Ricardo’s Theories Challenged by the Crises of 1825 and 1837

Shortly after Ricardo’s death, the crisis of 1825, the first global crisis of overproduction, swept over Britain. In 1837, a second global crisis erupted with far more devastating results. It was followed by years of industrial depression and mass unemployment. Stormy class struggles broke out, and in Britain out of this came the Chartist Movement, the first mass working-class political party. (1) It was during the depression that followed the crisis of 1837 that Marx and Engels were themselves radicalized. (2)

External gold drains and the Ricardian theory

In Britain, the crises of 1825 and 1837 were both preceded by major external drains of gold. (3) In order to halt the drain that threatened the continued convertibility of the pound sterling into gold, the Bank of England raised its rate of discount. (4) This reversed the gold drain, but financial panic followed by severe recession hit Britain and spread to other trading nations—not unlike the current global recession, which followed the panic of 2008.

But this was exactly what was not supposed to happen according to the Ricardian theory of world trade and comparative advantage. Remember, the Ricardian theory predicted that trade would remain pretty much in balance among the trading nations. (5) The gold reserves of the Bank of England would grow as more newly mined gold flowed in, but there should be no serious external drains.

According to Ricardo, any external gold drain implied that prices were too high in Britain compared to Britain’s trading partners. But according to the reigning Ricardian theories, such a situation could not be sustained. (6) Remember, according to Ricardo if the balance of trade began to shift against Britain and gold began to drain out, prices and nominal wages would start to fall. At worst, a negative balance of trade and payments meant that there was “too much” gold in Britain, so a reduction in British gold reserves was necessary to reduce the nominal prices and wages to levels where Britain’s trade and balance of payments would once again be in balance.

This process would unfold gradually on a day-to-day basis. It would, according to the Ricardian theory, ensure that the world’s gold reserves would be distributed in exactly the proportions that were necessary to allow the law of comparative advantage to operate to the mutual benefit of all trading nations regardless of their degree of development. Crises simply could not occur. But what was excluded in theory happened in practice both in 1825 and again in 1837. Something was seriously amiss.

However, the supporters of Ricardo’s theory of comparative advantage thought they knew where things were going wrong and how the situation could be corrected. The problem, according to them, was that the British currency system was too far removed from a pure gold circulation. The banks were issuing banknotes well beyond the actual amount of gold in the vaults of the British banking system.

In order to deal with this problem, the supporters of Ricardian comparative advantage, known as the “currency school,” proposed a reform that would tie the quantity of banknotes to the quantity of gold. (7) The proposed reform, the currency school claimed, would prevent any repeat of the crises of 1825 or 1837, and would enable comparative advantage to work in practice like it was supposed to work in theory.

Since banknotes as well as gold were acting as money, it was necessary to make sure the quantity of banknotes was the same as the quantity of gold within the banking system. (8) If such a system had been in effect in the 1820s and 1830s, the currency school argued, Britain’s balance of trade and payments would have remained pretty much in balance, and the crises of 1825 and 1837, with all their mass unemployment and suffering within the working class, would have been avoided.

The problem, according to the currency school, was not the capitalist system but rather bad banking practice, which could be prevented in the future by proper legislation. Basing themselves on Ricardo’s theories of world trade, comparative advantage, and the quantity theory of money, the currency school came up with a series of banking reforms that they claimed would prevent a repeat of the crises of 1825 and 1837. (9)

The reform program

The centerpiece of the reform proposed by the currency school was implemented in the Bank Act of 1844. The new legislation tied the total quantity of banknotes to the supply of gold that was in the Bank of England’s vaults. (10) In order to achieve this, the right of banks other than the Bank of England to issue banknotes was to be progressively phased out. Second, the Bank of England was divided into two departments: the Issue Department and the Banking Department.

The Issue Department’s job was to issue banknotes only to the extent that gold accumulated in the bank’s vaults. If gold flowed out of the bank, a portion of the banknotes would be canceled by the Issue Department. If gold flowed into the bank, additional banknotes were created in proportion to the additional gold in the bank’s vaults.

The other department was the Banking Department. Its job was to make loans and discounts and take deposits, mostly from the government and commercial banks. If it needed banknotes, the Banking Department had to turn to the Issue Department. In effect, the Banking Department functioned much like a bank that does not have the authority to issue its own banknotes.

With this legislation, the the quantity of banknotes in Britain would be tied to the inflow and outflow of gold. If the balance of trade and payments began to turn against England, gold would begin to flow out of the bank and the quantity of banknotes in Britain would immediately decline.

According to the the currency school, prices and money wages would begin to decline in response to the decline in the quantity of banknotes. This would quickly correct any incipient deficit in Britain’s balance of trade and payments. The gold outflow would therefore be nipped in the bud before it would lead to a crisis.

If, in contrast, Britain’s balance of trade and payments swung into surplus, gold would flow into the Bank of England leading to a growth in the quantity of banknotes in Britain. The result, according to the currency school, would be a rise in prices and money wages in Britain. Any British balance of payments surplus would be quickly eliminated. This, in turn, would prevent any offsetting payments deficits in the accounts of Britain’s trading partners.

With this reform, the currency school claimed, Ricardian comparative advantage would begin to work in practice just like it did in Ricardian theory. Say’s Law, which had been supported by Ricardo, would also become operative. Therefore, the currency school predicted, the “general gluts” of commodities that followed the panics of 1825 and 1837 would not recur in the future.

It didn’t work. Three years after the Bank Act was passed, a new panic hit Britain. Worse yet for the currency school, the Bank Act had to be suspended to quell the panic. (11) A decade later, yet another crisis, the crisis of 1857, forced the suspension of the Bank Act again. The Bank Act had to be suspended a third time during the panic of 1866. (12) Why wasn’t the Bank Act working?

The Bank Act did ensure that when gold flowed out of Britain the quantity of banknotes contracted. But prices simply didn’t react like the quantity theory of money—so essential for the theories of the currency school and Ricardo’s theory of comparative advantage—claimed they would. It was interest rates, not prices, that proved to be sensitive to a decline—and increase—in the quantity of gold in the Bank of England’s vaults and the consequent changes in the quantity of banknotes created by the Issue Department.

Indeed, between 1844, when the legislation went into effect, and 1873, the trend of prices in Britain was strongly upward, and the quantity of commodities in circulation within Britain expanded rapidly. But the quantity of banknotes in circulation, as opposed to banknotes lying idle in the Issue Department, progressively declined. (13) Banknotes were being replaced by checkable bank deposits, greatly reducing the need for banknotes, even in the face of rising commodity circulation and prices.

When Britain suffered a gold drain, it was interest rates not prices that reacted. Instead of prices falling, the rate of interest rose. These higher interest rates would then attract money from abroad as money capitalists invested in Britain to obtain a higher return on their “moneyed capital.”

As the global industrial cycle was approaching a peak, however, Britain—or any other nation running a balance of payments deficit—would find it increasingly difficult to attract the additional money capital that was necessary for it to finance its balance of payments deficit. For reasons I explained in the postings devoted to an “ideal industrial cycle,” money was “getting tight” across the globe.

Therefore, as long as the balance of payments deficit continued, interest rates kept on rising. And so did prices as long as the boom continued. Finally, panic would erupt.

The financial panic and subsequent recession would finally lower prices and wages but only at the cost of recession and mass unemployment. As the domestic market contracted, the British industrial and commercial capitalists would be forced to export more, while the contraction of the home market meant that Britain imported less. Instead of painless and gradual adjustments of prices and money wages, the balance of trade and payments deficits were corrected only by the crisis itself.

The crisis would break out successively in the various trading countries. For example, the crisis might begin in the United States as a negative trade balance drained gold from American banks. As the United States sank into recession, British exports to America would decline, while American exports to Britain would rise. British industries would begin to experience difficulties due to declining exports to the United States and increasing competition from American products within the British home market. At the same time, gold would begin to flow from Britain to America.

At first, this would be a response to high interest rates in the United States as British money capitalists took advantage of these rates and the consequent opportunity to purchase American securities at low prices. Prices of these securities would then rise sharply as the American crisis subsided.

As recession took hold in the United States, its balance of trade and payments would swing from deficit back to surplus. Gold would return to the American banking system, and American interest rates would fall. (14) But much of the gold that was now flowing into the United States was coming from the now-dwindling gold reserve of the Bank of England. Under the 1844 banking legislation, this meant the quantity of banknotes created by the Issue Department in Britain was declining causing interest rates to soar. (15)

But prices in Britain would only start to decline when the developing British recession brought about a contraction of monetarily effective demand within the British home market. Commodities would then pile up in British warehouses, leading to production cutbacks and mass layoffs. In order to get rid of the huge buildup in unsold commodities and meet the demands for immediate payment on the part of their creditors, British industrial and commercial capitalists would be forced to cut prices.

As recession-bound Britain imported less and exported more, Britain’s balance of payments account would swing back into surplus, leading, however, to balance of trade and payments deficits in France, Germany and other “continental” European countries. Soon, financial panics, or at least “tight money” and recession, would be spreading throughout continental Europe.

Therefore, before the crisis finally subsided, it would affect all the major trading nations of the time. Says Law, the quantity theory of money, and Ricardo’s law of comparative advantage were all missing in action.

Bank Act made crises worse

The Bank Act of 1844 not only failed to eliminate crises, it actually worsened them. Why was this? Before the Bank Act, the Bank of England could always issue additional banknotes to meet the increased demand for them during a crisis. True, the bank was restrained in this by its need to maintain the convertibility of its banknotes into gold, but it still had room to maneuver until the return flow of gold finally broke the crisis.

Under the Bank Act, however, the bank’s hands were tied. The demand for banknotes as a means of payment increased considerably during crises. The industrial, commercial and money capitalists would demand immediate payment in banknotes of debts owed to them, in fear that their debtors would go under.

During crises, the demand for banknotes was, therefore, much higher than it was under normal circumstances. We saw something similar last fall, when the demand for U.S. dollars suddenly soared driving up the exchange rate and gold value of the dollar after a long period of dollar weakness, since the dollar remains the main means of payment on the world market.

But the capitalist creditors back then knew that unlike the Bank of England before 1844—or the U.S. Federal Reserve System and the other central banks today—the Bank of England after the 1844 law went into effect could not issue additional banknotes to meet the additional demand for them.

The effect was much like throwing gasoline on a raging fire. Public knowledge that the bank could not issue additional banknotes to meet the abnormal demand—despite the fact that it had a considerable amount of gold in its vaults and the convertibility of its notes into gold was never in serious danger—would whip the demand for banknotes into a frenzy. Debtor would drag down creditor, banknotes would flow out of the banking system into private hoards, and the industrial crisis—the recession—was greatly intensified.

What would have happened last fall if legislation like the Bank Act of 1844 had been in effect?

With economic collapse threatening, the Bank Act would then be suspended. The Bank of England, though it was still obliged to pay five gold sovereigns for every five-pound banknote presented to it, was now free to meet the demand for additional banknotes just like it was before the Bank Act became law in 1844. As soon as the public heard that the Bank Act was suspended, the demand for banknotes would immediately plummet and the panic would end. Banknotes returned to the commercial banking system from private hoards. Interest rates would fall, the money market would promptly ease, and soon the economy would begin to recover.

With a brief exception during the 1857 crisis, the Bank of England did not even have to issue banknotes in excess of those allowed by the Bank Act. (16) The mere knowledge that the bank could issue such notes so reduced the demand for banknotes that no issue of extra banknotes was actually necessary.

As it turned out, the crises of 1847, 1857 and 1866, unlike the crisis of 1837, did not lead to prolonged depressions for reasons that I will explore when I examine the controversial theory of “long waves.” However, the Bank Act certainly failed to eliminate crises, and indeed made them worse than they would have been otherwise. As Marx put it, no banking legislation can eliminate banking crises—we have to abolish capitalism to accomplish that—but bad banking legislation like the Bank Act of 1844 can make crises worse.

The Bank Act of 1844 turned out to be bad legislation because the theories it was based on—the quantity theory of money, Says Law and Ricardo’s theory of comparative advantage, which depended on the truth of the quantity theory of money—simply weren’t correct.

Towards a correct theory of international trade and crises under capitalism

During the economic boom, when credit is freely available on the world market, some countries can run large deficits in their balance of trade and payments on current account by borrowing from other countries that can run offsetting balance of trade and payments surpluses on “current account.” But when the crisis strikes and credit is paralyzed internationally just like it is paralyzed nationally, debtor countries are forced to slash imports and creditor countries experience the collapse of their export markets.

Here we see yet another function of crises. Crises force countries to keep their trade and payments more or less in balance in the long run. During the crisis, deficit countries are forced to slash imports while surplus countries see their exports collapse. The expansion of international credit during the boom enables the balance of trade and payments among the trading nations to become increasingly lopsided. The crisis forces things back into balance once again.

We have seen this law in operation during the current crisis. The huge U.S. trade deficit has dropped considerably during the crisis, while the offsetting surpluses that other countries that trade with the United States have likewise declined. World trade has not only declined considerably since the current crisis began, it is now much closer to an equilibrium with much smaller trade surpluses and deficits among the trading nations. This has been achieved, however, only through industrial recession and mass unemployment just like it was achieved in the days of the Bank Act of 1844.

Next week, I will begin the examination of the work of John Maynard Keynes, perhaps today once again the most influential bourgeois economist. Keynes himself was greatly influenced both by the debacles that occurred under the Bank Act of 1844 as well as the Great Depression of the 1930s. I will especially examine Keynes’s proposed remedies for crises and how they have worked out in practice.


1 The main demand of the Chartist movement was universal manhood suffrage. While this demand seems extremely moderate, even reactionary, today—no demand for women’s suffrage—at that time it was considered a very advanced democratic demand. More significantly, it was the first time that the workers on a large scale organized themselves into a political movement to win political demands. The Chartist movement faded away during the great capitalist prosperity that set in after 1848. Its main demand was conceded by the Tory government of Benjamin Disraeli. Therefore, it was the British Conservative Party that actually carried out the program of Chartism.

2 In the the early 1840s, Engels was obliged to move to Manchester in England—then the world’s leading industrial center—to work for his father’s textile firm. Working for his father’s firm brought the young Engels face to face with the reality of capitalist production and exploitation, including the devastating effects of the prolonged industrial depression that had followed the crisis of 1837.

3 Under the gold standard that prevailed in Britain in the period I am examining, two types of gold drains were possible.

The first was an external drain. This occurred when the balance of payments turned against Britain. The rate of exchange of the pound would then drop to the point that it was cheaper for Britain’s foreign creditors to demand payment in gold and incur the costs of insuring and shipping the gold, since these costs were now less than the foreign exchange loss would be. The point below which it was cheaper to ship and insure gold rather than absorb the foreign exchange loss was known as the “gold point.”

The second was an internal drain. If for whatever reason the owners of banknotes lost faith in the banks that issued them, they might cash in their banknotes for gold coins—sometimes called “specie.” During the entire time between the resumption of gold payments after the world war that followed the French Revolution until the next world war, which began in 1914, no such run actually occurred in Britain.

Since gold coins continued to circulate in Britain to a certain extent, the coins would tend to accumulate in the Bank of England’ vaults during periods of recession or depressed business, but would again be thrown into circulation when business picked up. Except for this relatively minor phenomena, all drains against the gold reserves of the Bank of England were external drains.

4 The discount rate was the rate of discount charged by the Bank of England on bills of exchange—a form of commercial paper widely used in this period—that were purchased by the bank from other financial institutions.

5 Bourgeois political economy had by this time already pretty much abandoned the Ricardian theory of labor value, but Ricardo’s theory of foreign trade remained a pillar of economic orthodoxy then as it remains even today.

6 Ricardo had died in 1823 about two years before the first modern economic crisis broke out in 1825. How Ricardo, if he had lived, might have modified his theories in the light of this crisis and the crises that followed is something we can never know. It should be noted, however, that unlike the purely apologetic bourgeois economists that followed, Ricardo was willing to modify and even change his theories when he became convinced by further study or events that they were incorrect.

7 While the currency school was the dominant theory, some bourgeois economists supported a rival theory called the “banking school.” These economists opposed the Bank Act of 1844. The banking school held that the quantity of currency expanded or contracted in response to changes in the total amount commodities in circulation and the prices of those commodities, and not the other way around. Therefore, unlike the believers in the quantity theory of money, the banking school held that the money supply reacted to changes in prices rather than causing them.

The banking school advocated that the Bank of England should be willing to discount bills of exchange as long as those bills represented real commodities. This is known as the “real bills doctrine.” In the opinion of the banking school, as long as additional currency is “backed” by additional commodities, the increase in the amount of circulation will not cause inflation or currency depreciation.

The banking school strongly influenced the founders of the U.S. Federal Reserve System, who wanted a flexible currency system that would avoid the kind of debacles that had occurred under the Bank Act of 1844 in Britain. In the wake of the Depression of the 1930s, however, the banking school and its “real bills” doctrine fell into almost complete disrepute among bourgeois economists.

The Friedmanite bourgeois economic historians, especially, claim that the members of the Federal Reserve Board were simply unconcerned about the one-third decline in the quantity of money in the United States, because according to the teachings of the “real bills doctrine” the Depression meant that there was less need for money as the quantity of commodities in circulation and their prices fell.

According to the followers of Milton Friedman, it was this one-third decline in the quantity of money that actually caused the Depression. Instead, the bourgeois economists—and this includes the followers of both Milton Friedman and John Maynard Keynes—came to believe that “the Fed” should have aggressively expanded the “money supply,” much like it has done during the current crisis.

One idea of the banking school that does survive, however, especially among economists strongly influenced by Keynes, is the claim that the central bank doesn’t have to worry about inflation as long as there is substantial unemployment of workers and machines. As long as the economy is operating well below its capacity to produce—which as we have already seen is generally the case under capitalist production—the production of commodities can always be quickly increased in response to any increase in monetarily effective demand. Therefore, the ability to rapidly increase the quantity of commodities in circulation will prevent currency depreciation, since the currency will now be “backed” by the increased quantity of commodities in circulation.

8 Today’s supporters of the quantity theory of money—sometimes called monetarists—attribute the failure of the Bank Act of 1844 to end periodic major external gold drains and crises to a mistake the currency school made in its definition of money. The currency school claimed that money consisted of gold coin and banknotes. The monetarists believe that they should have included checkable deposits as well. Indeed, after the Bank Act of 1844 took away the note-issuing powers of the commercial banks, the total amount of banknotes in circulation steadily declined as credit money in the form of checkable bank deposits progressively replaced credit money in the form of banknotes.

9 Sound familiar? It should, since today once again the capitalist governments are promising to introduce new banking legislation that would see to it that a crisis like that of 2008 will never happen again! The only difference is that the currency school had a theory developed by one of the greatest economic thinkers who ever lived, David Ricardo, which if it had been correct would indeed have eliminated crises. Today’s would-be bank reformers have pretty much run out of theories on which to base their promised crisis-eliminating “banking reforms.”

10 This is a slight simplification. The Issue Department was allowed to issue banknotes backed by government bonds, the so-called fiduciary issue, up to a fixed amount. There were also provisions that required the Issue Department to hold a certain amount of silver, since China, for example, based its currency on silver rather than gold, and thus had to be paid in silver. But none of these details affects the essence of the matter.

11 The authors of the 1844 banking reform were wise enough to include this escape clause just in case the legislation didn’t work out as the Ricardian theories predicted.

12 Between 1866 and 1914, the Bank Act never had to be suspended again. Perhaps the knowledge that it would inevitably be suspended in the event of a banking panic made it unnecessary to actually suspend it.

13 According to the currency school and their quantity theory of money, virtually all the banknotes created by the Issue Department should have entered circulation. Instead, the banknotes increasingly simply gathered dust in the Issue Department’s vaults, as checkable deposits increasingly replaced banknotes in circulation.

14 Unlike Britain, the United States had no central banking system. The American gold hoard was divided between the for-profit commercial banks and the U.S. Treasury. Before the Civil War, internal drains, not simply external drains, did occur in the United States when panic-stricken depositors would demand “specie”—gold coins—in exchange for banknotes issued by the commercial banks. When the panic subsided, gold coins would return from private hoards to the banking system. Therefore, after a crisis the American banking system would rebuild its reserves by a combination of gold returning from private hoards and a return flow of gold from abroad.

A major internal gold drain also occurred during the winter of 1933. The examination of the causes of this internal gold drain belongs to the posts on the Depression of the 1930s.

15 The extremely high interest rates would allow the bankers and other top money capitalists to make enormous profits by charging usurious interest rates to desperate industrial and commercial capitalists, as well by as buying securities at bargain basement prices that would then soar in price as the crisis passed. Karl Marx charged that the Bank Act of 1844, which was supported by the leading British banking interests of the time, was designed in part to achieve this very result that so greatly enriched the bankers.

16 Ben Bernanke and his fellow central bankers no doubt wish that they could dispense with the crisis of 2008 and its aftermath so easily. It wasn’t enough to give themselves the authority to increase the “monetary base” to break the panic, they actually had to virtually double the supply of token money before the panic finally began to subside. And the recent downward movement of the U.S. dollar against gold and a rise in interest rates on long-term government bonds indicate that, unlike in the 19th century, confidence in the dollar and U.S. government bonds has indeed been shaken. Compared to the storm that the world economy has been passing through over the last two years, the crises of the 19th century were indeed mere showers.

3 thoughts on “Ricardo’s Theories Challenged by the Crises of 1825 and 1837

  1. Hello, let me first say that this is some great information. I came upon your site while researching Say’s Law in an attempt to form a rebuttal to a stern Austrian Schooler. I myself am a student of economics with a “non-denominational” stance that sees benefit in all schools of thought, even studied Marx in high school all four years.

    Anyway I have a question and am hoping you could help me. Say formed his law and refuted Malthus and Sismondi around 1803 I believe. In 1829, he actually refuted his original stance that “general gluts” are not possible by his theory when analyzing the financial panics of 1825-26 and the Bank of England:


    Anyway, I want to know if you have sources concerning the events of 1844 with the English Bank Reform, and the rise in Checkable deposits as opposed to Idle Banknotes. If all this is correct it shows that a 100% Gold Standard has its faults as well.

    If you have other sources that supports your statements above I would love to see them. Again thank you for this wealth of information. I’ll be a regular reader for sure.

  2. “Ricardos Theories Challenged by the Crises of 1825 and 1837 |
    A Critique of Crisis Theory” definitely makes me personally imagine a little bit extra.
    I really appreciated every individual section of this post.
    Thanks for the post ,Jacelyn

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