The 1772 Credit Crunch

July 3, 2014, updated July 2, 2020

In 1772, a credit crisis originating in London hit and spread over Europe and affected the American colonies. The cause was the creation and over-circulation of bounced checks then known as redrawn bills of exchange. Speculators used these bills to gamble with bank money and the deposits of other people. The end result was a loss of capital, creating a credit crunch, which led to an economic downturn hitting Europe and too-big-to-fail companies, like the East India Company which had to be bailed out.


banknote

Sound familiar? This is because the Credit Crisis of 1772 was essentially the same as the Credit Crunch of 2008 and even similar to the 1997 Asian Financial Crisis. Both were caused by the overtrading by speculators and both given the wrong solutions:

1772 Credit Crisis1997 Asian Crisis2007 Credit Crunch
Responsible bankAyr BankIMFLehman Brothers
Paper or Tool UsedChecks or Bills of Exchange, backed by estateHot moneyCollateralized Debt Obligations, backed by subprime houses
Immediate Losses£3m wiped out$9b ASEAN GDP and $170b South Korea GDP decline$300b wiped out
CauseSpeculators who wanted to get rich quickLocal and foreign speculators, such as forex tradersBankers who wanted to get rich quick
Solution 1773 Tea ActIMF BailoutTroubled Asset Relief Program (TARP) and QE
Immediate EffectThe American colonies revoltToppled governments in ASEAN, Riots against Chinese Occupy Wall Street

The 1773 Tea Act was used to bail out the East India Company, IMF loans were used to bailout the Asian banking system, and the TARP was used to bail out the investment banks. These solutions addressed the effect and not the cause of the crisis which were the big companies, or what Adam Smith called projectors.

The debtors of such a bank..were likely..chimerical projectors, the drawers and re-drawers of circulating bills of exchange, who would employ the money in extravagant undertakings..

The projectors of 1772 were the mercantile companies involved in the commodities trade. The projectors of 1997 were speculators such as George Soros involved in the forex trade, while the projectors of 2008 were the investment banks involved in the housing trade.

Same Problem, Same Wrong Solutions

Since the solutions did not address the root causes, more problems emerged. The Tea Act angered colonists, helping fuel the American Revolution, leading to the loss of the American colonies for Britain. The Asian Crisis led to protests which caused politicians to get replaced. TARP and quantitative easing created the huge but unproductive American debt without increasing GDP, in a phenomenon known as secular stagnation.

The QE solution is bit unique because it is arbitrary. Unlike the 1773 Tea Act which took money from the colonies and the IMF bailouts which come from its member countries, the money from QE is just created arbitrarily. While the sourcing of funds for the first two are felt immediately felt by the suppliers of those funds, the effects of QE have a long delay. The pain from the Tea Act and IMF bailouts were felt immediately, but the pain from QE will be felt by the later generations -- those who did not cause the problem. An easy proof is Japan which has been doing QE since the 90s and now has a huge public debt for little gain.

Such improvident anticipations gave birth to the more ruinous practice of perpetual funding. This practice puts off the liberation of the public revenue from a fixed period to an indefinite period, never likely to come. However, it raises more money than the old practice of anticipation. When men became familiar with funding, it became universally preferred to anticipation during great state exigencies. Relieving the present exigency is always the object of government. The future liberation of the public revenue they leave to the care of posterity.

The QE of the US, like Japan, also has created a huge public debt without raising GDP proportionally. This is because the money is merely circulating between dealers and dealers, and not between dealers and consumers. Every economy has two levels of circulation:

  1. The one between dealers and dealers. In Economics, this is M3
  2. The one between dealers and consumers. In Economics, this is M0 to M2, best represented by M1

QE gives money to the banking system in order to mobilize productive labor. However, because of the mercantile doctrine of profit maximization  this money is used instead to raise asset prices for resale and for increased outflows, and not for producing anything real. Thus, profit maximization under a regime of fiat (from the 70's), financial liberalization (from the 80s and 90s), and QE (from 2009) greatly increase M3 without increasing M1. Inflation is also not so much affected because the Consumer Price Index is based on things bought by ordinary people. This lack of inflation and employment then prompts central bankers to further increase M3, leading to more inequality.

Same Oppression, Same Riots [Updated July 2020]

Sooner or later, the inequality becomes unbearable and people begin to riot and rebel. The 1772 Credit Crunch ultimately caused the Americans to revolt. The Asian Crisis caused some Asian governments to change leaders. In the US, the inequality from QE led to the rise of populist leaders and, more recently, riots.

The recurrence of financial crises is rooted in the profit maximization doctrine, which is a moral issue at its core. This is why the solution to a banker's crisis can never be ultimately solved by the banker nor by any monetary policy. Instead, it is solved by fiscal and regulatory policies such as anti-trust. In the next post, we shall explain the proper solution to financial crises, as explained by Adam Smith, a moral philosopher.