'Crisis Chronicles: Railway Mania, the Hungry Forties, and the Commercial Crisis of 1847'

James Narron and Don Morgan

Crisis Chronicles: Railway Mania, the Hungry Forties, and the Commercial Crisis of 1847, by James Narron and Don Morgan, Liberty Street: Money was plentiful in the United Kingdom in 1842, and with low yields on government bonds and railway shares paying handsome dividends, the desire to speculate spread—as one observer put it, “the contagion passed to all, and from the clerk to the capitalist the fever reigned uncontrollable and uncontrolled” (Francis’s History of the Bank of England). And so began railway mania. Just as that bubble began to burst, a massive harvest failure in England and Ireland led to surging food imports, which drained gold reserves from the Bank of England. Constrained by the Bank Charter Act, the Bank responded by tightening policy. When food prices fell in the spring of 1847 on the prospects for a successful harvest, commodity speculators were caught short and a crisis, one of the worst in British history (Bordo), ensued. In this edition of Crisis Chronicles, we cover the Commercial Crisis of 1847.

Here's the part I want to highlight:

The Bank of England’s ability to contain the crisis as a lender of last resort was severely constrained by the Bank Charter Act of 1844 (Humphrey and Keleher). The Act gave the Bank of England a monopoly on new note (essentially money) issuance but required that all new notes be backed by gold or government debt. The intent, per Currency School doctrine, was to prevent financial crises and inflation by inhibiting currency creation. Adherents recognized that the Act might also limit the central bank’s discretion to manage crises, but they argued that limiting currency creation would prevent financial crises in the first place, thus obviating the need for a lender of last resort. But, of course, not all crises originate in the financial sector. In the case of the Commercial Crisis, the perverse effect of the Act was to cause the Bank to tighten monetary conditions in both April and October as gold reserves drained from the Bank (Dornbusch and Frenkel). In July, a coalition of merchants, bankers, and traders issued a letter against the Bank Charter Act, blaming it for “an extent of monetary pressure, such as is without precedent” (Gregory 1929, quoted in Dornbusch and Frenkel).

The panic culminated in a “Week of Terror,” October 17-23, with multiple banks failing or suspending payments to depositors in the midst of runs. The Royal Bank of Liverpool shuttered its doors on Tuesday, followed by three other banks, and by the end of the week the Bank of England held less than two million pounds in reserve, down from eight million in January. Systemic collapse seemed imminent. On Saturday of that week, London bankers petitioned Parliament to suspend the Bank Act, and by midday Monday it had done so, thus enabling the Bank to issue new notes without gold backing and to “enlarge the amount of their discounts and advances upon approved security” (J. Russell and Charles Wood, Bank of England). The ability to expand fiat note issuance increased liquidity and helped the Bank restore confidence, and the seven percent discount rate the Bank was charging attracted gold reserves back to its vaults (hence the maxim “seven percent will draw gold from the moon”). By December, interest rates were down substantially from their panic levels.

And the big question:

In contrast to the Bank of England in 1847, the Federal Reserve during the Panic of 2007-2008 was authorized to act as lender of last resort, and, in fact, the Fed acted aggressively to provide liquidity to the financial system in unprecedented ways. Through a variety of newly created facilities, the Fed expanded the types of institutions it would lend to, including nonbanks, and the types of collateral it would lend against, including asset-backed securities.

While some observers have praised the Fed’s actions, others, including some within the Fed, have been more critical. Partly in response to such criticism, the Dodd-Frank Act limits the Fed’s ability to lend to individual firms, as the Fed did during the panic, and a more recently proposed bill would further constrain the Fed’s emergency lending discretion. Will these reforms curb the moral hazard (excess risk-taking) that last-resort lending might invite? Might they aggravate future crises by curbing the Fed’s discretion as lender of last resort?

I have always believed that if another big financial crisis hits, the associated fear and panic would cause the Fed's emergency lending discretion to be restored.