EHS 2018 special: Long-term effects of financial crises

by Chenzi Xu (Harvard University)

The global financial crisis of 2008 was not unique. It had a precedent in the London banking crisis of 1866. Just as in 2008, the crisis began in the core financial market and spread to the periphery, the same happened in 1866.

The 1866 crisis has only been studied as a purely British event, but my research presents new evidence that it was a global financial crisis on the scale of 2008’s. The cities around the world that depended on British banks that happened to fail in London suffered immediate losses in exports activity. These losses took decades to recover, with the hysteresis persisting until the twentieth century.

In May 1866, Overend and Gurney, a bank’s bank and one of the most prestigious financial entities in London, declared bankruptcy. A panic erupted and almost 20% of banks headquartered in London failed. Crucially, these banks had been established in the mid-nineteenth century to globalise financial markets and trade, and they operated in cities around the world.

Figure 1 shows the concentration of British banking, and the degree to which the banking crisis in London affected them. Red denotes greater losses in British financing, and the size of the circles denotes the amount of lending before the crisis.

I study the impacts of the failures of British banks in London on trade activity around the world, outside of the UK, at hundreds of ports. At the extreme, losing access to all British credit caused exports to drop 80% in the year following the crisis. The aggregate global loss in trade was 17%, which is comparable to the levels seen in the latest crisis. Given that the mid-late 19th century was otherwise a period of great expansion and growth, the counterfactual without this crisis would have been even more spectacular.

The historical context also makes it possible to study the long-run effects, and I find that countries suffering the largest drops in the supply of British credit did not recover their exports to previous partners for several decades. These persistent effects suggest that losing access to financial markets can cause substantial hysteresis.

These long-term consequences of financial market instability have yet to be established for recent crises simply because not enough time has passed. But early evidence suggests that international trade has not rebounded, even ten years after the financial crisis.