This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Origins of Central Banking: E.M. Forster's Great Aunt Marianne

Our best single window into the origin of central banking in 1825 comes from English novelist E.M. Forster, whose great-aunt Marianne Thornton had helped raise him after his father's death and left him a legacy of £8,000 pounds, and who as a consequence wrote Marianne Thornton: A Domestic Biography 1797-1887,14 stringing her letters together with scene-setting prose. In the middle of 1825 Marianne Thornton’s younger brother, the 25-year-old Henry Thornton, was invited to join what had in earlier generations been the Thornton family bank as the most junior of its six partners. Marianne writes of profits of £40,000 pounds a year to be split among six partners.

In a letter of December 1825 to her friend Hannah More, she wrote that:

There is just now a great pressure in the mercantile world, in the consequence of the breaking of so many of these scheming stock company bubbles...

And she criticized the management of the bank that young Henry had just joined. The bank’s managing partner:

had been inexcusably imprudent in not keeping more cash in the House, but relying on [the bank's] credit ... which would enable them to borrow whenever they pleased....

Today we would say that the bank was overleveraged, and had made the mistake of including in its core capital reserves assets that had been misclassified as “AAA”. Marianne Thornton writes of an “inexcusably imprudent” reliance on the bank’s credit. But the essence of the mistake is the same. The story that Marianne Thornton tells in her letter to Hannah More has a modern ring.

Then there came a “dreadful Saturday [Marianne] shall never forget” and a run—a wave of depositors liquidating their accounts and depleting the bank’s reserves—leaving the bank vault “literally empty."

According to Marianne, all the other partners of Pole, Thornton, and company panicked:

[The managing partner] insisted on proclaiming themselves bankrupts at once, and raved and self-accused himself.... [Senior partner Scott] cried like a child of 5 years old...

Partner Pole was away at his country estate. Another partner was on a business trip. It fell to 25-year-old Henry to deal with the fact that in the last business hour of Saturday it was expected that Pole, Thornton:

would have to pay 33,000 [pounds], and they should receive only 12,000 [pounds]. This was certain destruction....

Henry Thornton quickly found another banker John Smith. Smith asked if the bank was solvent. Henry lied, and said that it was. Well, then, Smith said, Pole, Thornton would have all he could spare:

Never, [Henry] says, shall he forget watching the clock to see when 5 would strike, and end their immediate terror. ... The clock did strike ... as Henry heard the door locked, and the shutters put up, he felt [Pole, Thornton] would not open again but would be forcibly liquidated Monday morning...

There were, however, other wheels that had already been set in motion.

The First Lord of the Treasury, Robert Banks Jenkinson, Lord Liverpool, had been having conversations with Bank of England Governor Cornelius Buller about the need of the Bank of England to do something to calm the crisis by acting as a “lender of last resort”.16 John Smith had gotten wind of these conversations between Liverpool and Buller. And that Saturday evening, after the banks had closed, John Smith told Henry Thornton that if Henry truly believed that Pole, Thornton was solvent he, John Smith, would undertake to get it cash from the Bank of England. This was a shock. As Marianne Thornton wrote:

[T]he Bank [of England] had never been known to do such a thing in the annals of banking...

Sunday at 8 AM the members of the Court of the Bank of England who were in London were assembled to meet John Smith and Henry Thornton:

John Smith began by saying that the failure of [Pole, Thornton] would occasion so much ruin that he should really regard it as a national misfortune... then turned to Henry and said, 'I think you give your word the House is solvent?' Henry said he could ... [and] had brought the books.

“Well then”, said the governor and the deputy governor of the Bank, “you shall have 400,000 pounds by 8 tomorrow morning, which will I think float you”. Henry said he could scarcely believe what he had heard...

Monday morning, in the pre-dawn dark, Henry Thornton was at the Bank of England as Goveror Buller and Deputy Governor Richards personally counted out £400,000 pounds in bank notes. Marianne Thornton claims that one of the two said:

I hope this won't overset you, my young man, to see the governor and deputy governor of the Bank [of England] acting as your two clerks...

And:

rumors that the Bank of England had taken [Pole, Thornton] under its wing soon spread, and people brought back money [on Monday] as fast as they had taken it out on Saturday...

Henry Thornton had been irrationally exuberant and in error when he had sworn that the bank was solvent. The bank was eventually closed. The partners lost their capital shares. The Bank of England had to wait years before getting its emergency loan back in nominal terms, and it never recovered accrued interest. (But it did not care much.)

The particular intervention to support Pole, Thornton was only a small part of what the Bank of England did in the Panic of 1825. To quote from Bank of England Director Jeremiah Harman:

We lent [cash] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power...

Did it work? Relative to the 8% per year trend rate of increase in cotton consumption in Britain, it appears that cotton consumption in 1826 was some 24% below trend before rebounding with a 30% growth rate in 1827. Relative to trend it looks like a deep, albeit short downturn. There is good reason to fear that the downturn would have been considerably worse had the Bank of England behaved like the U.S. Treasury and Federal Reserve in the early 1930s, and washed their hands of the situation.

From the standpoint of Mill’s theory of how the flip side of deficient general demand for currently-produced commodities is an excess demand for safe and liquid financial assets, it is straightforward to understand how the Bank of England’s 1825-6 interventions would have boosted the economy. That the Bank of England was willing to guarantee the liabilities of Pole, Thornton turned them from shaky, risky assets back into “inside money”—safe, liquid assets that would satisfy the unusual demand at that moment for near-riskless stores of value and sources of liquidity. That the Bank of England was itself printing up extra banknotes—expanding its balance sheet—raised the supply of “outside money” that the government was providing to the banking system. That the Bank of England was taking action to deal with the crisis may have restored that elusive “confidence” which diminishes desired portfolio demand for an unusually-high amount of safe, liquid assets. And when banks, businesses, and households no longer wish to cut their planned expenditure below their expected income, the economic downturn is over. As A.C. Pigou quotes Alfred Marshall, the industrial depression

could be removed almost in an instant if confidence could return, touch all industries with her magic wand, and make them continue their production and their demand for the wares of others...