This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Aggregate Demand and Aggregate Supply: The British Downturn of 1825-6

It is unfair to expect Jean-Baptiste Say to have seen this back in 1803. He did not live in an industrial economy. He had not seen a deflationary financial panic or elevated cyclical unemployment. John Stuart Mill had the advantage of having seen the first industrial business cycle in Britain in the form of the 1825-6 downturn, a downturn generated by the 1825 financial crisis, which was in its turn produced by the collapse of the early-1820s canal boom.

Figure 1 plots the percentage change in British apparent cotton consumption across the bulk of the nineteenth century. In the forty-five years of peace between the end of the Napoleonic Wars in 1815 and the disruption of the global cotton industry by the U.S. Civil War that started in 1861, apparent cotton consumption by the textile factories of Great Britain declined in only seven episodes. Cotton textile production was the high-tech high-profit rapidly-expanding leading sector of Britain’s first industrial revolution, growing at a pace of more than 8% per year on average. 1826 was the second-worst decline in this leading sector, and in British industrial production in general.

It was this episode that John Stuart Mill was looking back on in 1829 when he evolved his view of the relationship between aggregate supply and aggregate demand as mediated by the potential for an excess demand for money and other financial assets.

And, also in 1829, it was looking back on this episode led Jean-Baptiste Say to revise his doctrine. In his Complete Course of Applied Political Economy, Say begins his analysis of 1825-1826 with the Bank of England’s recognition in late 1825 that many of its potential counterparties had overleveraged and overinvested in speculative canals, and were now of questionable solvency either on their own account or because many of their debtors had overleveraged and overinvested in speculative canals. The Bank of England therefore decided in 1825 to reduce its own risk by applying stricter standards:

[It] cease[d] to discount commercial bills. Provincial banks were in consequence obliged to follow the same course, and commerce found itself deprived at a stroke of the advances on which it had counted, be it to create new businesses, or to give a lease of life to the old.

And the consequence, Say wrote, was financial collapse:

As the bills that businessmen had discounted came to maturity, they were obliged to meet them, and finding no more advances from the bankers, each was forced to use up all the resources at his disposal. They sold goods for half what they had cost. Business assets could not be sold at any price. As every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared among merchants and among bankers, who having placed more bills in circulation than their personal wealth could cover, could no longer find guarantees to cover their issues beyond the undertakings of individuals, many of whom had themselves become bankrupt...

What of Say’s 1803 declaration that when there is a shortage of money in an economy, merchants “know well enough how to find substitutes for the product serving as the medium of exchange”?

What Say had missed in 1803 was that such “inside money” can be quite difficult to create. Only those economic agents whose solvency is common knowledge can create money. Only they can create the safe savings vehicles and stores of value that serve as means of payment and mediums of exchange that everybody will accept, and that everybody will accept because everybody will accept.

But what economic agency is of unquestioned solvency in a time of overleverage, overinvestment, and significant but unrealized losses whose location is unknown?

That was the problem created in 1825-1826 by the collapse of the canal boom, and by the Bank of England’s first reaction to the potential insolvency of its counterparties.