Bagehot

by James Grant

  † In “From Luther to Hitler,” a history of Fascist and Nazi thought published in 1941, William Montgomery McGovern, a professor of political science at Northwestern University, contended that Bagehot’s writings, especially Physics and Politics, served to inspire Adolf Hitler. If so, the Führer overlooked Bagehot’s expressed preference for discussion over battle and his plea, contained in his 1870 article “The Late Lord Clarendon,” for nonintervention in foreign conflicts. Thus, “We wish that foreign nations should, as far as may be, solve their own problems; we wish them to gain all the good they can by their own exertions, and to remove all the evil. But we do not wish to take part in their struggles.” David Clinton, “‘Dash and Doubt,’ Walter Bagehot and International Restraint,” Review of Politics 65(1):107.

  CHAPTER 15

  NEVER A BULLISH WORD

  In 1875, a select committee of the House of Commons, chaired by Robert Lowe, produced a history of eight years of English financial misadventure in faraway places. Central and South American governments had been borrowing money in London without repaying it—in some cases, without the means even to keep up the appearance of repaying it. “Semi-civilized,” was Bagehot’s characteristically unsentimental designation for the needy debtors.* Certainly, those governments were put upon, and some were insolvent. The parliamentary postmortem was a chronicle of rapacity and cupidity on the parts of the bankers, brokers, and loan managers, of venal ineptitude by the investors and borrowers. With one minor exception, none of the debtor governments had repaid “any portion of its indebtedness in respect of these loans, except from the proceeds of the loans themselves.” Thus did the City of London and its foreign clients anticipate the methods of Charles Ponzi.

  Censurable though it was, the MPs concluded, the malfeasance of the bankers, brokers, and loan contractors did not by itself clinch the case for remedial legislation. “Your Committee,” concluded the report of the Select Committee on Loans to Foreign States, “feel that it is not their duty to apportion the blame to the different actors in these transactions.” In support of this stance of moral neutrality, the committee quoted a comment attributed to the secretary of the London legation of the government of Honduras, in the wake of his country’s default: “the fault of the failure falls with equal force upon all who have interests, rights, claims, complaints, or any participation whatever in these matters. It is a kind of original sin, which reaches the most innocent who have anything to do with this undertaking.”1

  Perhaps one man was without sin. If Walter Bagehot ever wrote a bullish word on the public securities of Honduras, Spain, Costa Rica, the city state of Santo Domingo, Peru, Bolivia, Egypt, or the Empire of Turkey, there is no record of it. Bagehot was bearish because the governments were unfit, and besides, the interest rates they paid—or at least contracted to pay—failed to compensate English lenders for the catastrophic risks they bore. A “margin of security” was what every investor required, Bagehot counseled his readers, which Honduras, Costa Rica, Santo Domingo, and the rest were unable to provide. So saying, the editor of the Economist anticipated the twentieth-century American value investor Benjamin Graham, who would build a philosophy of investment on the imperative need for a “margin of safety.”

  Demand for the high-yielding bonds of faraway states has waxed and waned for two centuries. It waxed in the boom of the 1820s and waned in the years succeeding the bust. Investors filtered back into the market arrived in force in the aftermath of the failure of Overend Gurney in 1866. In the dull, post-panic British economy, savers strained to earn more than the 3.25 percent available on perpetual British government bonds.

  The straining was where the trouble started. Bagehot had warned about the perils of low interest rates since at least the early 1850s. “John Bull,” as he advised the readers of the Inquirer, quoting but not naming himself, “can stand a great deal, but he cannot stand 2 percent.” He pressed on: “People won’t take 2 percent; they won’t bear a loss of income. Instead of that dreadful event, they invest their careful savings in something impossible—a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea, a corporation for shipping skates to the Torrid Zone.”2 In 1867, with the Bank of England’s discount rate quoted at 2 percent on the button, savers invested their careful savings across the seas. Bagehot anticipated the consequences of the coming bond bubble almost before it began to inflate.

  Egypt, then a semi-autonomous province of the Ottoman Empire, was one such seeker of funds, and the Economist singled it out for special mention. “Many persons have not a distinct perception of the risk of lending to a country in a wholly different state of civilization,” the editor advised his readers in November 1867. It was the very month in which the first installment of Physics and Politics hit the stands; Bagehot, for one, had been giving the nature of primitive societies close and concentrated thought. “They can hardly imagine the difficulties with which such a country struggles, and the dangers to which it is exposed. They forget that national good faith is a rare and recent thing.”3

  Before modern financial disclosure, corporate insiders generally had the information that the public lacked, but in the case of Egypt, not even the Egyptian government had the figures. It would later come to light that the Egyptian state—its finances casually commingled with those of the spendthrift autocrat Ismail—owed £30 million of debt on less than £6 million of annual revenue.4 Neither did Bagehot have the Egyptian facts, though he intuited the essentials. “[O]ur notion of continuous political morality is very modern, and hardly penetrates to oriental despotisms,” he observed, before closing with the kind of words that typically resonate more in the rueful aftermath of a crash than in the carefree boom that precedes it: “We lend to countries whose condition we do not know, and whose want of civilization we do not consider, and, therefore, we lose our money.”5 Still and all, a new Egyptian loan that year was priced to deliver a current yield of 10 percent.6

  Admonitions were a staple of the Economist’s coverage of sovereign bond issuance in this era. Not quite three years later Bagehot wrote:

  in reality men of business have a great defect as investors of spare money. They are accustomed to a high rate of profit in their business, and they cannot but look with contempt on 5 per cent., 4½ per cent., and all such rates. They think that “any old woman could make those figures,” but that they, with their long experience of business matters, ought to make something much better. But if the years after panics (and not less but more than any other, the last year since 1866) were examined it would be found that such men of business did not make more but less.7

  Bagehot had pulled his punches in the critical months leading up to the Overend Gurney collapse—the legal risk made plain speech inadvisable, he claimed after the damage was done. There was no such holding back with respect to the risks of lending to improvident foreign governments. Here, Bagehot was forthright, unwavering, indefatigable, and seemingly indifferent to the City interests, both to their hostility and their blandishments.†

  In exposing the dangers inherent in overseas bond investing, the Economist performed a public service unmatched by any other leading newspaper in England or Scotland.8 And in urging the British government to forbear from intervening on behalf of English investors when foreign governments defaulted, Bagehot stood up for the ideal of personal responsibility in financial dealings. His literary, political, and biographical contributions to one side, the body of work he produced during the foreign-government bond craze of the late 1860s to the mid-1870s stands as his signal journalistic achievement.

  No such glory covered the financial facilitators of the City. An 1869 loan to the Republic of Santo Domingo set the investment tone for the 1870s. The issuing government received proceeds of only £38,000 out of the many hundreds of thousands of pounds raised through bond sales in its name. As for the investors, they received neither interest on their investment nor the return of their principal. News that the Santo Domingo senate repudiated the loan in July 1870
somehow failed to cross the Atlantic until September 1872. Practically speaking, the loan was a hoax, the involvement of J. S. Morgan & Co.—the firm headed by Junius Spencer Morgan, successful and well-reputed father of J. P. Morgan—notwithstanding. Not all of the proceeds were unaccounted for. Some £93,000 came into the possession of the consul general for the Republic of Santo Domingo in London, Edward Herzberg Hartmont. These funds Hartmont retained for himself, as the committee dryly reported, “and invested in his business, ‘partly good investments and partly bad investments.’” Certainly, in the case of Santo Domingo, original sin was front and center.

  Peru was a heavy and frequent borrower, though the former Spanish colony was no pillar of political stability. In the first quarter century of its existence as an independent republic, the Pacific-facing nation had had “50 changes of government, five constitutions, countless internal rebellions and five foreign wars, including wars with each of its neighbors except Brazil.”9 That took Peruvian history to 1845. In the interval from 1845 to 1876, there had been sixteen more presidents, of whom “ten accessed power through violent means, usually after a major rebellion or civil war.”10

  The government of Peru had borrowed and defaulted in the mid-1820s; not until 1849 did it patch things up with its foreign creditors. This unpromising start to Peruvian sovereign finance made no indelible mark on the English investors of Bagehot’s day. Like many investors in most days, they had no head for history.

  Governments and wars came and went, but if the demand for capital was likewise perennial—there were armaments to buy and railroads to build—so, too, was the income afforded by guano exports.

  English investors were content to trust in the seabirds whose droppings built the nitrogen-rich deposits on the Chincha Islands, 13 miles off the southwest coast of Peru. It was this ostensibly inexhaustible fertilizer revenue that paid the interest on the government’s debt, whoever happened to occupy the office of president. Guano sales topped £2 million annually between the late 1850s and early 1870s. As British farmers furnished much of that revenue with their pounds and shillings, and since those funds were earmarked in London for paying the British holders of Peruvian debt, the brokers and bankers could say that the high-yielding bonds were absolutely safe.

  Bagehot knew better. In 1870, he warned his readers against a pending £12 million Peruvian bond sale, observing that a drop in guano sales would ruin the government’s finances. Without such revenue, there would be no means to service the debt already incurred, never mind the pending £12 million. The new loan, Bagehot pointed out,

  is for ten times the annual revenue of the State, exclusive of guano; if England were to borrow £600,000,000, it would only be borrowing in proportion. As soon as there is no more guano there will certainly be an enormous deficit, and the creditor will either have to be sacrificed, or his claims met out of new loans, a process which could not be of long continuance.

  Then, too, receipts from the sale of guano weren’t “revenue” at all—it was a misnomer. They rather represented the liquidation of the national capital stock, “an exactly equivalent process to incurring debt; and the financial consequences of both borrowing, and selling its property, do not require to be stated.” One might ask, the banker-cum-journalist posed, why the government was borrowing at all. It must be that “the guano is not immediately available, that the Treasury is empty, and that is why Peru wants the money.”11

  Bagehot and the Economist were certainly correct, though it can’t be said that their prescience altered the course of events. In that time, as in others, investors demanded income. And no more in their time than in ours did the recitation of the facts slake that thirst for high rates of interest when only low rates were quoted on safe investments. John Bull was falling into the recurrent cyclical trap.

  Honduras, still another money pit, had raised £1 million in 1868 on the promise of a 10 percent yield, and was back again in June 1870 with another £2.5 million of bonds, also at 10 percent. On those £3.5 million of combined borrowings, the annual interest charge, £350,000, would amount to twice the government’s evident annual revenue—three times as much when allowing for payments into a sinking fund. Here, in the Economist’s words, was a “half-civilized” government borrowing more than it could possibly repay. If Honduras could pass for a solvent nation, anything could.12

  Bagehot was right about the market: it refused to listen. And he was right about the desperation of the Peruvian fiscal position. By 1872, the government in Lima was back to raise an additional £15 million. “If guano . . . does not yield at least £3,000,000,” Bagehot predicted, “the creditors will not be paid.”13 It subsequently came to light that guano exports yielded only £2 million a year.14 The creditors went unpaid.

  Peru did sell its £15 million of bonds, though at a heavy discount from par. The price had already dropped to 71½ from 77½ in October 1872 when Bagehot returned to the then familiar subject under a headline which left no room for misinterpretation: “A Warning To Investors In Foreign Government Securities.”

  “At certain times,” Bagehot resignedly led off, “it seems very useless to warn people about the risks of some foreign investments.” And this was one of those times, as

  almost any community that calls itself a State may obtain large sums from people who certainly make very little inquiry. They are tempted by the name of a State, the high rate of interest, the fact that everybody does the same, and other such irrelevant reasons, assisted too often, it is to be feared, by an artificial premium on the issues which the promoters contrive to maintain on the Stock Exchange.15

  A sweet reward to the prescient financial journalist is the pleasure of self-quotation (as prescience is intermittent, so is the pleasure sporadic). Tastefully, Bagehot let a statistical table sing his praises, for circumstances in the foreign loan market indeed provided him wide scope for self-commendation. The figures compared the prices of loans at the date of issue with the marked-down prices prevailing at the Economist’s press time. Honduras showed especially well: a collapse from an issue price of 80 in 1870 to 36 in 1872. The Santo Domingo bonds of 1869 had declined from 70 to 50. Bolivian, Costa Rican, and Paraguayan securities had likewise depreciated.

  “We doubt,” Bagehot wrote,

  if so great a disaster has for a long time befallen the investment of so considerable an amount of capital in Stock Exchange securities. The depreciation is almost on the scale which occurs when there is a great collapse of bubble companies, though the victims here are fortunately spared the worse aggravation of “calls” [the obligation on the part of the stockholder to stump up more money in the event of the insolvency of the enterprise in which he owns a fractional interest]. It is at least on a far larger scale than what takes place temporarily in an ordinary Stock Exchange “panic”—with this difference, that it has occurred in a quiet time, and from some inherent vice in the things themselves apart from the condition of the market.16

  The times were quiet but the savers were frenzied. Low interest rates had tempted them into heedless action—the very kind Bagehot had decried in Physics and Politics.

  THE YEAR 1873 IS notorious for the American financial panic that, while largely sparing London, disarranged commerce and finance on both sides of the Atlantic long after the first shock waves subsided. It was an autumn crisis, and Bagehot gave no warning of the coming storm that summer when he again took up the subject of Egypt. What he did foresee was the looming Egyptian bankruptcy—indeed, there was no need to foresee it. With some essential figures on Cairo’s financial position at last placed on the public record, he could see it with his own eyes.

  The nation that owed its creditors £30 million in 1867 was now on the hook for £63 million. Debt service alone exceeded £6 million a year, on annual revenue of perhaps £7.3 million. The difference left scant room for the tributes, bribes, wars, palace-building, harem maintenance, fetes, and public works that absorbed so much of the government’s income. The Suez Canal, the greatest of these
public works, was Egypt’s to pay for and Europe’s to profit by. The costs of the festival to celebrate its opening in 1869 were locally reckoned at £1.3 million. The cost of construction was as much as £17 million, by Egypt’s telling, and £10 million according to the French builder, Ferdinand de Lesseps. The cost in human life borne by the hapless peasants—fellaheen—many of whom were conscripted into the murderous pick-and-shovel work, is estimated in thousands.

  As for that £7.3 million in budgeted yearly revenue, Bagehot observed,

  according to our experience of foreign budgets, we should be inclined to doubt whether the actual revenue does not fall so far short of the estimate that the interest on the debt would absorb the whole of it. In other words, Egypt must be on the brink of insolvency, and entirely depends for paying its way on the funding or renewal of the immense mass of floating obligations at 12 percent interest.17

  Egypt was an example of the new face of the sovereign bond market. Creditworthy countries rarely borrowed in times of peace—they had too high a regard for their financial reputation to run up debts for no essential purpose. The striking feature in the contemporary London market was the presence of governments that borrowed to service their previously incurred debts.

  Spain was no newcomer to the concert of nations, but its government was one of these profligates. Spanish credit had fallen under suspicion when the cost of debt service came to absorb one-half of Spain’s public revenue. Turkey and Egypt had strayed well beyond that red line by allocating between two-thirds and three-quarters of governmental receipts to keeping creditors at bay. For Spain, there was no way out except, in 1873, default (in the wake of which, the desperate government was reduced to paying rates of interest of 30 percent and up—way up, according to The Times, which, in 1876, cited one Spanish loan “which brought the lender 109 percent”). “Turkey and Egypt possess, no more than Spain did, immunity from the rules of financial arithmetic,” the Economist warned, “and we cannot but believe that the same inexorable necessity will very soon arise.”