“Imperial Finance: A History of Empires”
It’s finally here. The second Investor Amnesia course launched this week… and wow is it exciting. This course offers more than eight hours of world class lectures taught by an incredible lineup of speakers. Highlights include:
- Marc Andreessen on anti-trust, Robber Barons & Golden Age of Piracy.
- Niall Ferguson reveals which financial innovations produce empires.
- Tracy Alloway explains how political chaos impacts investors.
- Mike Green uncovers episodes of monetary debasement and inflation.
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This week we are going to focus on one of my favorite “panics”… The Panic of 1825, a story of speculation that includes scams like real bonds being listed for fake countries…
The Panic of 1825
To convey just how speculative the year 1825 was, read this excerpt from a book explicitly written that year to warn against the perils of such rampant speculation. The author’s highlighted the misery of gambling in markets by detailing the South Sea Bubble of 1720 and how it compared to events in 1825.
With that, let’s dive into the Panic of 1825.
If we’ve learned one thing from the last two posts it is that war is expensive. Like in 1792 and 1819, background for the Panic of 1825 begins with the end of another expensive conflict: The Napoleonic Wars. These wars are not the focus of today’s discussion, so to briefly summarize… this conflict was a series of wars lasting roughly 15 years as Napoleon sought to establish French supremacy in Europe. Napoleon was opposed by shifting coalitions of other European powers that were primarily led by the United Kingdom. The Napoleonic Wars were eventually ended by Napoleon’s defeat at the Battle of Waterloo in 1815.
The excerpt and chart below from Pamfili Antipa‘s article in the Journal of Economic History highlights why these wars were relevant to the Panic of 1825:
“Between 1797 and 1821, in order to finance the Napoleonic Wars, Britain suspended convertibility of Bank of England notes into gold… in terms of monetary policy maintaining the suspension of the gold standard for such a long period of time was an innovation.
However, funding of the wars with France meant that the suspension was accompanied by inflation and public debt accumulation. By the time of Napoleon’s final defeat at Waterloo in 1815, the price level exceeded its 1797 level by 22.3 percent and the debt-to-GDP ratio climbed to 226 percent… only WWI would entail a larger increase in the debt-to-GDP ratio.”
To summarize the key points: Britain suspended convertibility of BoE notes into gold for 25 years in order to finance the Napoleonic Wars, which led to inflation and ballooning public debt. The British government’s problems were exacerbated by the fact that a key source of revenue had vanished when the national income tax was eliminated in 1816. The income tax had represented 20% of the Treasury’s revenues, and this sudden loss of revenue occurred when post-war debt servicing costs were significant. The severity of this situation is highlighted below:
Increasing debt servicing costs and decreasing revenues meant that the government needed to find a creative solution. Eventually, British leaders opted for an approach similar to Alexander Hamilton’s in the Panic of 1792. The British government tried to raise the prices of long-term bonds on the London Stock Exchange, which would allow the government to issue new debt at lower interest rates, reducing debt servicing costs.
“in the period immediately following resumption of the gold standard, the government continued to make payments into the Sinking Fund, which was used to make periodic purchases of long-term debt at market prices and retire it. In effect, the Treasury was running open market operations that increased liquidity in the economy. It did this by issuing Exchequer bills to the Bank and then using its credits with the Bank to retire some of the funded, long-term debt, mainly consols.
Encouraged by the possibilities of retiring high-interest debt and reducing expenditures in this way, the government overreached in 1823. At the end of that year, the government converted £135 million of its 5% bonds to 4% bonds. It then continued to take advantage of monetary ease early in 1824 by converting £80 million of the 4% bonds to 3.5%.“
In addition to these open market purchases of high-interest consols (long-term government bond equivalents), the government also began using its “plentiful gold reserves accumulated in the drive to convertibility… [to buy] war bonds from the public in exchange for cash.” And that’s not all…
This period saw a proliferation of “country banks”, which were really just smaller banks outside the city of London. These country banks had played an important role in financing local industry and infrastructure (canals, etc.) through issuing unbacked paper bank notes in small denominations. This had been a profitable business during the Napoleonic Wars, but the end of war and resumption of gold convertibility was a blow for country banks. Until, that is, the government agreed to let country banks continue issuing unbacked paper banknotes until 1833, even as gold convertibility had resumed. The key point here is that these country banks were a key source of liquidity and cheap credit for speculators down the line.
Although these details may seem boring and trivial, they are crucial for explaining everything that is to come, for two reasons. The first is that the government’s purchases and retiring of war bonds / higher-yielding consols created a liquidity boom. Second, since the government’s strategy was to lower yields on consols in order to reduce debt servicing costs, investors now found themselves in a low yield environment.
So, investors had cash on hand because the government re-purchased their consols / war bonds, and in terms of re-investing this cash, the yields available on bonds were now unattractively low. You can probably guess where this is going… *cough* reach for yield *cough*
The Reach for Yield
One thing that rarely changes in financial history is investors’ tendency to “reach for yield” when low interest rates force them further out the risk curve. The chart illustrates this problem. In 1995, investors could achieve a nominal 7.5% annualized return just by allocating to Bonds. In 2015 that same return required a more complex allocation to illiquid and private investments like Real Estate, Private Equity, etc.
Well, things were no different in 1825 than they are now.
“British investors used to safe returns ranging between 4 and 6% for the past 20 years now found their options limited to yields between 3.5 and 4.5%.”
Latin American Fever
While today it is Private Equity and Private Debt strategies that have been popular among investors “reaching for yield”, in 1825 the high-yielding asset du jour was Latin American bonds. Their sudden popularity stemmed from the fact that many countries had recently gained independence from Spain.
“The collapse of Spanish control over its American empire during the Napoleonic Wars led to a variety of independent states being formed out of the former colonies by 1820. Battling one another for control over strategic transport routes, mainly rivers and ports, and over state enterprises, mainly mines, each appealed to foreign investors as a source of government finance and as a means to substitute foreign expertise and technology for the vanquished Spanish.
Their government bonds and their mining shares found a ready market in the London Stock Exchange, which had become the dominant marketplace for finance capital in the world during the Napoleonic Wars. The loan bubble of 1822-25 ensued, eventually giving British foreign-bond holders their first experience with defaults by sovereign states.“
The chart below shows how attractive these high-yielding Latin American bonds were at at time when Consols yielded just 3%.
One must remember, however, that these foreign bonds were being issued in London at a time when even tickers were not yet invented. This meant that British investors interested in buying Latin American bonds would have little-to-no information on the country in general, or its prospects. This was the perfect environment for something like the Poyais scam to take place.
The Poyais Scam
Gregor MacGregor had the most Scottish name imaginable, and was also deemed the ‘King of Con-Men’ by The Economist. MacGregor earned this title by finding an uninhabited piece of land off the coast of Honduras, creating a fictitious country called Poyais, and selling over a billion dollars worth of ‘Poyais bonds’ in London. He did this by misleading investors into thinking the uninhabited jungle he had found in Honduras was actually a legitimate country boasting beautiful architecture, an opera house, parliamentary building, cathedral, and more.
As he sailed back to London from “Poyais”, MacGregor began plotting how he would lure investors into his new scheme. Given the excitement for Latin American bonds that already existed in London, MacGregor had no difficulty enticing investors into buying Poyais bonds. When the Grand Cacique of Poyais (MacGregor’s self-appointed title) arrived in London he wasted no time spreading the word about investment opportunities in his newly discovered kingdom.
The hype surrounding Poyais evolved into full-fledged mania as thousands of engravings were sold around London and Edinburgh portraying the magnificent buildings and infrastructure of Poyais (that did not actually exist). To reiterate, Poyais was a largely uninhabited jungle with no infrastructure of the sort. But, no matter! Offices were opened in London and Edinburgh for selling Poyais land grants to excited applicants at 4 shillings an acre.
After drumming up a frenzy from the British public, MacGregor focused his attention on courting investors. In 1822 the Scotsman issued Poyais bonds with 6% yields that eventually reached a value of some $3 billion measured in modern values. Incredibly, the bonds were backed by the export-tax revenue that Poyais would allegedly generate, despite the fact that there was no infrastructure, people, or businesses in the region. At one point, the Grand Cacique even secured bonds against the revenues of a non-existent mining company in Poyais. These boring details, however, did not prevent investors from purchasing MacGregor’s fraudulent bonds.
Investors in MacGregor’s Poyais Kingdom were jolted back into reality when the English and Scottish settlers arrived at their new home in Honduras.
The first ship, Honduras Packet, set sail on September 10, 1822 with 50 settlers on board. Many of them came from poor background, and had left their homeland for the utopia that MacGregor had promised. Few would live to take the return journey back to Britain. As the ship finally pulled into the port of Poyais, nothing could have prepared the passengers for what they encountered. Far from being a tropical paradise with beautiful infrastructure, the land was uninhabited and undeveloped, apart from a couple mud-huts on the beach.
Unfortunately for the new arrivals, this discovery was only the beginning of their troubles in paradise. Shortly after they came on land, a hurricane tore through the region, sweeping away their ships. In an instant, the Poyais investors and settlers found themselves stranded. Then, when the situation couldn’t seem to get any worse, the settlers were stricken by either yellow fever, or malaria.
“Not one, was able to assist another out of such a number, and many of those who had newly come from Scotland were well advanced in years, and had come here to end their days in peace and comfort.” — Poyais Survivor
Eventually, seven ships in total came to Poyais with passengers looking to settle in MacGregor’s fairy tale paradise. Of the 240 settlers that arrived, only 60 survived.
Domestic Joint-Stock Companies Explosion
As the above chart from Michael Bordo shows, it was not just foreign investments that British investors were enamored by, however. There was also an explosion in joint-stock companies at home in Britain that tickled speculator’s fancy. As Winton Capital describes it:
‘From this time ‘bubble schemes came out in shoals like herring from the Polar Seas’, illustrated by the fact that the number of bills coming before Parliament for forming new companies shot up from 30 in March to 250 in April.
All manner of companies were ﬂoated. Many were related to Assurance; there were also some novel ventures such as the Metropolitan Bath Company which aimed to pump seawater to London so that poor Londoners could experience seawater bathing, and the London Umbrella Company which intended to set up umbrella stations all over the capital.
Many ventures, however, were arrant swindles designed to test investor credulity. Such examples include the Resurrection Metal Company, which intended to salvage underwater cannonballs that had been used at Trafalgar and other naval battles, and a company (possibly a parody) which was set up ‘to drain the Red Sea, in search of the gold and jewels left by the Egyptians, in their passage after the Israelites’.”
The statistic in that first paragraph is most indicative of the craze. 30 bills for forming new companies went to Parliament in March 1825, but just one month later in April there were 250!
Conclusion: The Panic of 1825 & The Bank of England
The New York Fed provides an excellent summary of the actual “panic” that set in in 1825:
“the London stock and bond market crash in April 1825 that brought on the panic does not seem traceable to a single exogenous shock, such as a crop failure… Bordo notes that, in March, the Bank sold a considerable sum of Exchequer bills, which contracted the monetary base and may have contributed to the crash. Or perhaps, he suggests, it was a sunspot. Whatever the precise trigger, the crash caused “commercial failures” and a “drop in collateral values” that slowed activity over the ensuing months.
By summer of that year, the price of Latin American bonds had fallen by half. Banks were highly exposed to such debt, so their nervous depositors began to withdraw. By December, there were outright runs, and as the panic spilled into 1826, fully 10 percent of the banks in Wales and England failed (The Economist). As the money and credit supply contracted, bankruptcies and unemployment soared while production slumped.”
The market chaos began in April of 1825 when the Bank of England raise interest rates, which coincided with the collapse of Latin American mining companies like Real del Monte Mining Co., a popular speculative stock at the time. It’s shares tanked from £1,550 in April 1825 to £200 by the summer.
As general enthusiasm for Latin American investments waned, the previously popular sovereign debt issues from these countries also began to decline. The prices of Latin American bonds were cut in half during the summer. As many banks were heavily exposed to these Latin American bonds, and their depositors knew as much, there were bank runs as nervous depositors came to withdraw their money. The Economist estimated that 10% of the English / Welsh banks failed.
This is where the Bank of England’s role is important.
“The Bank of England in 1825 was a public bank, not a central bank. The Bank had three loyalties: its shareholders, the British government, and its correspondent commercial bankers. In the first half of the nineteenth century, the Bank of England was learning to balance these three roles.
During the suspension period, the Bank made considerable profits from its issue of inconvertible banknotes. With [gold convertibility] resumption, profits declined; hence there was less incentive to discount freely on unprofitable paper. Indeed, the Bank had not yet adopted Bagehot’s (1873) “Responsibility Doctrine” of acting in the public interest first to allay a banking panic or to prevent a stock market crash from spilling over into the monetary system…
the Bank’s reluctance to lend early in 1825— when signs of stress were looming, merchants in the Latin American trade were failing, and the Bank raised the discount rate and cut back on advances later in the summer—likely exacerbated the crisis. Therefore, when the Bank finally did act in December, it was much too late to prevent a large number of banks from failing.”
Yes, you read that correctly. While there was clearly chaos in markets and the looming threat of a full blown panic, the Bank of England raised interest rates in the summer of 1825. It was not until December of 1825, after much of the damage had been done, that the Bank of England came back in to act as a lender of last resort.
And that, my friends, is the Panic of 1825!
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Sources & Further Reading
How Fiscal Policy Affects Prices: Britain’s First Experience with Paper Money
Michael Bordo’s Commentary on Paper Below
The Financial Crisis of 1825 and the Restructuring of the British Financial System
Crisis Chronicles: The Panic of 1825
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