July Crisis and the Panic of 1914

The most significant political and diplomatic crises often have financial repercussions. In the case of the ‘July Crisis’, the series of events which tragically cascaded into the First World War, the financial effects were overshadowed by the more terrible prospect of war itself. Still, the financial events of the summer of 1914 were historically significant both because of the scale of the panic and its results. The Panic of 1914 predicted the manner in which future financial crises were addressed, by means of state intervention of a sort the 19th century never saw but which has characterized financial history since.

July Crisis

On June 28, 1914, the heir to the Austro-Hungarian throne was assassinated in Sarajevo. While this would eventually lead to war, at first all looked fine. It was just another Balkan crisis and there had been crises in the Balkans regularly and nothing major had come of them. On Thursday July 23 though, Austria sent a threatening ultimatum to Serbia which finally made the risk of war too large to ignore. The diplomatic events that started with the assassination and ended with the beginning of the First World War have become known as the ‘July Crisis’. It was in late July that the financial markets were confronted with the rapidly approaching reality of a world war.

Panic in London

On the eve of the war as before, London’s money markets and stock exchange were dependent on short-term funding from commercial banks. In the money markets, ‘discount houses’ would purchase bills of exchange from sellers who wanted liquid cash for their bills, often exporters, wholesalers, or others who received them in business. These discount houses funded their holdings of bills with loans from banks. Meanwhile, ‘accepting houses’ would guarantee payment of bills, making them more marketable and easily discounted. On the stock exchange, brokers and ‘jobbers’ would similarly finance their holdings of securities with short-term loans from banks.

Responding to the foreboding news, the financial panic of 1914 began on Monday July 27. There was a run on the discount houses and the stock market as banks withdrew funding. In addition to withdrawing liquidity by calling in loans, they raised liquid cash themselves by selling bonds and bills and hoarded gold in anticipation of a bank run. By Thursday July 30, liquidity had been drained from the money markets in London to such an extent that there was a complete standstill in this previously vibrant market. The next day, for the first time in its history, the London Stock Exchange indefinitely suspended trading and a bank failure occurred the day after that.

Panic in New York

The crisis was not confined to London or even especially felt in London. Some fifty countries saw some sort of financial panic on the eve of war in 1914, whether manifested in bank runs or stock market crashes. The markets in the United States were affected even if the country would not enter the war until 1917. Foreign investors, looking to raise cash where they could, sold American securities and converted their dollars into gold which they would repatriate and exchange into their local currencies.

Further, American firms with debts in London were having those loans called in by their lenders, requiring them to sell dollars and buy sterling to honor their debts. Together, these developments caused the dollar to plunge to $6.75 against the pound despite the currencies being pegged at $4.87 to the pound by a mutual gold standard. The falling dollar made American gold look cheap and encouraged larger outflows of gold from the U.S.; some believed the country would abandon the gold standard altogether.

As in London, the New York Stock Exchange closed its doors on July 31 on the orders of the Secretary of the Treasury William McAdoo. The exchange would remain closed for four months. This helped slow the selling of securities and in turn the outflow of gold.

Stabilization

During the crisis, the Bank of England stepped in to buy more bills of exchange. In doing so, it followed ‘Bagehot’s Rule’, requiring that emergency credit be provided at a penalty rate. During one week, the Bank was buying bills at a discount rate that had increased from 3% per annum to 4%, then to 8%, and finally 10%, the highest interest rates in the world at the time. The rising rates allowed the Bank to attract gold from abroad, replenishing reserves which were depleted as the Bank redeemed for gold the banknotes held by skittish holders. The line of people at the Bank of England redeeming their banknotes for gold was over two-hundred people long. As with other belligerent countries, Britain’s government eventually suspended the gold standard.

Line to exchange Bank of England notes for gold, July 31, 1914

Also in Britain, a special bank holiday was announced that ran from August 2 through August 6 as the stock exchange remained closed. It was during this period, on Tuesday August 4, that the country entered the war. A moratorium on private debts was also implemented to give debtors some relief, an unprecedented action that would be extended twice.

The list of stabilization measures goes on. A new £1 and a ten-shilling note were also put into circulation by the government and banks could redeem deposits in these rather than in gold coin. Named ‘Bradbury’ notes, after the secretary of the Treasury, the new emergency money had a very basic design at first as production was rushed. It didn’t matter though, they managed to prevent a bank run.

“I never thought I should have so many Bank Holidays together or that there should be so much Bank about them and so little holiday! I have spent them from morning till late at night in meetings and conferences.” – Quote by the Deputy Chairman of Lloyds Bank

To support the banks, a new emergency currency was introduced in the United States as well. The new money was authorized on August 3 by McAdoo and named ‘Aldrich-Vreeland’ notes after the legislation that permitted their creation, passed a few years earlier in response to the Panic of 1907. Banks were allowed to meet withdrawals with this new currency, protecting their reserves and so, like the ‘Bradbury’ notes in Britain, they safeguarded the financial system from bank runs.

As in Britain, interest rates rose in the United States as well. A $108 million gold fund was also organized by the recently created Federal Reserve, the Treasury, and a syndicate of banks. The fund was used to convince foreign creditors that American indebtedness could be repaid in gold. Demands for repayment diminished after this restored confidence and so less than $10 million would actually be used. Measures like these saved American borrowers with foreign borrowings coming due, the government of New York City just one among them. The U.S. dollar was no longer trading at a discount by November 11, 1914.

The Bank of England cut interest rates to 5% once the bank holiday ended and widened the eligibility of bills it would purchase. This resolved the immediate liquidity problem but the accepting houses were still troubled by the fact they could not receive payments from the overseas issuers of bills, especially those in warring countries. The Bank of England first purchased some of these bills and then advanced the acceptance houses money on a longer-term basis to repay obligations they owed. The £74 million that was advanced under this facility only became due one year after the conclusion of the war. This freed up capital for the acceptance houses to guarantee more bills.

The Bank exercised considerable discretion in its funding, deliberately withholding financing from banks that were not themselves lending to firms. Still, much of the assistance given to banks was not lent and the volume of banks’ deposits simply kept with the Bank of England grew from £30 million to £105 million between August and December. In the United States though, bank credit was not withdrawn so much and lending continued in a manner not characteristic of financial panics. This favorable outcome is attributed to the use of emergency currency.

To replenish its depleted reserves, the Bank of England created gold repositories across the British Empire. This allowed depositors to part with their gold in exchange for a credit received in London. The Bank’s gold reserves rose from £38 million before the panic to £73 million in December. Around the same time as the Bank’s reserves reached this level, gold also began to flow back into the United States. Britain’s moratorium on enforcement of private debts was successfully lifted on November 4 despite anxiety that the move would revive the panic. The panic remained suppressed.

On January 4, 1915, the London Stock Exchange reopened and no other British financial institutions had failed after August. That said, the market for bills of exchange never fully recovered and government treasury bills replaced private bills as the benchmark short-term money market instrument trading in London. This latter development was probably inevitable since there would be £1.2 billion in Treasury bills outstanding by 1919.

In Britain at least, no greater financial crisis would be seen in the 20th century. The event was exceptional in still other ways. The value of government support provided during the Panic of 1914 exceeded even that of 2008 as a share of national income and it was similarly controversial. The official interventions in the financial markets of the United States also seemed uncharacteristically large for the era. Still, all this panic and the efforts to prevent the crisis from worsening were overshadowed by the diplomatic crisis and the war that soon after began.

Lesson

Economically, the 20th century was characterized, if not defined, by greater state intervention. So, whereas financial history in the 19th century was driven by non-state actors, the 20th century was one determined to a very large degree by the acts of governments. This is partially attributed to the two world wars. As the unprecedented actions taken by officials at the onset of the Panic of 1914 seems to suggest, governments are more willing to intervene in financial markets during times of war than otherwise.

More from the Tontine Coffee-House

Read about the forms of emergency currency issued during shortages of money during the First World War and the financial consequences of the outbreak of war in September 1939. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.