The Credit Crisis Of 1772

Last updated on December 30, 2021

The credit crisis of 1772, also known as the panic of 1772, was a financial crisis originated in London. The crisis deteriorated banking confidence in the country, which then spread to the fall of confidence in the neighboring banks in Europe.

The crisis was considered the greatest in the last 50 years in the region, dragging more than 500 banks in London to bankruptcy and also collapsed 30 European Banks.

Despite of its massive impact, the credit crisis of 1772 is not that well known, although it happened right between two crises events, namely, the banking crisis of 1763 and the American revolutionary war. As its name suggests, the banking crisis of 1772, similar to a typical banking crisis, was led by the contagion impact of bank runs. Despite its great impact, the actual cause of the crisis remains controversial.

What Lead To The Credit Crisis Of 1772

It has become a usual character of a crisis that the times before the crisis was filled with expanding economic activities and high credit dependency, or economically acknowledged as credit boom.

The story of the credit crisis in 1772 began with the story of trust between British banks and American planter. The time before 1772 was the time when England expanded its colonialism to the land of America. On the land, British creditors observed the bankability of planters, who were also in need of working capital from banks.

American colonies experienced capital scarcity for crop and produce so they proposed new loans from British banks through dual-trade system. A dual-trade system is the trading scheme provided by British banks for American colonies to determine the type of credit provision they preferred.

On one side, American planters were allowed to trade directly with British merchants who further sold the commodities through a commission system. On the other side, American planters were also allowed to sell the commodities to agents in the colonies, who channeled the goods for sale. Both schemes offered a one year of interest-free credit and banks would charge the planters for a late payment or deficit. The history records show that the second scheme was used more intensively than the first one.

Prosperous Years

The two schemes became very popular, particularly after trade and tax policies were favorable to support them, such as the Townshend Acts and the Boston Non-importation agreement. This situation made the period of 1770 – 1772 very prosperous for the two parties (Britain and American colonies) with sound political environment.

The flow of commodities between the two parties were also accelerating, which incentivized banks to provide more capital provision for both parties. Inevitably, credit expanded significantly during the period, driving the economy to inflationary gap and making the commodity prices rise beyond their fundamental values.

Early Signs Of A Credit Collapse

Up to this point, the economy was overheated, and it was vulnerable from external shocks, but it was not yet transformed into a crisis until the collapse of market sentiment.

Few historical records argue that the sentiment of market collapsed due to the fraud and speculation on the bill of exchange. The bill of exchange is a transaction scheme between two parties where one party can draw bill from another party.

The speculation happened when two parties continuously drew and discounted bill on each other, followed by the flow of goods. This activity led to overstock of inventories and was very vulnerable from fraud.

The fraud was, in turn, found in the form of fictitious bills of exchange where one party drew fictious bills on another party, and vice versa. This practice boosted the size of credit without the actual money inflow. The market considered this as unsustainable practice and dragged the sentiment negatively.

Inflationary gap and the market’s negative sentiment are sufficient to impose negative shock on the economy. The credit boom finally collapsed and degraded commodity prices to its fundamental values and caused debtors struggle to pay debt.

Even worse, no one trusted each other, causing the market of bill of exchange become frozen. As a consequence, credit activity was on bottleneck and this imposed liquidity risk on banking business. For example, the shares of East India Company (EIC) fell dramatically and caused Alexander Fordyce, a London-based banker, to loose £300,000 of shares of the company.

The Actual Credit Crisis Of 1772

In June of 1772, the crisis officially began when two London banks went to bankruptcy. The bankruptcy exacerbated rumors in the market and then burst the credit bubble into a panic when debtors decided to simultaneously withdraw their money from the banks, dried up the liquidity in the banking sector, and caused hundreds of American planters struggle to pay debt.

Conclusion And Impact

In conclusion, the banking crisis of 1772 occurred due to interaction of three elements; the overheating economy, financial fraud, and banks’ weak supervision on debtors’ historical activities.

The impact of the banking crisis of 1772 was contagious and steep. The Bank of England took immediate actions by increasing the bill discounts, expanding more credit to troubled banks and injecting more working capital to selected parts of the private sector.

In 1773, the Bank of England also injected £1.4 million of government loan to the East Indian Company and helped the company to avoid the bankruptcy.

Overall, it required two years for the economy to recover back to its pre-crisis level.