by Felix Martin
As time went on, the bill brokers began to act not only as agents of the commercial banks, but as finance houses in their own right. Banks would deposit their excess funds with the brokers on demand, and the brokers themselves would discount the provincial or foreign entrepreneur’s bills.15 The risk now resided on the brokers’ balance sheets—and they would reap any profits: in modern terminology, they had ceased to be just brokers and had become dealers. By the middle of the nineteenth century, the London bill brokers were the merchant bankers at the very heart of the global financial system—the direct heirs of the Italian exchange bankers of medieval Europe, but lords and masters of an estate incomparably more international, more complex, and more wealthy. When Parliament established a committee to investigate the London capital markets in 1857, the reaction of its members to an account of the bill brokers’ role was nothing short of astonishment. Did the Governor seriously mean to say that “[a] man cannot buy … tea in Canton without getting credit from Messrs Matheson or Messrs Baring?” they asked. “That is so,” came the reply matter-of-factly. Even six thousand miles away, it was the name of a bill broker in Lombard Street that was wanted to persuade a merchant to part with his goods. It was via the bill brokers that “English credit supplies the capital of almost the whole world.”16
By the 1830s, Overend, Gurney was the greatest bill broker in all of Europe. By the 1850s, it was the greatest in the world, turning over £170 million a year, taking deposits from every bank in the City, and discounting bills of industrialists and merchants from Lancashire to Lahore. The firm returned annual profits of more than £200,000 to its partners, and had a balance sheet ten times larger than those of the two biggest banks in Britain combined.17 Never in history had there been so uniquely important a banking house or one whose name and credit were so synonymous with the credit of the nation’s—even of the world’s—economy. As Walter Bagehot attested, the reach of the credit of the greatest bill broker in London was such that “[n]o one in the rural districts (as I know by experience) would ever believe a word against them, say what you might.”18 It was “the most trusted private firm in England”: so great was public confidence in its acumen at screening borrowers that “[p]robably not one-thousandth of the creditors on security of Overend, Gurney and Co., had ever expected to rely on that security, or had ever given much real attention to it.”19 It is just such unquestioning confidence in credit that is the essential ingredient of liquid financial markets, as the Governor of the Bank of England knew: “[b]anking … depends so much on credit,” he concluded, “that the least blast of suspicion is sufficient to sweep away, as it were, the harvest of a whole year.”20
This was a lesson that had been learned time and time again in the course of the preceding half-century. The year 1825 had seen the first financial crisis of the industrial era, following a speculative bubble generated by the over-expansion of the new country banks. When it burst, it had brought the country to “within twenty-four hours of a state of barter.”21 Thereafter crises had occurred with alarming regularity. In 1836, a bubble in railway bonds burst. A decade later, there was another boom and bust; and in 1857 the end of the Crimean War sparked an investment boom that again ended in distress and panic. Many a bank had been laid low by one or other of these successive crises; but Overend, Gurney and Co. had survived them all, and prospered. The crisis of 1857 forced two momentous changes to the “Corner House,” however.
The first was a regulatory development. Ever since their transformation into dealers carrying risk on their own balance sheets after the crisis of 1825, the bill brokers had enjoyed access to loans from the Bank of England in times of crisis. But in the Bank’s view, the crisis of 1857 had exposed a tendency to rashness amongst the bill brokers: the Directors had noticed that the lion’s share of the Bank’s emergency lending had for the first time gone to the bill brokers rather than the banks.22 There was much talk of the fact that access to the emergency facilities was encouraging the brokers to invest in over-speculative bills. The Bank’s Directors therefore resolved in March 1858 to end the bill brokers’ access.
At the very same time that its business environment was changing in this way, the house of Overend, Gurney and Co. faced a second challenge. The original managing partners retired, and a younger generation took the reins. It quickly became apparent that they lacked some of the distinctive Quaker qualities of their illustrious forebears. In contrast to the stern solidity of the fathers, the sons were precipitous in their decision-making, ambitious for the trappings of wealth, and—the most dangerous flaw of all in a banker—credulous. If the 1690s had been the decade of the Projector in London, it was the company promoter who was ubiquitous in the 1860s; and where the former had been famous for his amazing, if sometimes harebrained, inventions, the latter was a byword for little more than the main chance—if not outright fraud. The new managing partners of Overend, Gurney and Co. quickly attracted a strong following amongst such characters; indeed, as one of their own clients put it, “a miniature court of Louis XIV.”23
The intention of the Bank’s withdrawal of its lender of last resort facility from the bill brokers had been to discourage the riskier end of their discount business. At Overend, Gurney, however, it had exactly the opposite effect. The new partners lost no time in filling the firm’s portfolios with a succession of speculative, long-term, and high-risk investments. Early on, their own appetite for the famous Quaker virtue of hard work began to flag, and they started to delegate much of the firm’s investment strategy to a newly recruited lieutenant, a certain Edward Watkin Edwards. As a former partner in a well-known firm of accountants and an ex-assignee of the bankruptcy court, he was “regarded at the ‘Corner House’ as a great mathematician and a high financial authority.”24 His true calling was less elevated: “[m]y vision,” he told a prospective borrower, “is to become a very rich man.”25
The combination of all these changes proved disastrous. In the space of two years, Overends’ annual profit of £200,000 had turned to a loss of £500,000. The new managers attempted to regain profitability by taking more risk. They made a bold foray into emerging market bonds, financed a port development in Ireland, and made a host of other long-term, speculative investments, the only unifying feature of which was that every one was funded, as was the way with the bill brokers’ business model, by deposits from the commercial banks that could be withdrawn on demand. If, heaven forbid, there was to be a market panic, and the banks were to demand those deposits back, there was now no question that without support the firm would be exposed as insolvent.
By April 1865, the situation was becoming desperate, and the partners met to weigh up the options. It was clear that new capital was needed to make good the losses and supply the means to rebuild the firm’s fortunes. The question was where it should come from. New partners could be allowed to buy in; or the old partners could put up more money; even a merger with a rival bill broker was considered. But in the end, it was the oldest trick in the City’s books that was chosen: an initial public offering that would transform the partnership into a public company and thereby offload the problem on to that perennial saviour of the City insider’s bacon—the general public.26 Those in the know were suspicious. The Economist went as far as the libel law would allow when it welcomed the fact that a public offering of shares would oblige Overends “to publish an account of the nature of their business” which “[f]or many years it has been a matter of public notoriety … [has been] of a sort different from those conducted by bill-brokers ‘pure and simple.’ ”27 But as the partners well knew, such subtle admonitions sailed miles over the heads of most prospective investors. “Needless to say,” wrote one eminent historian of the episode, “the public did not read the prospectus, and in consequence the issue was a great success.”28
For the first few months of its existence, shares in the new limited liability company, Overend, Gurney and Co. Ltd., traded at a premium. But late in the year, the Bank felt it needed to put another squeeze
on the market. Bank Rate was raised to 8 per cent, and at the beginning of January 1866 the first sign of distress appeared in a most unfortunate quarter. A middling boutique railway bond arranger went into default on liabilities of £1.5 million. As bad luck would have it, the name of this quite unrelated firm was Watson, Overend and Co. Now the ignorance of the market worked against Overends. A connection was assumed, and—just as a precaution—withdrawals began. It became known that the old partners were having to sell assets. The withdrawals accelerated. In two months, £2.5 million worth of deposits streamed out of Overends, even as loans continued to go bad and the general panic spread. In a final gamble, on 9 May, the management made an urgent and humiliating appeal to the Bank of England for emergency support. But a general crisis was in prospect, and to bail out one firm alone would open the Bank to unanswerable charges of encouraging moral hazard. The Governor’s response was therefore swift and unequivocal. There would be no lifeboat. At 3:30 p.m. on Thursday, 9 May 1866, Overend, Gurney and Co. Ltd. suspended payment.
The effect of Overends’ failure was catastrophic. “It is impossible to describe the terror and anxiety which took possession of men’s minds for the remainder of that and the whole of the succeeding day,” reported the Bankers’ Magazine. “No man felt safe. A run immediately commenced upon all the banks, the magnitude of which can hardly be conceived.”29 The next day—the day that was to become known in City folklore as Black Friday, the ancestor of many a Black day since—was worse. “[A]bout midday the tumult became a rout,” reported The Times. “The doors of the most respectable Banking Houses were besieged … and throngs heaving and tumbling about Lombard Street made that narrow thoroughfare impassable.”30 It was a classic financial crisis: “Not long ago, men trusted everybody; it would almost seem that now they will trust nobody.”31 All liquidity had evaporated. No broker would deal. Only the Bank of England continued to discount bills at the punitive interest rate of 9 per cent. Over the preceding week, its reserves had already fallen by half. Now, in a single day, it lent £4 million. The Directors were transfixed. As the Governor put it afterwards, “I do not think that anyone would have thought of predicting, even at the shortest period beforehand, the greatness of those advances.”32
By Saturday, everything was confusion. In the morning, the Chancellor of the Exchequer, William Ewart Gladstone, reassured the House of Commons that although there was “panic and distress … without parallel in the recollection of even the oldest men of business in the City of London,” he had “not the least reason to suppose” that the Bank would ask him to suspend the Act stipulating the strict upper limit to the note issue.33 He then returned to the Treasury to find the Bank’s Governor telling him that with only £3 million left in its reserve, the Bank could not withstand another day like Friday, and asking just that. Gladstone acceded, signing a letter of suspension like the ones that had been needed in 1847 and 1857, on the condition that Bank Rate be further raised to 10 per cent. As in previous crises, the mere word that the Bank’s firepower was no longer limited was enough to quell the panic. The acute phase of the crisis began to subside, and though the demand for sovereign money remained unusually high for months following the crisis, the focus shifted to counting the casualties in the post-Overends era. These were considerable. Three English and one Anglo-Indian bank had been forced into liquidation—at a time when there was no deposit insurance. Dozens of bill brokers and finance companies had gone under.
But as always, the real ramifications of the crisis were felt far beyond the medieval wards of the City of London and long after the acute panic had subsided. All over the country, the credit crunch resulting from the damage to confidence brought a severe contraction of business. More than a hundred and eighty bankruptcies were recorded in the three months following Black Friday.34 Unemployment rose from 2.6 per cent in 1866 to 6.3 per cent in 1867, and rose again in 1868 before a proper recovery took hold. Sectors that relied particularly heavily on credit, such as the global shipping industry operating from the wharfs of London’s East End, were especially badly affected: the annual report of the Poplar Hospital, a charitable institution for dockers, recorded that “there has never been a year so pregnant with disaster both public and private.”35 All in all, it had been the greatest financial crash since 1825—indeed, if only by virtue of the far more advanced development of the City and its international importance compared with that time, the greatest crash of all. Little wonder, then, that the editor of one contemporary journal, surveying the wreckage seven years later, called the collapse of Overend, Gurney which had sparked the catastrophe, “the model instance of all evil in business.”36
WHAT ECONOMICS FORGOT
That journal was The Economist, and its editor was none other than Walter Bagehot—the first of the thinkers that Lawrence Summers identified as representatives of an invaluable, but neglected, tradition in economic thought. Bagehot occupies a singular place in the history of economics. He was born in 1826, and so had no formal training in economics: he used to refer to himself as “the last man of the ante-Mill period,” referring to John Stuart Mill’s 1848 Principles of Political Economy, the first real textbook of economics which organised the subject to be taught in schools and universities.37 Bagehot had learned everything he knew on the job—first as a banker, working for an uncle who controlled the largest bank in the West of England, and later as a financial journalist. Yet the profound influenee of his writings after he became editor of The Economist in 1860 on both economic thought and economic policy was without precedent. “Bagehot’s position amongst English economists is unique,” wrote Keynes in 1915, summing up the conundrum. “Some of his contributions to the subject are generally acknowledged to be of the highest degree of excellence. And yet in some respects it would be just to say that he was not an economist at all.”38
Close familiarity with actual developments in the commercial and financial worlds was, however, of far greater worth than any amount of abstract theorising. Never was this more so than in the case of the crisis of 1866. When Overend, Gurney failed, Bagehot had already lived through three financial crises and their attendant economic slumps. These crises, he had come to realise, were an intrinsic feature of the modern monetary system as it had evolved over the previous century. The received economic wisdom on how to manage and prevent them, however—the wisdom of Adam Smith and John Stuart Mill—was hopelessly out of touch with reality. The potential consequences of this mismatch, Bagehot believed, were disastrous—and he had devoted many pages of journalism in the previous decade to attempting to correct it. After the Overends crisis Bagehot resolved to write a simple statement of his case—something that could be understood by the politicians who would need to introduce the reforms. The result, published in 1873, was his masterwork—Lombard Street, or, a Description of the Money Market.
Lombard Street deliberately set out to be short, polemical, and lively—“a piece of pamphleteering, levelled at the magnates of the City and designed to knock into their heads, for the guidance of future policy, two or three fundamental truths,” as Keynes called it.39 Yet it was also a brilliant work of economic exposition and analysis. Two features in particular distinguished it from the works of Mill and the classical school. The first was that Bagehot’s economics started explicitly from money, banking, and finance—which Bagehot saw as the governing technology of the modern economic system. The second was that Bagehot insisted that theory should be constructed to fit the reality of the monetary economy, rather than the other way round. The very title and opening sentences of Lombard Street proudly advertised these departures from the abstract economics of Bagehot’s classical forebears. “I venture to call this Essay ‘Lombard Street,’ and not the ‘Money Market,’ or any such phrase,” wrote Bagehot, “because I wish to deal, and to show that I mean to deal, with concrete realities.”40
And what Bagehot saw as the most basic reality to be grasped about the modern monetary economy was that the conventional understanding of money as g
old and silver—the understanding adopted by habit by the man in the street, and the one promoted by the academic economists of the day—was confused. The slightest acquaintance with Lombard Street revealed that the money overwhelmingly used by businessmen was by and large private transferable credit: above all, bank deposits and notes. “[T]rade in England,” he explained, “is largely carried on with borrowed money.”41 This simple and apparently innocent fact, Bagehot argued, had profound ramifications for understanding the modern economy’s cycles of boom and bust, and how to moderate them. If money is in essence transferable credit—rather than a commodity medium of exchange, as the academic economists insisted—then fundamentally different factors explain the economy’s demand for it. Meeting demand for commodities is a simple matter of ensuring a sufficient supply on the market. When it comes to transferable credit, however, volume alone is not enough: the creditworthiness of the issuer and the liquidity of the liability come into play. And both these factors are determined not technologically or physically but by the general levels of trust and confidence. “The peculiar essence of our banking system,” wrote Bagehot, “is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”42
It was from this starting point alone that a proper understanding of the modern economy could be constructed, Bagehot argued. The central importance of the intrinsically social properties of trust and confidence called for a quite different focus for economic analysis than that of Mill and the classical school. “The main point on which one system of credit differs from another is ‘soundness,’ ” wrote Bagehot. “Credit means that a certain confidence is given, and a certain trust reposed. Is that trust justified? And is that confidence wise? These are the cardinal questions.”43 And the answers to these cardinal questions were, he was sorry to disappoint his academic elders, not amenable to mechanical theorising. “Credit is an opinion generated by circumstances and varying with those circumstances,” so that genuine insight into the functioning of the economy requires an intimate familiarity with its history, its politics, and its psychology—“no abstract argument, and no mathematical computation will teach it to us.”44