History lesson: The birth of central banking as we know it

The Week‘s Brad DeLong provided an interesting history lesson on the first use of interventionist government policy in the interests of national financial stability.

The Panic of 1825

Writing in December 1825 to her friend Hannah More, [Marianne Thornton] said: “There is just now a great pressure in the mercantile world, in the consequence of the breaking of so many of these scheming stock company bubbles.”

Sound familiar? These were not bubbles in high-tech stocks or in mortgage lending and house prices, however, but bubbles in shipping lines, canals, and textile-spinning factories.

And, of course, the bank of which young Henry Thornton had been a partner for only four months had gotten itself badly undercapitalized. The managing partner “had been inexcusably imprudent in not keeping more cash in the House, but relying on [the bank’s] credit . . . which would enable them to borrow whenever they pleased.”

Except, of course, that in 1825 just as in 2009, no bank can borrow cash on the one day it really needs to, for every other bank really needs it on that same day. Which is why there came a “dreadful Saturday I shall never forget,” when a run on the bank was made, with “one old steady customer” withdrawing, without warning, his entire £30,000, leaving the bank vault “literally empty.”

“Never, [Henry] says, shall he forget watching the clock to see when five would strike, and end their immediate terror. . . . The clock did strike . . . as Henry heard the door locked, and the shutters put up, he felt [Pole, Thornton] would not open again but would be forcibly liquidated Monday morning.”

There were, however, other characters in motion. Robert Banks Jenkinson, Second Earl of Liverpool, First Lord of the Treasury and Prime Minister of His Majesty George IV, had been having whispered conversations with Bank of England Governor Cornelius Buller and his deputy John Baker Richards. Liverpool said that it was of vital importance that the banking system of London not collapse under the weight of speculation and the popping of all those stock company bubbles.

Liverpool claimed he could not get Parliament to appopriate money to save the banks or to prop up asset prices: Parliament was populated by tax-paying landlords who did not especially trust the stock-jobbing financiers of London. Liverpool had spent much of the past year warning bankers that if their “overtrading” were followed by “revulsion” and “discredit,” that he would not spend Treasury money to rescue them.

However, Liverpool told Buller, the Bank of England might. The Bank of England had a peculiar semi-private status with enormous autonomy. And everyone knew it was too big to fail—it was, after all, the Bank for the entire British Empire, and the Empire would stand behind it.

So the Bank of England could save the situation even if the government could not. Moreover, it seems Lord Liverpool said to Buller, if it becomes necessary I want you to print up banknotes in excess of the legal limit, and to lend out your gold reserves even though the Bank’s charter requires you to keep them in your vaults.

The following morning, Sunday, at 8:00 AM, Bank of England Governor Cornelius Buller, Deputy Governor John Baker Richards, along with every member of the Court of the Bank of England who was in London, were assembled to meet John Smith and the twenty-five year old Henry Thornton.

Marianne Thornton picks up the story: “John Smith began by saying that the failure of [Pole, Thornton] would occasion so much ruin that he should really regard it as a national misfortune,” and he also praised Henry Thornton beyond all reason, saying “what he had seen of the conduct of one of the partners . . . had convinced him that could [the bank] be saved for the moment,” the crisis would pass. Smith “then turned to Henry and said, ‘I think you give your word the House is solvent?’ Henry said he could . . . [and] had brought the books.

“’Well then’, said the Governor and the Deputy Governor of the Bank, ‘you shall have four hundred thousand pounds by eight tomorrow morning, which will I think float you’. Henry said he could scarcely believe what he had heard.”

Henry Thornton arrived at his own bank before opening with £400,000 in cash. The run on bank funds then recommenced. But “rumours that the Bank of England had taken them under its wing soon spread, and people brought back money [on Monday] as fast as they had taken it out on Saturday.”

This was the birth of central banking as we know it.

The Bank of England had accepted the role of maintaining orderly markets and financial stability in a crisis. Why? Because the prices of financial assets are too important to be left to the market when it is panicked and when letting prices reach market levels will mean unemployment for hundreds of thousands in 1825, or tens of millions today.

Ben Bernanke’s Public Private Investment Partnerships—the vehicles for purchasing banks’ toxic assets—are a natural development, even a Burkean development, of policy that has been pursued for 184 years now.

When politicians wash their hands of a financial system in crisis and fail to intervene on a large scale, things do not turn out well. The most notable example was 1929-1933, when, at least according to Herbert Hoover, Treasury Secretary Andrew Mellon persuaded Hoover that “even a panic is not altogether a bad thing” because “it will purge the rottenness out of the system.”

Did 1825 turn out better? We think so. George IV was not executed on Tower Green. Lord Liverpool’s head was not carried about London on a pike. The spinning of cotton into thread in Britain in 1826 was 11 percent lower than in 1825—the first serious industrial recession—but it bounced back and grew 30 percent from 1826 to 1827.

And the bank of Pole, Thornton? Alas, Henry Thornton was irrationally exuberant when he swore that the bank was solvent. The bank was eventually closed. The partners lost their capital shares. The Bank of England had to wait years before getting its emergency loan back. (They did not care much; they were too big to fail, and Lord Liverpool thought they had done well.)

Henry’s career prospered thereafter. Even though the financial ship that he had seized command of as a junior partner foundered, the consensus was that he had displayed great energy, good judgment, a cool head, and a facility with figures that made him worth backing in the future.

My takeaways from this tale:

  • Bubbles and recessions happen, even if your economy is based on little more than textiles and shipping.
  • The semi-private, autonomous nature of a central bank can be greatly useful if you need to undertake measures that are politically inconvenient/unacceptable but nevertheless prudent.
  • This is far from being the first time the world has seen losses socialized and profits privatized.
  • A bad bank is a bad bank is a bad bank; even a bailout probably won’t save it in the long term.
  • However, in even temporarily bailing out a bad bank, you can save a greater purpose: Overall stability and confidence in the system is maintained (or at least less damaged).


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