MAY/JUNE 1998 Larry Neal is a professor of economics at the University of Illinois at Urbana-Champaign.* 1815 had prolonged and deepened unnec- The Financial essarily the economic troubles accompany- ing the transition from a wartime to a Crisis of 1825 peacetime economy. Nevertheless, the British government and the Bank of Eng- and the Restruc- land pursued much the same strategy after World War I, again taking six years after the turing of the peace treaty to resume convertibility—and at the prewar standard. Again, monetary British Financial ease that followed resumption led to a surge of prosperity, speculative ventures in System the capital markets, and eventual collapse of the financial system. The difference was that in 1825-26, there was a systemic stop- Larry Neal page of the banking system, followed by widespread bankruptcies and unemploy- oday’s financial press reports regularly ment, while in 1931 there was abandon- on evidence of systemic risks, financial ment of the gold standard, followed by Tfragility, banking failures, stock market imperial preference and worldwide move- collapses, and exchange rate attacks through- ments toward autarky. So much for the out the global financial network of the lessons of history! 1990s. To a financial historian, these As pessimistic as Acworth was in asses- reports simply reprise similar concerns and sing the consequences of Britain’s first return * The author acknowledges with risks in numerous episodes of financial to the gold standard in 1821, the conse- gratitude the support of the innovation and regime change in the past. quences of the ensuing monetary expansion University of Illinois during his True, the 1990s have the peculiar feature of and speculative boom that ended in the sabbatical leave of 1996-97 emerging markets among newly indepen- spectacular collapse at the end of 1825 as well as the Guggenheim dent states that are trying to market either proved to be not so dire in the long run for Foundation and the British their government debt or securities issued the British economy. The policy changes Fulbright Commission, for by their former state enterprises. But this that affected the monetary regime—the research efforts on this project. situation does not eliminate the relevance exchange rates, the structure of the bank- This version of the paper has benefited not only from the of past episodes; it merely limits it to fewer ing sector, the role of the Bank of England comments of the discussant, periods. The period after World War I had and the management of the government’s Michael Bordo, and participants many of the same problems, for example, debt—while minor in each particular and at the conference, but also although policymakers then subsumed slow to take effect, were cumulatively from comments and sugges- them largely under the issues of whether, effective in laying the basis for Britain’s tions made during seminars at when, and how to return to the pre-war dominance in the world financial system the University of Illinois (espe- gold standard that had created a much more until the outbreak of World War I. This cially Lee Alston and Salim benign financial system worldwide. Policy- outcome contrasts sufficiently with the Rashid), Indiana University makers of that time were much more inter- disappointing pattern of British economic (especially George von ested than their modern counterparts in progress during the twentieth century after Furstenberg and Elmus exploring lessons from the past. both World War I and World War II that Wicker), and the Research Triangle in North Carolina For example, William Acworth’s classic perhaps we should take a fresh look at the (especially Douglas Fisher, study, Financial Reconstruction in England, economic and financial transition after the Judith Klein, and Gianni 1815-1822, was published in 1925. He Napoleonic Wars. What caused the prob- Toniolo). Remaining shortcom- argued convincingly that the severe defla- lems identified by Acworth that culmi- ings and misinterpretations of tionary policy followed by the government nated in the stock market crash of 1825 the facts are, of course, the and the Bank of England after peace in and the English banking system’s failure to sole responsibility of the author. FEDERAL RESERVE BANK OF ST. LOUIS 53 M AY /JUNE 1998 withstand its impact? More important, why reforms, but it enabled them to become did the British government’s relatively modest increasingly effective over time. True, reforms prove to be so effective in the long crises continued to arise throughout the run? Perhaps we can glean more useful rest of the century as the British economy lessons for today’s policymakers than pre- was subjected to repeated shocks of wars, vious historians have been able to provide. famines, frauds, and foreign defaults. But The argument developed in this paper the evolving financial sector of the British is that the common element in all the economy surmounted each crisis with problems of Britain’s first return to gold increasing confidence, and all the while arose from the pressures of coping with these firewalls were preserved. The firewalls vastly increased informational uncertain- meant that relationships among financial ties within the existing structure of Eng- intermediaries and financial markets had to lish institutions.1 These problems started be maintained by short-term contracts in a with the Treasury itself, confronted by the competitive market environment rather than difficulties of servicing the huge govern- by regulations imposed by centralized ment debt accumulated during the Napole- authority with long-term rigidity. onic Wars and deprived of its primary The focal point for these new market source of revenue, the income tax. They relationships was the market for discounted continued within the Bank of England, commercial bills that arose rapidly in impor- forced now to take on new responsibilities tance after the crisis of 1825.3 Once again, while searching for new sources of revenue as in earlier crises and in those that were to to replace its wartime profits. They were follow until World War I, the British finan- compounded by the response of the Lon- cial sector was able to find a market solution don capital market, which produced a to the problems created by its relatively inef- bewildering array of new financial assets to ficient and disparate financial institutions. its customers to replace the high-yielding In the longer run, the flexibility of response government debt now being retired. All provided by the combination of markets and this left the London private banks and financial intermediaries coexisting in the their corresponding country banks—as British financial system enabled it to with- well as their customers in agriculture, stand exogenous shocks and to finance trade, and manufacturing—floundering in expansion of the real economy. To elucidate the resulting confusion. The government’s and elaborate this argument, I analyze, in piecemeal reforms, introduced during the turn, the shock to the financial system of crisis of 1825 and its immediate aftermath, shifting from wartime to peacetime finance provided smoother patterns of tax collec- in 1821, the financial crisis that occurred at tions and interest disbursements, established the end of 1825, the Bank of England’s Bank of England branches throughout Eng- efforts to pick up the pieces, and, finally, land, stimulated country bank competition the rise of a market in discounted commer- with joint-stock companies outside of Lon- cial bills that put things right again—for don, and eliminated the Bubble Act of 1720. awhile. The lessons of each episode high- Even the bankruptcy laws began to be rewrit- light the importance of appraising the ten in 1831.2 financial system as a whole, rather than These disparate reforms made margi- focusing on what appears to be its weak- 1 Note the emphasis on English, nal improvements in the efficiency of est link. In retrospect, it seems critical to rather than British, institutions. information gathering and processing by allow information to flow freely among The Scottish and Irish banks avoided the Panic of 1825 the government, the central bank, the the various parts of the system in order almost entirely, a fact that banking system, and the stock market that markets may form to price and caused much soul-searching while preserving the separation of functions intermediate risk. At the time, the Bank among the English at the time. among them. Maintaining these “firewalls” of England refused to divulge important 2 among the types of institutions making up information and remained aloof from Duffy (1985), ch. 1. the financial sector of the British economy market activity until it was forced to act, 3 King (1936), ch. 2. diminished the immediate impact of the usually too late. Only gradually were F EDERAL RESERVE BANK OF ST. LOUIS 54 MAY/JUNE 1998 these lessons learned; now is not the time practical autonomy, however, remained to forget them. intact as the government still relied on it for managing its remittances and, espe- cially, its recurrent issues of debt—both THE SHOCK: FROM long-term, funded debt (perpetual annu- WARTIME TO PEACETIME ities comprised mainly of 3 percent consols) FINANCE IN 1821 and short-term, unfunded debt (one-year In the expansion of war finance that Exchequer bills bearing daily interest). The the Napoleonic Wars induced in Britain, all Treasury at this point was the Bank’s strongest parts of the British financial system pros- defender against the criticisms of the Bullion- pered. At the top, the Treasury benefited ists, arguing that the needs of war finance from increased taxes, especially the income justified the fall in the exchange rate of the tax, as well as the expanded market for its paper pound. debt, both long-term, funded debt and As a result, for three years after the short-term, unfunded debt.