The Nightmare before Christmas: Financial crises go global in 1857

Tobias Neumann.

A railway boom in America’s Midwest goes spectacularly bust.  Sixty-two of New York’s commercial banks close – out of sixty-three. Meanwhile in Britain, a decade gilt-edged by gold discoveries in Australia and fuelled by the Crimean War was beginning to lose its lustre.  Thus the scene was set for the first global financial crisis shaking markets in New York, London, Paris and across the world.  A crisis so severe it forced the Bank of England to “break the law” to survive.

Gold and iron

First California in 1849, then Australia in 1851: gold rushes. The precious metal unearthed in only a few years made the 16th century treasures brought to Spain by Cortés and Pizarro look like trinkets.  This mattered beyond the arts and interior design: gold was currency.

In the UK, the 1844 Bank Charter Act required the Bank of England to back its notes issue by gold, or up to a limit of £14m by government securities.  It also required the Bank to exchange gold for notes and vice versa at a fixed price removing all direct influence by the Bank over the money supply. This meant that the huge influx of gold resulted in a considerable monetary stimulus in the early 1850s and a booming economy (Hélène Rey describes a modern version of this where the global credit cycle plays the role of gold).

Though the gold rushes filled the Bank’s vaults in the early 1850s, the subsequent years were marked by a sustained drain on the Bank of England’s gold reserves, as shown in Chart 1.

The reason was that Britain had a considerable trade deficit: the country sent gold abroad to buy foreign goods faster than the Australian mines could replenish it.  To counteract this drain, the Bank of England would increase Bank Rate.  The higher rates achievable in Britain compared to abroad would bring in foreign capital and therefore gold.

Chart 1:  Bank of England gold reserves and Bank rate

Chart 1

Source: Bank of England Daily Accounts

From 1853 to 1856 Britain was at war with Russia in Crimea.  Though this provided a boost for war-related industries, it also created a strain on gold because the country needed to buy most of its raw material needed to wage war and the Russian market was cut off for exports.

Meanwhile, the United States were deploying gold and iron not to wage war but to build railways.  And build they did: between 1849 and 1857 America added 21,000 miles to its railway network (for comparison: Britain’s current railway network is about 10,000 miles long).  Who paid for that?  To a considerable degree foreigners: UK investments in American assets, for example, were £80m, highlighting how important international finance had become by the mid-19th century.

By 1857 the railway boom had turned feverish.  The lure of Kansas alone led to some expectation its population would increase by 70,000 people a year (this did transparently not happen: the population of the Sunflower State stood at 107,206 in 1860).

Why did Kansas disappoint?  The most plausible cause may be political, not economic: the US Supreme Court denied African Americans citizenship and ruled that the US government did not have the power to ban slavery in US territories.  The political uncertainty regarding slavery made the territories less attractive to immigrants from the populous North, dampening prospects for expansion.

The remainder of the US story follows a familiar playbook: asset prices fell, a major bank fails, panic ensues and contagion spreads. But for the first time in history, the crisis spread abroad.

Break the law or break the Bank

The gold outflow during the decade and the associated high interest rates created tight monetary conditions in Britain, which in turn left the economy in a fragile state.

Then it happened.  On October 13 all but one of New York’s banks suspended cash payments.  The Banque de France increased its discount rate to 6.5% that day. Discount rates had already risen in Amsterdam and Berlin.  On the 19th Bank Rate was raised to 8%, the highest since the crisis of 1847.  Meanwhile, the rut in America continued: all in all, 1,415 banks suspended payment in October alone.

At the same time, the Bank of England’s stock of liquid assets (the ‘banking reserve’) was dwindling.  Why did that matter?

In 1857 the Bank of England was still a private bank making loans and accepting deposits.  These deposits to a large extent came from private-sector banks.  In the absence of deposit insurance private banks needed to hold a sufficient reserve of liquid assets, mostly gold and Bank of England notes.  They didn’t keep those in their own vaults (vaults being expensive) but deposited them at the Bank of England.  Ultimately, all liquid asset reserves of the entire British banking system ended up in the Bank of England as deposits.  This was a peculiar arrangement.  In Walter Bagehot’s words:

The result is that we have placed the exclusive custody of our entire banking reserve in the hands of single board of directors […] who have no particular interest […] in keeping it undiminished – who have never been told […] to keep it undiminished – who […] would have a greater income if it was diminished – who […] need not fear ruin if it were all gone and wasted.

The result was that the Bank may not have held a socially optimal level of reserves.

On 27 October, Liverpool Borough Bank failed. The Bank’s reserve fell by 6% as private-sector banks withdrew their deposits (see Chart 2).  On 29 October the Deputy Governor of the Bank of England, Bonamy Dobree, wrote in his diary:

Mr David Barclay Chapman [of Overend Gurney] called to know whether they could rely on the Bank for unlimited assistance if pressed.

On the 30th:

Mr Barnett called […] to know if the Bank of England in case of necessity would make an advance to CB Co (Clydesdale Bank Co) […].

Messrs Chapman and Barnett got their money.  And so it continued: assistance here, advances there, all eating away at the precious reserve.  By Guy Fawkes Night the banking reserve had burned down to 65% of its October level.  The Bank raised the interest rate to a historic high of 9% but the bonfire continued.  A week later, having raised the interest rate to 10%, the situation was even bleaker.  The banking reserve stood at £581,000, having collapsed by nearly 90%.  The Bank and with it the British financial system were on the brink of bankruptcy.

On 12th November, the Bank of England received a letter from Prime Minister Palmerston and his Chancellor of the Exchequer:

Letter

Letter from the Prime Minister and Chancellor to the Governor, 12 November 1857
Source: Bank of England Archive G6/397

Chart 2:  Bank of England gold reserves and banking reserves (period of suspension of the 1844 Act highlighted)

Chart 2

Source: Bank of England Daily Accounts

As in 1847, the Government allowed the Bank to issue notes in excess of the limits imposed by the 1844 Act.  And this time the Bank did so..  On the 14th Bonamy Dobree came to the Bank unusually early at 8.30am (10.45am being his normal time).  His early arrival underscores the gravity of what he wrote in his diary:

Diary

Bonamy Dobree Diaries
Source: Bank of England Archive DS/UK/264

£475,000 of the bonds he instructed the Chief Cashier to issue were ‘illegal’; a day later another £1mn were added.  It worked, albeit slowly.

On the 17th, Dobree noted that “agents’ letters from Birmingham and Leeds report several failures & several more likely to take place” and “run in Ireland continues”.   Though there was a glimmer of hope on the 18th, as the “run in Ireland [was] diminishing”, the following days Mr Barnett, and several others, returned to ask for more money. Perhaps the most notable firm seeking, and receiving, assistance was George Peabody & Co, which would later become JP Morgan.  But by the end of November the situation had improved markedly.

Dobree

Bonamy Dobree: Deputy Governor from 1857 to 1859, Governor from 1859 to 1861

On 4 December the Government tabled the promised bill indemnifying the Bank for breaching the 1844 Act.  Disraeli, then on the opposition benches, summed up the cross-party support for the bill (though others, for example Karl Marx, were less forgiving in their commentary):

The distress is general. It is not confined to this country, … it prevails in the United States.… Its influence is felt in Germany, in Austria, in Prussia, in Denmark, [and] in Sweden. [T]he Directors of the Bank have acted in [a] magnanimous spirit; and if, at the suggestion of the Government, they have consented to take an illegal step, I think, … it would be cowardly and vindictive to throw any obstacle in the way of their indemnity.

The bill was passed on 11 December, and the crisis came to an end on 24 December in Britain, just in time for Christmas Day.  That day, the Bank removed the illegal notes from the economy and lowered Bank Rate to 8%. The nightmare was over.

As Bagehot wrote: “The panic of that year for the first time taught the Bank directors wisdom and converted them to sound principles”.  It needed the world’s first global financial crisis to do so; let us hope the recent crisis has had a similar lasting effect on policy makers.

Merry Christmas.

Tobias Neumann works in the Bank’s Prudential Policy Division.

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