Less regulation, not more, is answer to current financial crisis

The 19th century should be the inspiration for the government and regulators looking at how to deal with the current financial crisis, according to a prominent economist.

“The story I have to tell you is a story of caution, depression and the world of debt. Caution is the big lesson to be learnt from the financial crisis and the other is there is nothing new,” said Forrest Capie, professor emeritus of economic history at Cass Business School, the keynote speaker at the Family Office Investment Summit in London on June 11.

For him the key to understanding today’s financial crisis and what the correct reaction should be lies not in the Great Depression but in the 19th century. To Capie the depression era did not constitute a financial crisis as there was no breakdown of the payment system.

In the 19th century the world and specifically England experienced a string of crises, in 1825, 1836, 1847, 1857 and 1866. After this spate of drama, there was a blissful period of 100 years of relative calm.

These dates also had more to do with the present day financial crisis than any comparison with the Great Depression, declared Capie.

All of the 19th century financial crises had common features. In essence each was fuelled by easy money and an asset price boom, followed by a tightening of monetary policy, leading to fear, panic, crash and disaster.

The reaction that finally ended the stream of financial crises was not over-regulation of the financial sector but rather appropriate and proportionate application of duties and a lessening of the regulation of the sector.

According to Capie by the time the country was able to enjoy relative financial peace, the Bank of England had finally adopted and understood its role as a lender of last resorts. The banking sector respected the prudence of a healthy balance sheet and the markets themselves had been freed from over-regulation.

The problems of the current crisis came about when banks forgot the value of a strong balance sheet and started to behave yet again like the financial sector in the 19th century.

During the spate of crises in the 19th century “lessons were learnt sufficiently well for 100 years of stability. Banks found their own way to appropriate balance sheet behaviour,” Capie noted.

In the lead up to 1825 there was easy money, speculative investment and huge investment in new South American republics. There was a boom in the stock market and then fears concerning the Bank of England’s monetary reserves. This led to a tightening of monetary policy and the ensuing crash.

There were major panics on Wall Street in 1792, 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987 and 2008. The 1836 crisis occurred after a huge real estate crash, much like the subprime fiasco of 2008.

Runaway train
In 1847 the East India Company was increasingly adventurous and there was a “loss of caution”, said Capie. In 1847 the Bank of England cut the base rate at the same time as railway mania was surging throughout the country. A booming economy resulted, ending with the inevitable crash.

The 1850s saw feverish speculation in the American West over gold. Bank rates followed market rates down and when the bad news from the gold fields of America filtered back, “the game was up, the bank rate went up, there was a panic and banks failed,” said Capie.

The 1860s, the high point of the Victorian boom, saw the worst financial banking crisis in England. Overend, Gurney & Company, a London wholesale discount bank, collapsed in 1866 owing about £11 million (close to £1 billion today). When Overend, Gurney & Company suspended payments, panic spread across London, Liverpool, Manchester, Norwich, Derby and Bristol. Until events at Northern Rock in September 2007, it was the last run on a British bank.

Walter Bagehot’s 1873 book, Lombard Street, took its title from the bank’s address, 65 Lombard Street. The observations of Bagehot, who became the editor of The Economist, remain relevant and are sometimes cited by central bankers today.

With this latest shock the politicians and regulator put things in place for the long period of stability that followed.

In 1887 the City of Glasgow Bank was regarded as one of the most progressive of the Scottish banks, particularly in the international scene where it had considerable dealings in America, India and Australia. Its branch system was the largest.

However, on October 18, 1878 an investigator’s report was published revealing that the bank’s most recent balance sheet was fraudulent and over £5 million had been lost by the bank in questionable circumstances.

This was not a case of business misfortune but of unsound and dishonest methods. There was, however, no panic and no financial crisis. This, believes Capie, was because by then banks knew how to arrange their finances, the Bank of England was acting as a true lender of last resort and, crucially, the government was keeping out of the way and letting the system sort itself out.

The next scare came in 1914. This, said Capie, had all the elements of a financial crisis as the payment system was “glued up”. Brokers were feeling the pinch and banks began calling in loans. Unusually, there was no boom preceding this crisis.

But, noted Capie, the crisis did not develop. The Bank of England “took appropriate action and the system continued to run.”

The next significant date was the exchange rate crisis of 1931, said Capie. This is when the UK, along with many other countries including the US, abandoned the gold standard. The high interest rates in the 1920s were also putting a strain on the system.

Again, Capie pointed out, there was no financial crisis. The banking system was entirely stable and in fact over the period of 1929–32 bank profits “hardly dipped”.

So, concluded Capie, the Great Depression is not the episode to turn to when “seeking information on the past to look at the present”.

The Great Depression was the most catastrophic event in US history after the Civil War. It is an intensively researched topic, yet still there are disagreements about what caused it and explanations for its recovery,” said Capie.

In the UK there was no great depression. “The inter-war years were not as bleak as often portrayed. There was a recession with output falling in 1929–32 but economic performance in the 1920s was better than before,” Capie noted.

The reason for the fall in UK output was simply the country’s departure from the gold standard. “It was monetary expansion that changed Britain’s fortunes and gave it a different experience to the US,” he said.

Circumstances in the US were markedly different. With a boom in the 1920s, the stock market soared while interest rates remained low. The Federal Reserve became nervous and tightened money in 1928, initially attracting funds. But the boom continued and did not end until the bubble burst. The Fed then tried to prevent the downturn turning into a full-scale depression but failed to appreciate the scale of the disaster from a macro-economic point of view.

Capie noted that at present the concerns are about withdrawing liquidity too soon from the system and the high levels of government debt. “No doubt the scale of the current debt is serious and is likely to grow over the next few years,” admitted Capie.

The current debt-to-income ratio is in the order of 60%. However, Capie noted that the UK has had higher debt-to-income ratios. For example, after the Napoleonic War, it was around 250%, falling to 30% by the end of the 19th century.

At the end of World War II the ratio was back to something like 150%. In the three occasions when the debt ratio was in triple digits “there was no disaster and the growth rate was entirely satisfactory,” noted Capie. “The trick is to get the economy back on a growth path.”

Words of wisdom
What lessons can be learnt from history? Capie admitted AJP Taylor’s oft-quoted axiom that the one big lesson is that there are no lessons is overstating the case. “There are few if any simple lessons. There is no manual you can pull off the shelf to guide you when circumstances arise,” said Capie. However, there are patterns. “Lessons in the 19th century were learnt. How else do you explain 100 years of stability after recurrent crises?” asked Capie.

The lessons, he simply stated, should be that banks should know what a secure balance sheet looks like and stick with it. He warned the Bank of England not to take its eye off its core function as a bank of last resort.

“Its function is to provide liquidity in times when it is needed and when the Bank of England accepted this as its role, it did not allow the money supply to collapse. Liquidity was injected to calm panic and was removed when the crisis was over. The failure to provide liquidity is disastrous,” Capie said.

The fear of deflation is nothing compared to the fear of no liquidity. Capie pointed out that in the 1930s there were huge bank failures in the US. One third of all banks failed. There was a tightening of regulation and there were 40 years of stability. In the UK there was no banking collapse, no change in regulation and it, too, had 40-plus years of financial stability.

So the final lessons concern international trade and finance. “These things may seem extremely obvious but they also keep happening. If a company or activity is growing rapidly we should look closely at it. If there is an especially high return on an investment, examine it closely. In good times it is easy to smile at it and say the world has changed and is different. But in times of crisis these warnings are more readily heard,” warned Capie.

He said the UK had got into trouble because it had “given up on older forms of behaviour. The Bank of England was not acting as the lender of last resort. It had changed its behaviours.”

From then on the problems mounted. “It is a pity we can’t hold on to the lessons,” bemoaned Capie.

The basis of the payment system in England worked well when there was appropriate liquidity and cash ratios were held. In the build-up to the financial crisis over 15 years, liquidity ratios went from 15% to close to zero. “When older people questioned this, they were told there was no need to hold liquidity because it was readily available any time it was needed,” said Capie. That was clearly not the case in the end.

“After each crisis in the 19th century steps were taken to deregulate. In the last 50 years the climate has been if anything goes wrong to regulate and the tendency has been for more regulation. In the 19th century it was exactly the opposite. Crisis, wrong thinking, deregulation. This pattern allowed banks to go forward,” noted Capie.

Perhaps that is a pattern that should be repeated otherwise, Capie believes, the world could be in for another series of financial crises if the lessons of the present disaster are not sufficiently learnt.

Forrest Capie

Forrest Capie is professor emeritus of economic history at the Cass Business School. His areas of expertise include monetary economics, financial history, UK monetary history 1870–1970 and Britain in the world economy.

After working as an accountant for Ford Motor Company and as a civil servant in the Department of Trade and Industry in New Zealand, Capie read economics and economic history at the University of Auckland and the London School of Economics.

Among the many books he has written are Depression and Protectionism, A History of Money: from AD 800 and The Lender of Last Resort.

Capie has co-authored a number of papers including The Inter-War British Economy. He has also written papers on monetary and trade history and was editor of The Economic History Review from 1992 to 1999.

Examples from the past

1825
It is unclear what caused the April 1825 collapse. In March the Bank of England had sold a large block of Exchequer bills to contract the circulation.  In succeeding months the bank continued to follow a cautious policy.

The collapse of stock prices triggered commercial failures. By autumn a number of country banks also failed. When several important London banks failed,  a full-fledged panic ensued in early December.

The Bank of England reversed its discount policy and began acting as a lender of last resort. The bank was saved at the last minute from suspension of convertibility by gold flows from France.

However, although the bank’s discount policies were liberal, it acted too late to prevent massive bank failures, contraction of loans and a serious recession in early 1826.

The English crisis then spread to Europe and to Latin America, prompting a general default on its sovereign debt. In the aftermath of the crisis, blame was placed on the country banks for fuelling the stock market boom and on the Bank of England for not policing them.

1836
The 1836 crisis occurred after a huge real estate crash. In the early 1830s settlers were pouring into the American West and buying land from the Government Land Office (GLO), as were an increasing numbers of speculators. Land prices rose swiftly. The speculators borrowed from local banks to maximise their leverage, counting on the rising prices to guarantee them a profit despite the interest costs.

The GLO had sold $2.5 million worth of land in 1829. By
the summer of 1836, it was selling $5 million worth of land each month.

Local banks, many of them under-capitalised and poorly regulated, proliferated. The then US President Andrew Jackson was partly responsible for this. He disbanded the Second Bank of the United States (BUS), removing the primary source of discipline in the banking system. His transfer of federal deposits from the BUS to state banks allowed those banks to increase their lending to speculators.

But Jackson hated speculation, paper money and banks. Probably unaware of his own role in fuelling the real estate boom, he wanted to end it. As soon as Congress adjourned for the year in July 1836, he issued an executive order requiring the GLO to accept only specie (gold and silver), not bank notes, as payment for land.

This brought the speculation to a screeching halt. Unfortunately, it also triggered an economic disaster. As Americans exchanged their bank notes for gold and silver, western banks had to call in loans to stay liquid. Weaker banks began to collapse and the credit crunch caused manufacturing to falter.

The boom turned to bust.

 

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