchell (1962); for 1880-1990: National Bureau of Economic Research.
Annual.  Five-year-centered moving average of year-to-year change in log price index.
U.K. Inflation Rate
1821 31 41 51 61 71 81 91 1901 11 21 31 41 51 61 71 81 1991REFERENCES
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The financial crisis of 1825 and the restructuring of the British financial system - commentary

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