Panic of 1825

In the panic of 1825, the expansionary monetary policy of the Bank of England fueled a stock market boom and tight money ended it. The Bank acted as lender of last resort, but too late to prevent massive bank failures from creating real economic distress.

Prelude
At the end of the Napoleonic wars in 1815, the Bank of England worked to restore specie convertibility at the pre-1797 suspension parity. After the successful resumption in 1821, 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). This 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.

Burst of the bubble
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". 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.

"We lent it," said Mr. Harman, on behalf of the Bank of England, "by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.' After a day or two of this treatment, the entire panic subsided, and the 'City' was quite calm."

On Dec. 24, 1824, the coin and bullion on the Bank was £10,721,000. On Dec. 25, 1825, it was reduced to £1,260,000.

The Bank was saved at the last minute from suspension of convertibility by gold flows from the Banque de France. The English crisis spread to Europe and also to Latin America, prompting a general default on its sovereign debt. A serious recession followed in early 1826. 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.

Links

 * The Feds Before the Fed by H.A. Scott Trask, March 2004