The "Panic of 1825" as a Model of Financial Crises


The boom of financial and technological innovations, market euphoria and bubbles, the explosive growth of financial intermediaries, rising raw materials prices and blind investor trust instantly turned into panic. This is not a description of the dot-com crisis or the global financial crisis of 2008, but of the events that took place 200 years ago. The crisis of 1825 became a template for future shocks and at the same time led to changes in monetary policy and regulation that are still in place today.

This is the first article, opening a series of texts about economic and financial crises – their causes, consequences and the lessons that we should learn from them. From these articles on GURU, you will learn the history of capitalism – how it got sick and how it recovered.

Jan Melkumov


At the end of 1821, a man who called himself "His Serene Highness Gregor the First, Sovereign Prince of the State of Poyais" arrived in London. In salon conversations, he revealed that the purpose of his visit was to attract new settlers from Great Britain to his country, located in the Gulf of Honduras in Central America. Hence, he was ready to sell property rights to land plots, officer ranks and noble titles of Poyais to British subjects at a reasonable price.

Having discovered a keen interest in profitable foreign bonds in London, Cazique Gregor decided to immediately satisfy the demand of British investors and, with the help of the former Lord Mayor of London, Sir John Perring, he had organized through the London Stock Exchange the issue of Poyaisian bonds for the amount of 600,000 pounds sterling at 6% per annum (according to other sources, the amount was 200,000 pounds sterling, however, it is possible that the bonds were issued at a significant discount, which was common practice). Given that the British government bonds, the "consols", offered investors a yield of no more than 3% per annum, it is not surprising that the issue of Poyaisian bonds was a huge success and bond prices almost immediately went above par. Cazique Gregor himself was also very popular in London salons. Moreover, many recognized in him the Scottish officer Gregor MacGregor, who had recently fought in the ranks of the British army in Spain against the troops of Napoleon, and after that together with Simon Bolivar fought against the Spanish troops for the independence of Latin America. And since the political landscape there changed frequently and unpredictably, there was no reason why a former British officer could not have become the prince of some new Latin American country?

There was no shortage of those wishing to go to this new country that seemed to be blessed. Already in September 1822 and January 1823, the first group of 250 colonists left for Poyais on two ships. Everyone wanted to start a new happy life. Upon arrival, they discovered that the new country did not look like Cazique Gregor was describing it. There was no port, no city, no roads, and the local Indians had never heard of the Poyais. The settlers decided that some kind of mistake took place and that it should soon be fixed, but for the time being they needed to survive. However, life away from the civilized world turned out to be unbearable for them, especially when tropical diseases soon broke out. It was only in May 1823 that a passing British ship noticed the unfortunate and began evacuating the survivors to British Belize. When this news reached London, Poyaisian bonds naturally completely devalued and all losses fell upon the investors.


The Bubble Is Inflating

The history of the fictional country became a kind of pinnacle of the financial madness of the 19th century, just like the tulip mania in the Netherlands 200 years before that and the American mortgage crisis almost 200 years after. "Money, again, has often been a cause of the delusion of the multitudes <...> Men, it has been well said, think in herds <...> they go mad in herds, while they only recover their senses slowly, one by one," British author Charles Mackay wrote back in the 1840s. Today, he may be called the forerunner of modern behavioral finance.

But what is the cause of such madness? American economist Charles Kindleberger described the algorithm of this process in his classic workManias, Panics and Crashes: A History of Financial Crises, based on the Hyman Minsky model of the credit cycle. According to it, any period of heightened financial speculation is preceded by a significant change in economic conditions, which Minsky called displacement, followed by a boom, euphoria, profit-taking, and, finally, panic. An impetus can come from technological inventions and innovations, the discovery of new production methods and the creation of new products (like the Internet in the 1990s), and sometimes the appearance on the map of new countries that had not previously been part of the world economy. Almost all of these happened to be the case 200 years ago.

Since the last third of the 18th century, England was going through the Industrial Revolution that did not only transform the country’s economy, but also changed its place in the international division of labor. Along with it, important changes took place in the financial and especially the banking sectors: since the 1780s, country banks started opening up. They were issuing their own banknotes and providing loans to new enterprises to replenish working capital. By 1810, there were already about 800 such banks. According to a number of researchers, without this new source of credit the Industrial Revolution would have simply lost its power. Meanwhile, this financial innovation created the illusion of endless credit and helped in the financing of increasingly risky projects, provoking a kind of euphoria among lenders and investors (just as the financial innovations of the early 21st century became one of the drivers of the global financial crisis of 2008).

Another instrument that heated up investors' appetites was the free sale of stocks. Although it was banned in Britain (companies required a special permission from the authorities) back in 1720 after the infamous collapse of the South Sea Company, in the 19th century the authorities no longer sought to strictly apply this law. In 1770, stocks of only five companies were traded on the London Stock Exchange, whereas by 1824 the number soared to 624.

The wars with Napoleon played their role, and resulted in the gold standard being abolished in England between 1797 and 1821, which the need to finance government (primarily military) expenditures led to an increase in public debt and expansionary monetary policy. To replace the coins withdrawn from circulation, banks were allowed to issue banknotes, which increased the money supply and led to an increase in prices. By the time of the Battle of Waterloo in 1815, the price level exceeded its 1797 level by 22.3% (it was high inflation for that time), and the public debt was 226% of GDP (the volume got larger only a hundred years later, during the First World War). Nevertheless, the creditors trusted the British government, so about 90% of the additional expenditures were financed by loans.

During the Napoleonic Wars, the British government issued bonds worth 400 mln pounds sterling. Deals (often speculative) with these securities yielded considerable profits: for example, stockbroker David Ricardo earned more than 0.5 mln pounds, after which he decided to retire from stock trading and found a calmer occupation becoming a renowned economist and a member of parliament.

After the end of hostilities in 1815, the British government began to refinance its debts by buying back on the market outstanding bonds with high yields and issuing new ones with a lower coupon. Investors (both British and foreign), who had previously willingly invested in the consols, began to look for more profitable financial instruments. This contributed to increased interest in international securities. The consols were substituted by the foreign government bonds: first, in 1817, they were the French bonds that were issued (with the participation of the Baring Brothers banking firm) to make reparations, and the following year saw the Prussian government borrowing, organized by Nathan Rothschild. After that, foreign borrowings came one after another: Spain, Russia, Denmark, the Kingdom of Naples, Greece, Austria, Portugal were all rushing to take advantage of the opportunity to replenish their financial resources in an easy way.

Meanwhile, a series of bond issues by the new Latin American governments became an actual avalanche. The Spanish American wars of independence were the obvious impetus to it: they resulted in the emergence of new states that had previously been Spanish and Portuguese colonies. Little was known about these new countries, but rumors pointed at their enormous wealth. This was enough to arouse enthusiasm among investors and creditors, which quickly turned into euphoria.

In March 1822, Simon Bolivar’s ambassador in London organized the issue of a 2 mln pounds bond loan for the newly established Republic of Colombia with a yield of 7% that was more than twice the yield of British consols. Unsurprisingly, they saw great demand from investors. The Colombian case was followed by bond issues of Chile, Peru and the already mentioned "Poyais State". However, even the scandal with the latter did not cool down investors’ enthusiasm: in 1824 and early 1825, Brazilian, Colombian (second issue) and Mexican bond loans were issued in London. The terms of the Chilean loan explicitly stated that the buyer of five bonds with a nominal value of 100 pounds sterling could purchase them by paying only a 10% advance. Just five months after the issue, the rate of these bonds increased by a quarter, which meant an effective yield of 250% in less than six months. No wonder that in such an environment, the issue of a Peruvian loan caused a scuffle among investors who feared that they would not manage to get the desired bonds?

A salient feature of these issues was that borrowers received significantly smaller amounts than was stipulated in the bond prospectuses: British banks charged not only rather large commissions, but also the amount of future interest payments. According to the vivid expression of the economic historian Leland Hamilton Jenks, "they received a commission for raising the money, a commission for spending it, and a commission for paying it back." In some cases, the second and third bond loans of the same borrower were used to repay the first one: this is how Ponzi schemes were brought to life. One example is an Argentinian loan, organized in 1824 by Baring Brothers, for 1 million pounds, of which Argentina received only 570,000 pounds.

These events, of course, spurred investment euphoria (its common scenario was described by Robert Shiller in the book Irrational Exuberance that was published in 2000 after the dot-com crash). The environment was supported by financial journalists, who were not too scrupulous in their work after receiving nice paychecks from the loan organizers for favorable articles about borrowers and their securities. For example, in 1826, already in the midst of the crisis, the then young Benjamin Disraeli (the future British Prime Minister) was hired to write an article saying that rumors of a crisis and default were unfounded.

A similar role was played by celebrities and well-known figures, primarily members of Parliament, who were included in the boards of directors of new companies and who were engaged – for a remuneration – in promoting their securities among investors. One of these figures, John Wilkes, a member of Parliament from Sudbury, even earned from the newspapers the name of "Bubble Wilks" for taking on the promotion (for remuneration, of course) of new companies in a number of industries, including mining, railways, natural gas production, etc. The promotion consisted primarily in the fact that he persuaded other members of Parliament to join the board of directors and thus raise the profile of the relevant firm.

The number of foreign securities listed on the London Stock Exchange increased from just a few in 1820 to 35 by 1825, of which 12 were Latin American (see chart).


Index of 50 stocks on the London Stock Exchange, 1811-1831 (1822=100)


Source:The Financial Crisis of 1825 and the Restructuring of the British Financial System by Larry Neal (the University of Illinois at Urbana-Champaign)


This was accompanied by the rising prices of most commodities, which, as it was assumed, would be exported by the borrowing countries in exchange for the exports of British industrial goods. Therefore, no financial difficulties were expected, and, on the contrary, most people at that time believed that British trade and industry were at one of their best conditions. Frederick Robinson, Chancellor of the Exchequer, who was later derisively nicknamed "Prosperity Robinson", talked about this in his parliamentary speech in February 1825.


The Bubble Is Bursting

At the end of 1825, this euphoria, as always, unexpectedly, came to an end. By that time, the number of new securities issues (not only by foreign governments, but also by newly created British companies) was already too large to generate the same interest of speculators. There was more accurate and reliable information about the conditions of Latin American borrowers, which did not really correspond to what was written in the issue prospectuses. The rates of Latin American securities began to decline, and new issues no longer stirred up enthusiasm among investors. The stock price of one of the leading Latin American mining companies, Real del Monte, that was previously extremely popular among investors, fell from 1,550 to less than 200 pounds. The former optimism and trust quickly vanished, investors began to race to sell their holdings, most of which were bought on credit. In turn, banks stopped issuing securitized loans, which further intensified the panic.

The Bank of England, seeing an increased demand for money, was concerned about the reduction of its gold reserves and its possible insolvency (there were banknotes worth 19 mln pounds in circulation, and there was less than 4 mln pounds of gold in the vault). As a result, the regulator curbed its operations and refused to lend to other banks, including the largest ones like Rothschild and Baring banking firms, not to mention country banks. This only worsened the crisis, causing 73 out of 770 country banks to stop operations and go bankrupt. Since country banks lent to local production and trading firms and these firms kept their working capital in those banks (and owners kept their personal savings in them), the consequences for the economy were not long in coming. For example, the construction industry (as indicated by the number of produced bricks) shrank by 30% in 1826 compared to 1825, exports of the cotton industry dropped by 20%, and imports of wool shrank by more than half. The number of bankruptcies more than doubled from 1,141 in 1825 to 2,590 in 1826. It was the first large-scale overproduction crisis. The shops were overstocked with goods, there was more than enough food, but credit and trust vanished, and only gold was accepted as a means of payment, financial historian Edward Chancellor writes with reference to the memoirs of people of that time. According to William Huskisson, who was then the President of the Board of Trade, the country was 48 hours away from barter. And a British financier Alexander Baring later wrote that all trust disappeared: it was hardly possible to find a person who trusted his neighbor, and everyone tried to use their resources only for themselves. It was hard to remember a period in history with such a state of panic among people, Baring added.

Eventually, the government tried to take emergency measures: despite calls to suspend the gold standard, it was saved by a gold loan received from France through Nathan Rothschild, who delivered 300,000 gold coins to the Bank of England (secured by an equivalent amount of silver). The mint hastily minted gold sovereigns, and the Bank of England received permission to issue banknotes of one- and two-pound sterling denominations (before that, the smallest was five-pound sterling banknote), which somewhat helped to reduce the cash shortage and mitigated the non-payments crisis. Although the Bank of England did begin to operate as a lender of last resort, it was too late. Only in 1826 its lending (mainly to commercial banks) increased from 20 mln to 25 mln pounds, but it has not been able to stop the wave of bankruptcies of country banks that was followed by bankruptcies in the real sector and rising unemployment. There were even calls for the government to organize the emigration of the unemployed from England to the British colonies in order to calm down the riots that arose in different parts of the country and were accompanied by the destruction of machines, which the workers blamed for their troubles.

As for Latin American borrowers, all of them, with the exception of Brazil, have stopped payments on their bonds. This episode is often referred to as the first debt crisis of developing countries and the first massive international debt crisis. Peru was the first to stop paying on its debt in April 1826, followed by Colombia in May. Then, within two years, they were joined by Chile, Mexico, Guatemala, the city of Buenos Aires, as well as Greece and Portugal. Investors who bought their bonds have lost almost all their money. Partial refund was made by the city of Buenos Aires, but only 70 years later so only heirs of the actual investors could get it.

Sir Walter Scott was among those affected, and his publisher and manager James Ballantyne went bankrupt due to the bankruptcy of a bank. Since Scott had an agreement with the publisher, the writer, who was then 55, turned out to owe creditors about 46,000 pounds. At a meeting with them, he declared that he would "be their vassal for life, and dig in the mine of his imagination to find diamonds" to pay the debt. In the end, he managed to do it: according to Edward Chancellor, his imagination turned out to be more productive than the South American mines, for the intended development of which the bonds on the London Stock Exchange were issued.


The Aftermath

The crisis affected primarily England and Wales, while for Scotland its impact was rather small, not to mention continental Europe. The acute phase of the crisis was not long: for example, pig iron production, which dropped by 10% in 1826, soared by 33% the following year. The impact on the financial sector was more noticeable.

One of the consequences was significant changes in the British financial system and regulation of banks. The bans on stock trading that had existed since 1720 were finally lifted. Commercial banks that had previously operated in the form of simple partnerships (and the number of possible partners was limited to six) were given the opportunity to be established in the form of joint-stock companies (however, limited liability was still more than 30 years away). Restrictions were imposed on the issue of unsecured banknotes by country banks. The Bank of England has taken the first steps to act in the interests of the banking community and the economy as a whole, and not in the interests of its shareholders, i.e. to become a full-fledged central bank – a regulator of the financial market and a lender of last resort, if necessary.

The crisis has also exposed the problem of information asymmetry: borrowers usually know much more about their financial situation and about their projects than lenders. This problem (later described by the Nobel Prize winner George Akerlof) looked quite specific in relation to the situation of the 1820s: creditors (buyers of bonds) really knew very little about borrowers. Banking houses (the organizers of bond issues, obliged to inform investors) not only did not provide creditors with any reliable information about borrowers (which they themselves did not always have), but described their fine present and future in every possible way, encouraging investors to buy securities of popular issuers and at the same time enriching themselves at the expense of huge commissions. During the collapse, many (but not all) of these bond issue organizers went bankrupt, and this happened to become a common story for the subsequent financial crises.

According to the American economist and historian Michael Bordo, the crisis of 1825 was a rehearsal for many other crises that were yet to come. And we will tell you about them in our future articles.