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The First International Financial Crisis: Free Banking Failure or Regulatory Failure?

December 2, 2011
in Blog

The Baring Crisis of 1890 is pointed out as the first modern international emerging financial crisis. The collapse of the banking system in Argentina came very close to triggering a financial crisis in London, the major international financial center. Banks in the United Kingdom were highly exposed to Argentinean debt, especially the Baring Brothers & Co., at that time the world largest merchant bank.

The year 1890 also marks the end of the Law of National Guaranteed Banks in Argentina. This system of guaranteed banks lasted only for four years, from 1887 to 1890. It was the collapse of this experiment which almost triggered a crisis in the financial sector in the United Kingdom. The United Kingdom acted fast and avoided a spread of the crisis. Nevertheless, the question of how this crisis evolved in the first place is important. Was this a case of inherent instability in the financial sector or the outcome of unsound regulation? For instance, della Paolera and Taylor (2001, p. 240), Vázquez-Presedo (1971, p. 37), Schuller (1992, p. 29), Cortés Conde (1989, pp. 195-204), Gerchunoff, Rocchi and Rossi (2008, p. 84) and Llach (2007, p. 93) suggest, or imply, that the Law of National Guaranteed Banks was a kind of free banking system. This, however, is not the case if one looks closer to what the law actually imposed on the banks.

Before the 1880s, there were numerous issuer banks in the country. The most important of these banks were related to the public sector and were used to finance the budgets of the states. In the early 1880s, a new monetary law enacted a national currency, to which all other banknotes would have to be convertible. Under this law only 5 banks were allowed to issue the new banknotes: (1) Banco Nacional, (2) Banco de la Provincia de Buenos Aires, (3) Banco Provincial de Santa Fe, (4) Banco Provincial de Córdoba and (5) Otero & Co. The last one was the only private bank. The first four belonged to the largest provinces in Argentina.

This new law went into effect in January 1883, but by late 1884 banks started to abandon the convertibility. Finally, inconvertibility was declared for a period of 2 years, when a new arrangement will be prepared for the monetary system. This was the Law of National Guaranteed Banks.

The Law of National Guaranteed Banks was inspired by the U.S. “free banking laws,” but with some modifications and important differences. For instance, in the U.S. the banknotes did not have the benefit of legal tender laws, though this was the case in Argentina. Under the Law of National Guaranteed Banks, the banks were not required to issue convertible notes, as was the case in the U.S., where banknotes were be convertible to greenbacks. Importantly, in the U.S. the banks were able to create a market for already existing bonds, while in Argentina the banks would have to invest on new bonds. These new bonds were illiquid in the market, meaning that the banks did not have the opportunity to sell them in exchange for cash.

The system worked as a channel to issue new debt and to avoid the problems of budget deficits. The banks were required to use gold to buy National Gold Bonds from the federal government. The banks were allowed to issue banknotes backed on these bonds. Therefore, on one hand, the federal government received gold that was intended to be used for payment of the federal debt; on the other hand, the guaranteed banks borrowed gold from London to invest in the National Gold Bonds. In other words, the state banks became brokers of the federal government that acquired the gold needed to cancel previous government debts.

Since the National Guaranteed Bonds paid a higher interest rate than the rate charged by London, the guaranteed banks faced the incentive to expand their activities by borrowing more gold to buy more National Gold Bonds. The following table shows the increase in money supply with a clear increase since 1887:

 

1884

1885

1886

1887

1888

1889

1890

22.0%

22.0%

12.1%

33.1%

44.0%

43.0%

-1.1%

Source: (Cortés Conde, 2008, p. 337)

 

Given past experiences with monetary institutions in Argentina, the public was unwilling to leave their gold with the federal government. The situation became the following: The guaranteed banks borrowed gold from London. Then, the guaranteed banks lent the gold to the government in exchange for the National Gold Bonds. Therefore, the banks were allowed to issue more banknotes in the form of credit to the public. The public used these banknotes to buy gold in the market; gold provided by the federal government. As a result, the federal government and the state banks were providing to the market the means necessary to produce an internal drain of gold. The following table shows the percent of public hoarding:

 

Year

Specie Stock

Specie Held in Banks

Public Hoarding of Specie

Percent of Public Hoarding

1884

22.90

20.70

2.20

9.61%

1885

20.80

17.40

3.40

16.35%

1886

33.10

26.50

6.60

19.94%

1887

33.00

21.90

11.10

33.64%

1888

69.10

52.70

16.40

23.73%

1889

52.40

22.00

30.40

58.02%

1890

54.30

10.00

44.30

81.58%

Source: (della Paolera & Taylor, 2001, p. 53)

 

During this time the government kept a budget deficit; therefore, a budget surplus could not be used to offset the loss of gold. Eventually the system would not be able to hold it anymore. In late 1889, the national government decided to pay part of its debt to the guaranteed banks with paper currency rather than specie, hurting the portfolio of the banks in London that were loaning gold to the guaranteed banks. London became reluctant to accept further debt from the guaranteed banks and finally the system of Guaranteed Banks collapsed, affecting the Baring bank.

It is clear that this was not a case of free banking, where banks are free to use the reserves they consider appropriate rather than being forced to invest in bonds from a government with a chronic budget deficit. The profit maximization strategy of the banks consisted in arbitraging between the national gold bonds and the gold in London, not by managing savings from the market. The public was saving outside the banks, either hoarding or transferring their deposits to other countries. If banks were actually competing for savings in the market, they should not be able to expand their banknotes when gold is going out of the system. Just as the U.S. was not a case of free banking, neither was the Argentinean case . The Baring Crisis of 1890, the first emerging financial crisis, was the result of unsound monetary regulations, not of inherent banking instability.

References

Cortés Conde, R. (1989). Dinero, Deuda y Crisis. Buenos Aires: Editorial Sudamericana.

Gerchunoff, P., Rocchi, F., & Rossi, G. (2008). Desorden y Progreso. Buenos Aires: edhasa.

Llach, L. (2007). The Wealth of the Provinces: The Rise and Fall of the Interior in the Political Economy of Argentina, 1880-1910. Harvard University.

della Paolera, G., & Taylor, A. M. (2001). Straining at the Anchor: The Argentine Currency Board and the Search for Macroeconomic Stability, 1880-1935. Chicago and London: University of Chicago Press.

Schuller, K. (1992). The World History of Free Banking. In The Experience of Free Banking (Dowd, K., ed). London and New York: Routledge.

Vázquez-Presedo, V. (1971). El Caso Argentino. Buenos Aires: EUDEBA.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

image from Mises.org