From The Milken Institute Review, October 31:
If you haven’t heard of Jón Daníelsson, it’s about time. Daníelsson is an Icelandic-born, Duke University-trained economist who teaches at the London School of Economics. The author of two technical tomes on the subject, he’s devoted a career to studying the anatomy of financial risk. And for the last decade he has directed LSE’s Systemic Risk Centre. Oh, did I mention he’s from Iceland, which arguably suffered the most spectacular financial implosion of any economy in the 2008 meltdown? Actually, Iceland dug its way out almost as rapidly as it dug its way in — but that’s another story....
Leendert Pieter de Neufville was only 21 in 1751 when he founded his Amsterdam bank, De Neufville Brothers. His big chance came a few years later with the Seven Years’ War — what Americans call the French and Indian War.
Amsterdam was then the most sophisticated financial center in the world, leading in financial innovation and having the most creative bankers and the highest amount of speculative capital. The Dutch guilder was the U.S. dollar of its day, the reserve currency that facilitated trade throughout Europe and beyond.
De Neufville took full advantage, building up one of the world’s wealthiest and most prestigious banks by financing the Prussian side of the war. He lived well, furnishing his house only with the finest-quality objects and owning an excellent collection of paintings — but not a single book.
The way he made his money was thoroughly modern: rapid, irresponsible financial innovation in the form of acceptance loans, not all that different from the financial instruments so damaging in the 2008 crisis. Cheap short-term borrowing was used to make long-term loans at high interest rates involving long chains of obligations, spanning multiple banks and countries.
The key to all the profit was borrowed money. For every 23 guilders he lent to Prussia, De Neufville supplied one and borrowed 22 secured by commodities. Highly profitable in good times, but it didn’t take much for things to go wrong, as they did spectacularly when the war ended in 1763, culminating in the first modern financial crisis.
Commodity prices crashed because the farmers could now finally start producing again, making all the commodity-based collateral behind De Neufville’s acceptance loans worth little. Investors got spooked and decided not to roll over these short-term loans — they all went on strike, just like their successors in 2007. As De Neufville didn’t have enough ready cash to repay his creditors and keep his bank alive, he had to sell his vast holdings of commodities. However, that only caused prices to fall further, a process known as a fire sale. Falling prices induce speculators to sell, and when they sell prices fall further in a vicious loop. It did not take long for De Neufville to default.
Thus was born the first global systemic crisis, described at the time as a pest epidemic. It spread with raging speed from house to house. The city of Hamburg was hit hard, and on August 4 its mayor wrote to the mayor of Amsterdam asking him to bail out De Neufville. Amsterdam refused.
Fortunately, the crisis turned out to be relatively short-lived, and Amsterdam, Hamburg and the other major centers recovered quickly. Berlin suffered badly because of how its emperor, Friedrich II, reacted. He imposed a payment standstill and bailouts, violating the contracts that allowed funds to flow from Amsterdam to Berlin and causing the bankers to mistrust the Prussian authorities. The money stopped moving, and a severe recession ensued. Not the only time a government’s response to a crisis made things worse.
The ABCs of a Crisis
The 1763 crisis is what might now be classified as a V-shaped crisis, except for Berlin, which suffered a U crisis. In a V crisis we see a sharp temporary drop in economic activity, but as nothing fundamental is destroyed the recovery is similarly quick. The Asian crisis in 1998 was of the V variety, while the Great Depression and the 2008 crises, given their sharp crash and slow recovery, were U shaped. What about Covid-19? The jury is still out, but it seems closer to K — quick winners and losers.
De Neufville’s creditors tried to claw their money back but with limited success. He was forced to auction off some of his paintings in 1765, including The Milkmaid by Johannes Vermeer for 560 guilders, now one of the finest attractions of the Rijksmuseum in Amsterdam. Leendert managed to retain most of his houses, including one at Herengracht 70–72 in Amsterdam, a very desirable address then as now.
What happened in 1763 was a systemic financial crisis, and the chance of that happening is systemic financial risk. For the remainder of the book, I will omit the word “financial” and just call it systemic risk. This was the first modern global financial crisis because it was not a crisis caused by war or crop failure, but rather by shadow banking [unregulated informal banking] and the extensive use of sophisticated financial instruments allowing risk to hide and spread by efficient and interconnected financial centers.We have experienced many systemic crises since, and it is remarkable how similar they all are.....
....MUCH MORE
Two quick notes. If you recall, after the financial crisis Iceland's Eyjafjallajökull volcano went off and the joke du jour, in certain circles, was:
Iceland goes bankrupt, then it manages to set itself on fire.
This has insurance scam written all over it.
and if one is inclined to learn more about the comparisons with the present time, the Federal Reserve Bank of New York's Liberty Street Economics blog has a snappy little post:
"Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market"
which we wrapped with another story in "New York Fed: When Berlin Was an Emerging Market (and today: tokenized real estate bonds open to retail investors)"
