Economy

1914 reminds us how markets can be upset in August

BY George Trefgarne   /  10 August 2017

What is the connection between Donald Trump and the chief cashier of the Bank of England? This curious question occurred to me after the Bank of England’s blog admitted this week that the Bank misled the market over a War Loan issue in 1914. At the time, the Bank said the issue was oversubscribed, when in reality it was a flop and it picked up half of it itself.

Are we about to experience something similar?

The War Loan story was, for the most part, already known. It is, for instance, in Richard Roberts’ excellent 2014 book Saving The City (OUP), about the financial crisis which followed the shooting of Archduke Franz Ferdinand on the 28th June 1914.

“The war came like a bolt from the blue and nobody was prepared,” wrote Gaspard Farrer, a partner in Barings Bank to a correspondent at Kidder, Peabody in New York. After more than a century of continuous growth, London was the world’s pre-eminent financial centre and the London Stock Exchange the world’s largest equity market.

The global financial system effectively depended on loans of one kind or another, raised in London, including the sterling bill of exchange.

All was initially calm, but after Austria-Hungary issued an ultimatum to Serbia to crack down on its home-grown terrorists or face invasion, the markets experienced a sudden convulsion which, according to Mr Roberts, exceeded anything before or since, including the Wall Street Crash of 1929 or the Credit Crisis of 2008.

Several European countries (including Germany, whom the chancellor Lloyd George suspected of orchestrating the whole thing) announced payment moratoria, and effectively remittances ground to a halt, causing London financial houses to call in short term loans. The remittance system, the gold market and the discount market completely seized up, causing short term money market rates to double to 5%.

Within days, the authorities had to implement emergency measures. The Bank Charter Act was suspended – essentially enabling the Bank of England to issue more notes against securities other than gold – and the Stock Exchange was closed for six months. Bank Rate was raised to 3% and at one point reached 10%. A payment moratorium on bills of exchange and five-day bank holiday was declared. The Treasury itself printed £1 notes. A general run on the banks was only narrowly avoided.

At one point, it was expected that Schroders would cease trading because its senior partner, Baron Schroder was a German citizen. But Slaughter & May pressurised the Home Secretary to grant him an immediate naturalisation certificate and for George V to back it up with a royal licence (a device used to protect Russian merchants during the Crimean War).

This was the tumultuous backdrop to the War Loan issuance described by the Bank’s Bank Underground blog. In November 1914, to help finance the war effort, Lloyd George announced a £350m War Loan would be raised, with a coupon of 4½%. As Richard Roberts says, with the stock exchange still closed and acute investor uncertainty in the air, the issue was “a fiasco” and it was uncovered.

Of the £350m, the clearing banks subscribed to £106m and the Bank of England £40m, but the general public took only £91m, leaving a shortfall of £113m. To disguise the failure, the Bank arranged for its chief cashier, Gordon Nairn, and his deputy, Ernest Harvey, to subscribe personally and it then secretly held the securities on its balance sheet as “other securities”.

John Maynard Keynes, in a secret Treasury memo, later praised this as a “masterful manipulation of the Bank’s balance sheet”. A failure of the War Loan issue would have been a disaster, causing gilt prices to collapse and jeopardising future capital raising. It would have fatally undermined Britain’s war strategy, which, just as in the Napoleonic Wars, was premised on using its naval mastery to blockade Germany and strangle its economy, while deploying a small army to the Continent and tapping its capital markets to subsidise allies.

What, might you ask, is the connection between War Loan episode with Donald Trump? Only that the current bull market and economic recovery – a bit like the great Edwardian expansion of the early 20th century – are getting a bit long in the tooth.

Is it possible that the ultra-low volatility of the last 12 months continues much longer? One thing which could upset it is the situation in North Korea and Mr Trump’s “fire and fury” ultimatum.

Sadly, both Mr Trump and Kim Jong-un seem to exhibit many of the same bombastic personality traits as the German Kaiser Wilhelm II in 1914, which contributed to the precipitate plunge into conflict. At the very least, an armed confrontation or stand-off in the Pacific might ignite an absolutely classic bout of late summer volatility. That is not a cheery thought. Let us hope that this comparison remains no more than a historical curiosity.