138. Trade and the worst financial crisis of the century—in 1866

Episode Summary

Executive Summary: The episode examines how the 1866 failure of Overend and Gurney triggered a London banking panic, collapsing trade finance for exporters worldwide. Using Chenzi Xu’s research, the hosts show that when British banks supplying most global trade credit failed, exposed ports saw exports plunge sharply and trade relationships shift permanently, with effects still visible decades later.

Main Topics: Trade finance and the timing gap in exporting (Priority: 5/5): The episode explains how exporters need upfront funding to buy inputs and pay workers before being paid by overseas buyers, making bank credit essential to international trade. London’s dominance in 19th-century global trade finance (Priority: 5/5): British banks headquartered in London supplied most trade credit across global port cities, often financing trade between third countries using sterling as the transaction currency. The 1866 Overend and Gurney collapse as a supply shock (Priority: 5/5): The bank failure sparked panic and a wave of bank failures, creating a quasi-experimental shock to the supply of trade credit rather than a demand-driven decline. Short-run trade collapse after credit loss (Priority: 5/5): Ports exposed to failed London banks experienced a dramatic immediate drop in exports, showing how dependent trade was on bank intermediation. Long-run restructuring of trade networks (Priority: 4/5): Even after banks recovered and new lenders entered, exporters and buyers formed new relationships that persisted, leaving decades-long trade effects. Lessons for modern policy and trade wars (Priority: 4/5): The study suggests that any major increase in trade costs—whether from banking crises or tariffs—can permanently rewire trade patterns and supplier relationships.

Key Arguments: Trade finance is crucial because exporters must pay costs before receiving payment from importers; banks bridge this gap. London-based banks were uniquely important because they operated globally, knew local exporters, and could lend in sterling. The 1866 crisis provides a cleaner causal test than modern recessions because it was a sudden collapse in credit supply, not just weak trade demand. Exposure varied by location depending on which London banks had lent there, allowing comparison across ports with different reliance on failed institutions. A complete loss of access to British bank funding caused exports to fall by 68% in the year after the crisis. The shock had persistent effects because trade relationships are costly to rebuild and buyers often switch permanently to new suppliers. The findings imply that large trade-cost shocks, including tariffs and trade wars, may create long-run changes in global sourcing patterns.

Data Points: Share of trade credit from London banks: Over 90% - Average share of trade credit supplied by London-based banks in any given city during the period World export coverage of London banks: 98% - London banks operated in countries accounting for 98% of the value of world exports Banks failed in crisis: 12% - Share of banks that completely failed during the 1866 banking crisis Export decline after losing access to British bank funding: 68% - Ports that lost all access to British bank funding saw exports drop in the post-crisis year relative to the previous year Long-run effect window: Decades - Trade effects persisted well after the crisis, with measurable impacts still found in 1910 Recovery of banking sector in exposed places: Within 5 years - New banks entered places with high exposure to British bank failures over the following five years Example of exposure variation: 20% vs 80% - Illustrative comparison of bank-failure exposure across ports such as Buenos Aires and Valparaiso Time since crisis effects still visible: 1910 - Buyer-side trade patterns still showed effects decades after the 1866 crisis

Pivotal Quotes: "Trade finance, it helps to fill this timing gap." — Samaya Keynes: Explaining the basic role of trade finance in exporting "Places that lost all access to British bank funding saw their exports drop by 68% in the post-crisis year relative to the previous year." — Chenzi Xu: Summarizing the main empirical result on short-run trade effects "exporters that were very exposed to these bank failures systematically export less in the decades afterward." — Chenzi Xu: Describing the persistent long-run trade effects

Implications: The episode shows that finance shocks can permanently reshape trade networks. For today, it suggests tariffs, trade wars, or banking disruptions may not just reduce trade temporarily—they can re-route global supply relationships for years.