Learning from Mistakes: How the 1825 Crisis Led to Advances in Macroeconomics

This paper demonstrates that prior to the 1825 crisis the Bank of England directors had a limited understanding of the nature of the early 19th century bank-based money supply and of how their policies determining the circulation of Bank notes could affect the macroeconomy through the banking system. It shows that, just as modern crises transform our understanding of the financial system, there is substantial evidence that the 1825 crisis promoted advances in economic thought (i) by making clear the Bank’s effect on credit extension throughout the country and the associated macroeconomic fluctuations, (ii) by teaching the Bank the importance of stabilizing the money supply (iii) and by advancing the understanding of the role of the lender of last resort. This paper also makes clear the essential role of the development of a bank-based payments system, where bank liabilities comprise a significant portion of the circulating money supply, and bank lending therefore plays an important role in monetary dynamics, in our understanding of macroeconomics. In particular, the onset of the macroeconomic fluctuations known as the business cycle are closely associated with the fluctuations in bank liabilities that arise in a bank-based payments system.