The Trafalgar squeeze of global liquidity
Summary
Focus
We investigate a historical episode – the financial crisis of 1805–06 following the Battle of Trafalgar – that offers valuable lessons for today's global financial system. The crisis was triggered when Europe was cut off from Latin American silver, which served as the main form of international liquidity at the time. The resulting shortage of "safe assets" led to severe disruptions in banking, credit and trade across Europe.
Contribution
The paper analyses a rare episode of exogeneous shortage of global liquidity. The 1805–06 period qualifies as a Kindleberger gap, like the 1930s and the 1870s. We confirm typical consequences of shortages of global liquidity: financial intermediation shrinks abruptly across domestic markets as various agents hoard the international safe asset.
Findings
The shortage of silver after the Battle of Trafalgar had three major consequences. First, it triggered a financial panic and a cascade of bank failures. Second the hoarding of silver, notably by the Bank of France, implied a shortage of means of payment which in turn curtailed economic activity. Third, the 1805–06 financial crisis marked the end of the dominance of Latin American silver in the international monetary system.
Abstract
The severity of financial crises is exacerbated by the lack of international liquidity or the absence of a global lender of last resort. This was evident during the Long Depression (1873–1896), the Great Depression (1929–1936), and, as we show in this paper, during the 1805–1806 crisis that followed the Battle of Trafalgar. The latter took Atlantic trade routes away from Spain and cut off Europe's access to Latin American silver, the key high-powered money of the time. This silver shortage led the Banque de France to cut lending by nearly 50% within three months, deliberately tightening credit to hoard specie and restore the value of its bank notes. In turn, no less than 20 Parisian banks failed, credit collapsed and European financial and money markets experienced acute stress, reflected in rising silver prices, pressure on the metallic reserves of other central banks such as the Banco de San Carlos in Madrid, and disruptions in bills of exchange markets across Europe, from Cádiz to Hamburg. The 1805–1806 crisis highlights how a safe asset's status requires both its resilient supply and the credibility of its issuer.
JEL classification: E41, E58, F33
Keywords: Spanish dollars, Kindleberger gap, International Monetary System
