By Robert P. Baird of digital emunction
When, back in March, the Bank of England announced that it was adopting a program of quantitative easing, The Economist reported the news with some trepidation. While recognizing that the threat of deflation was real and imminent, the magazine gave voice to the fear that “that the border being crossed may be an inflationary Rubicon.” Though it came down ultimately (if barely) on the side of the new policy, you could almost hear the shrieks escape the magazine’s inflation hawk of a soul. (Four months later, The Economist’s attitude toward the policy had changed considerably.)
With one eye where one eye always should be—on Monty Python—The Economist announced the BoE’s plans to create money from thin air with the headline, “And Now for Something Completely Different.” What the magazine did not mention was that there was a time when the Completely Different was Completely Ordinary—or at least Not Completely Unexpected. Almost 150 years ago, in an issue dated May 12, 1866, The Economist would confidently tell its readers that Peel’s Act, which enforced the gold standard, was unsustainable in times of panic:
It is often said that Sir R. Peel’s Act broke down in 1847 and 1857, but it should also be said that it must always break down under like circumstances. Its provisions are adapted to a state of quiet and tranquility…. But those provisions are not adapted to a state of alarm and confusion. On the contrary, they tend to aggravate that alarm.
The diagnosis was no mere intellectual exercise. When the article was published Britain was in the midst of a panic caused by the failure of Overend, Gurney and Co., the so-called “banker’s bank.” At the height of the panic, the London Times would describe a full-fledged bank run: “The doors of the most respectable banking houses were besieged…and throngs heaving and tumbling about Lombard Street made that narrow thoroughfare impassable.” The Economist’s proposed solution was a temporary suspension of Peel’s Act, which would produce an effect not all that different from quantitative easing: it would allow the Bank of England to print money at will. Sure enough, by the time the next issue of the magazine appeared the British government would suspend Peel’s Act and the banking crisis would subside.
Four years later, the author of the May 12 Economist article, also the editor of the magazine, set out to write a book drawing on his experiences during the panic of 1866. The author-editor was Walter Bagehot, and the book he produced was his now-classic Lombard Street: A Description of the Money Market.
As its subtitle suggests, the explicit intent of Lombard Street is to describe the banking industry in concrete and comprehensible terms: “A notion prevails that the Money Market is something so impalpable that it can only be spoken of in very abstract words,” Bagehot says. “But I maintain that the Money Market is as concrete and real as anything else; that it can be described in plain words; that it is the writer’s fault if what he says is not clear.”
Bagehot more than makes good on the promise. Lombard Street is a fluent read, written in a conversational style that The Economist still brags about to this day. Unlike most of the financial media in his day (and ours) Bagehot avoids jargon as a matter of principle and makes his subject neither more nor less complicated than it needs to be. As a result, his descriptions of basic economic phenomena—how money is borrowed and lent, why booms and busts occur, the early history of banking—are limpid and precise.
Lombard Street reaches well beyond mere description. Beneath the book’s genial surface lies a closely argued polemic against the Bank of England that rests on a simple thesis: “All our credit system depends on the Bank of England for its security. On the wisdom of the directors of that one Joint Stock Company, it depends whether England shall be solvent or insolvent” (emphasis his). Out of this argument grew the main polemical point of Lombard Street, which later became known as “the Bagehot principle”: that the Bank of England ought to act as a lender of last resort in times of panic, lending freely (albeit at penalty interest rates) to anyone who could offer good securities as collateral.
Of course, as Bagehot is quick to admit, this was a bit of an odd polemic, since the Bank of England was already de facto following the course he prescribed. What he objected to were the Bank’s words, not its deeds. “Though the Bank, more or less, does its duty, it does not distinctly acknowledge its duty,” he said, and that lack of acknowledgment forms the main target of his polemic. He protested against the pretense that the Bank of England’s private ownership and management made it like any other bank. The BoE was not like any other bank in Britain, he insisted, because the government had given it special privileges and monopolies (not least, a monopoly on printing money). Nor was it even really necessary to argue that the Bank had a special public responsibility, since some of its directors had incautiously admitted as much. What was needed, Bagehot argued, was public acknowledgement of that responsibility, and a restructuring of the Bank along the lines of that acknowledgment. (Bagehot didn’t live long after the publication of Lombard Street, but I doubt he would have been surprised to learn that none of his recommendations were taken up until well into the 20th century.)
Bagehot makes his case against the Bank of England as interesting as a 150-year-old polemic can be, but let’s face it: outside the cramped quarters of Ron Paul’s cranium the question of establishing central banks is pretty well settled. What remains vital in Lombard Street is Bagehot’s thinking about the history and structure of the banking system—which, for all the hype, hasn’t changed as much as some might like to think—and the causes and effects of financial panics. As is often the case with classics, what we take from the book depends in large part on what we ask from it.
If we want relevant maxims, we will find them, for Bagehot was a master of concise observation. It is impossible to read a sentence like the following, for example, and not think of the last couple of years: “Every great crisis reveals the excessive speculations of many [banking] houses which no one before suspected, and which commonly indeed had not begun or not carried very far those speculations, till they were tempted by the daily rise of price and the surrounding fever.” Or this, on fraud: “The good times too of high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, there is a happy opportunity for ingenious mendacity.” Or this, on bank failures: “Any aid to a present bad Bank is the surest mode of preventing the establishment of a future good bank.”
If we come to Lombard Street looking for something more substantial—a theory, say—we will find that too. The Bagehot principle is only the start, for it doesn’t take much imagination to recognize that the basic lesson of Lombard Street is the same lesson we’ve all been (re)learning these last couple of years: that the pretense of government non-intervention in our financial system—i.e., the idea that the financial markets can ever be truly free—is exactly that, a pretense. And while a person might be able to dream up several theoretical schemes to keep a financial panic from destroying the real economy, historical circumstance has left us with only one real option: a bank with the government-guaranteed authority to print money must stand as the lender of last resort.
(Readers of this blog know don’t need to be told how vigorously central banks around the world have embraced the lender-of-last-resort role that Bagehot prescribed, but if proof were lacking they could turn to Richard Fisher, the CEO and president of the Dallas Fed, who last February called Bagehot a “patron saint” of central banking who had, along with Henry Thornton, written “the basic playbook for how a central bank, as the economy’s lender of last resort, deals with a financial crisis.”)
Bagehot also argues vigorously against those who would suggest that deposit banking was the logical outgrowth of economic laws of nature, insisting that the whole scheme came about by chance and historical contingency. It is, he admits, the most ordinary thing in the world for an Englishman to put his money in a bank and to expect a five-percent return on his deposits. But he insists that there is nothing natural about any part of this. Only a peculiar set of historical circumstances could produce a system in which it seemed normal to trust a stranger to hold—not to mention loan out—your money. (One of the book’s most famous anecdotes describes Alexander Pope’s father retiring to the country with twenty thousand pounds in a strongbox, from which he’d draw whatever he needed for household expenses.) Likewise, there was nothing “natural” about earning interest, as a simple look around the globe proves:
Most saving persons in most countries are afraid to ‘put their money’ into anything. Nothing is safe to their minds; indeed, in most countries, owing to a bad Government and a backward industry, no investment, or hardly any, really is safe.
The most important lesson of Lombard Street may well be its relentless insistence on what notions like “the long boom,” “the risk revolution,” and “the Great Moderation” have encouraged us to forget: that for all its power, a credit-based financial system is fundamentally a fragile thing. “The briefest and truest way of describing Lombard Street,” Bagehot writes early on, “is to say that it is by far the greatest combination of economical power and economical delicacy that the world has ever seen.” The power of the system is obvious: by the seeming magic of leverage, “a new man, with small capital of his own and a large borrowed capital, can undersell a rich man who depends on his own capital only.” But the delicacy usually remains hidden. It’s only during times of panic that we’re forced to recall the true nature of credit, which is never more and never less than its etymology suggests: i.e., a form of trust. “The peculiar essence of our banking system,” Bagehot says, “is an unprecedented trust between man and man: and when trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may also destroy it.”
As a society we’ve recently paid a huge price to be taught that risk is an essential, not incidental, part of our financial system. Already the lesson seems destined to be forgotten, but it’s a small comfort—small, but real—to know that Lombard Street will be there to remind us again, if we’ll let it.