The first global credit crisis
June 2022 marks the 250e anniversary of the outbreak of the credit crisis of 1772-3. Although little known today, it was arguably the first “modern” global financial crisis in terms of the role played by the private sector. credit and financial products played into it, in the financial contagion pathways that spread the initial shock and in the way authorities intervened to stabilize markets. In this article, we describe these developments and note the parallels with modern financial crises.
The evolution of the credit crisis
The crisis of 1772-3 was global in scope, with failures spread across Britain and the Netherlands, the other major European financial centers, and as far afield as St. Petersburg and the West Indian and North American colonies (as mentioned in a previous article). Economy of Liberty Street Publish). Over the course of a year, it disrupted credit markets, negatively affecting banks and non-bank borrowers.
There were two waves of failures. Triggered by the flight of the Scottish banker and speculator Alexander Fordyce, panic broke out on June 9, 1772, in London, with the experimentation Bank of Ayr in Scotland a significant casualty soon after. Another series of failures hit Amsterdam in the winter of 1772-3; the most notable of these was the old Bank of Clifford, considered by contemporaries to be the second most important bank in Europe.
Since the role of rapidly evolving private credit markets was crucial in precipitating and spreading the crisis, we begin with an overview of the private credit instruments prevalent at the time.
Bills of exchange helped transmit contagion
The bill of exchange was the main tool of credit fueling trade at that time: a promise to pay money (usually foreign currency) in a defined place and at a certain time. It was basically an IOU that a merchant or bank could “accept” or ask someone with stronger credit to accept (guarantee) on their behalf. Depending on the distance the invoice or related shipments might have to travel, the invoice would typically have a due date of up to one year, although three to six months is more common.
Although originally created to support short-term trade, a note could (and was) endorsed by third parties in payment of debts before its maturity, effectively serving as a substitute for paper money. All parties (including endorsers) signing an instrument were jointly and severally liable for the debt, thereby diversifying credit risk in normal times. During times of distress, however, the bill’s credit liability features served as a means of financial contagion since all undersigned parties were at equal risk of being called for the entire debt.
The bill of exchange was also increasingly used in long-term finance by “rolling” an expiring bill with a corresponding bill on the same date, in a process known as pivoting. This helped traders secure their working capital, but also allowed speculators to fund purchases of long-term, high-risk assets, such as commodities or stocks. The risk of “rollover” inherent in this process is similar to that underlying the global financial crisis. crisis from 2007-9.
Mortgage innovations in the mid-eighteenth century are notable for their contribution to the financial instability on the eve of 1772 and the failures of that year. Mortgages themselves became more speculative as they included riskier loans, such as those secured by West Indian plantations run on behalf of absentee landlords. Because the loans were bundled and sold as mortgage-backed securities (MBS), they spread the underlying risk widely among investors.
MBS (negotiations in Dutch) were published on a large scale in the Netherlands in the 1760s. They were sold to wealthy private investors, often in increments of 1,000 guilders, a sum of about six to eight times the annual income of a particular citizen. The plantation sector in the Caribbean fueled the boom, with mortgages on Dutch and Danish plantations in the West Indies being used as collateral for more than 40 million guilders of new loans (about 22% of Holland’s GDP) in the years 1766. -72 only. By the end of the decade, the volume of new loans exceeded productive investment opportunities.
Stock market speculation, then as now, relied heavily on margin lending. Notaries and other intermediaries had long used the pledge of securities as the basis for short-term loans. In the Amsterdam market, these loans were usually for six months, with an option to renew if both parties agreed. A haircut on the pledged securities ensured that in the event of borrower default, the value of the collateral would be more than sufficient to cover the losses.
These investments were often cross-border, with the Dutch acting as the main financiers of speculation in British stocks and debt securities. Increasingly, sophisticated investors were lending through arrangements similar to those used today by prime brokers when lending to hedge funds. These lenders ensured that they could re-margin their loans in response to market movements and thus were able to avoid losseseven as a credit crunch gripped the market.
However, not all lenders have demonstrated this level of sophistication. Some lent against illiquid securities, such as negotiations. Others have failed to obtain legal control of warranties, and disputes over who was entitled to what share of funds recovered from creditors continued for many years thereafter.
Clean up the mess
To quell the panic and ensure the trading economy did not collapse, authorities used tools familiar to modern readers: secured loan facilities and lender-of-last-resort powers.
In Amsterdam, the city authorities have set up a secured loan facility open to anyone with eligible collateral to pledge. Loans backed by various warehoused goods (Beleningskamer loans), and provided at standardized advance rates, replaced some of the lending capacity that had been lost. While these loans were relatively small in size, the very existence of the facility halted the downward spiral of forced commodity liquidations and helped bring private lenders back into the market. These loans, combined with the arrival of shipments of precious metals called from other European financial centers, ensured that the markets resumed their normal functions by mid-1773, although investors absorbed large losses.
The Bank of England provided last resort loan from 1772 (although the term itself was not coined until three decades after the Depression). The Bank provided liquidity by increasing the volume of its discounts. Due to usury laws, the Bank was forced to ration these loans instead of raising its discount rate as Bagehot would suggest later. But the Bank has not been shy about deploying additional means of containment, such as supporting the biggest note acceptors in London with targeted short-term loans, through which they could in turn support their customers.
As intense as the twin panics of 1772-1773 were, authorities managed to stabilize markets and restore confidence in the economy. These events gave a greater role to the institutional infrastructure of finance, concentrated around central banks and other establishments, and created a set of financial stabilization techniques that are still used today. The availability of these new tools was fortuitous, as Europe entered the period of the most profound changes in economic growth and capital investment in human history.
Stein Berre is director of the surveillance group at the Federal Reserve Bank of New York.
Paul Kosmetatos is a Lecturer in International Economic History at the University of Edinburgh.
Asani Sarkar is Financial Research Advisor for Nonbank Financial Institutions Studies in the Research and Statistics Group of the Federal Reserve Bank of New York.
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.