Breaking News from 1825

I mentioned the Panic of 1825 briefly yesterday.

More detail is available from the St. Louis Fed: main article by Larry Neal and commentary by Michael D. Bordo.

The more things change …

These problems started with the Treasury itself, confronted by the difficulties of servicing the huge government debt accumulated during the Napoleonic Wars … They were compounded by the response of the London capital market, which produced a bewildering array of new financial assets to its customers to replace the high-yielding government debt now being retired.

Only as more information came in or as investors began to pull out of higher risk investments and seek safer, better quality assets did price differences begin to show up.

The credit collapse led to widespread bank failures (73 out of the 770 banks in England and even three out of the 36 in Scotland) and a massive wave of bankruptcies in the rest of the economy, reaching an unprecedented peak in April 1826. The Bank of England and the London private banks joined forces for once by blaming both the speculative boom and the subsequent credit collapse on excessive note issue by the country banks. They argued that the ease of note issue had encouraged the more careless or unscrupulous partners in country banks to invest in highrisk, high-return financial ventures such as the Poyais scrip that were being offered on the London capital market.

Asymmetric information is the term applied to the usual situation in which borrowers know more about the actual investment projects they are carrying out than do the lenders. Lenders, knowing this, charge a premium proportional to the uncertainty they feel about the borrowers in question. This situation, in turn, creates an adverse selection problem, in which higher-quality borrowers are reluctant to pay the high interest rates imposed by the market, while lower-quality borrowers are willing to accept the rates and to default if their ventures fail.

The coup de grĂ¢ce occurs when higher-risk borrowers are asked to provide collateral for additional loans, and the financial collapse decreases the value of their collateral. The outcome is a general wave of bankruptcies.

Update, 2007-09-20: It is interesting to contrast the 1825 bail-out of the banking house of Sir Peter Pole with the 2007 bail-out of Northern Rock. In testimony to parliament, BoE Governor King stated:

U.K. banking laws prevented the central bank from a covert rescue of Northern Rock Plc, which it would have preferred.“The bank would have preferred to have acted covertly as lender as last resort, to have lent to Northern Rock without publishing it,” King told a parliamentary committee in London today. “As a result of the market abuses directive (of 2005) we were unable to carry that out.”

4 Responses to “Breaking News from 1825”

  1. […] That sounds to me like an overgeneralization. When fear takes over, I am more inclined to agree with Larry Neal and his diagnosis of informational asymmettry exemplified, he says, in the Panic of 1825. Few lenders even have the desire to determine creditworthiness – especially if they have potential obligations that they may have to meet – and those few that do may set the “creditworthy” bar uneconomically high. […]

  2. […] vehicle to push along various long-standing agendas. The crisis itself is merely a tired rehash of the panic of 1825 and it’s […]

  3. […] This has been a bone of contention since at least 1825. […]

  4. […] lack of trust in the authorities: when the BoE lent money on good collateral to Northern Rock, they felt they should do so covertly, in contrast to prior practice … doubtless feeling that their word that the instution was […]

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