On the crisis of 1763

Via alea I found this paper by Schnabel and Shin on the Crisis of 1763.  While the paper does a good job of showing that the balance sheet channel of crisis transmission proposed by Shin and Adrian was alive and well in the 18th century, I’m not sure that it captures some of the most interesting features of the crisis of 1763.

First of all, the crisis of 1763 was one of the first instances of a lender of last resort acting to save the financial system.  The finance of the Seven Years War (aka the French and Indian War) had led to large scale interbank liabilities across the continent.  [Aside: one of the most important works on the evolution of money that has yet to be written is probably a careful study of the financial innovations and interrelations that made the finance of this war possible.]  For this reason the British banks were heavily exposed to the Dutch banking system — and were able to convince the Bank of England to provide liquidity support to the largest Dutch banks through the crisis.  This action was so remarkable that it is mentioned in the Wealth of Nations (II.2.85).

Notably, this stabilization of the financial system appears to have had moral hazard effects.  As Schnabel and Shin detail, leveraged speculators triggered the crisis in 1763.  While there were some failures in 1763, leveraged speculation would trigger another crisis in 1773.  In this instance, the British banks were less exposed and the Bank of England had just embarked on tighter policies designed to restrain the growth of speculative asset bubbles.  For these reasons, no cross-border liquidity support was forthcoming and two of the largest banking houses in Holland collapsed.

This collapse which was closely tied to both moral hazard and leveraged speculation was a first step in the complete collapse of Holland as an economic power.  With the failure of its largest banks, Holland lost its comparative advantage in trade — low cost short-term financing.  It is not likely to be a coincidence that Holland’s economic growth rates never recovered after this episode.  Without robust economic growth the public debt and ongoing military expenses became an overwhelming burden.  By 1795 — less than a quarter of a century after the 1773 collapse — the Dutch Republic was no longer an independent country.

Personally, I think that the lessons of the Crisis of 1763 are much harsher than those drawn by Schnabel and Shin.  An economic powerhouse still in its heydey faces a financial crisis and is bailed out.  Just ten years later the next crisis comes, and there is no bailout this time.  The resulting financial collapse ends the country’s status as an international financial power and over time as an economic power.

Financial systems are not stable entities.  They come and they go.  A policy that manages to put the financial system on sound footing for another half-century — such as Roosevelt’s reforms or the Bretton Woods agreement — are all one can hope for.  Policymakers should be focused on reforms that will buy our financial system another half-century of stability.

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