What Bagehot Means for 21st Century Central Bankers

By Laurent Le Maux, Professor of Economics, University of the Western Brittany,Research Professor, University of Paris Panthéon – La Sorbonne. Originally published at the Institute for New Economic Thinking website

Walter Bagehot published his famous book, Lombard Street (1873) almost 150 years ago. The adage “lending freely against good collateral at a penalty rate” is associated with his name and his book has always been set on a pedestal and is still considered the leading reference on the role of lender of last resort. The academic literature goes as far as to consider that Bagehot preached a kind of “Copernican” revolution, that Bagehotian “wisdom” achieved a mature reflection on nineteenth-century central banking theory. In the aftermath of the global financial crisis of 2007-09, central bank officials often argued in their lectures that Bagehot’s dictum was well-founded and continued to provide a useful framework for mitigating the effects of financial crises. These views are revisited in my INET Working Paper.

In this respect, the title of Charles Goodhart’s article, “Game Theory for Central Bankers” (Journal of Economic Literature, 1994), is inspiring. In the late twentieth century in the United States and Europe, rational expectation theory and game theory determined the analysis and practice of central banking. Similarly, in early nineteenth-century Britain, quantity theory and the currency principle contributed to the growing opinion in the Club of Political Economy in London and finally to the adoption of the 1844 Act presented by Prime Minister Robert Peel. Thus, Bagehot’s recommendations were enunciated under the particular banking architecture enacted by the British parliament in 1844 – the Peel system – which was featured by the separation of the Bank of England into two departments, the issue and discount departments, and by the active discount rate policy.

Without a clear understanding of the theoretical grounds and the institutional features of the British banking system throughout Victorian times, any interpretation of Bagehot’s writings remains vague if not misleading – which is worrisome if they are supposed to provide a guideline for policymakers. Furthermore, beyond the historical context of Bagehot’s Lombard Street, the difficulties also lie in understanding its implicit theoretical underpinnings. Bagehot repeatedly stated that he did not delve into monetary and banking theory but rested his arguments on experience and narrating history. Surprisingly he went as far as to contend that the theoretical discussion would have ended with the adoption of the 1844 Act – even though the 1848 and 1857 parliamentary inquiries and the controversy between Thomas Tooke and Robert Torrens clearly show that it was not the case.

While the currency doctrine governing the 1844 Act gave no scope for the lender of last resort, the Chancellor of the Exchequer authorized the Bank of England to suspend the statutory rule of issue in 1847, 1857, and 1866. After the 1866 crisis, Bagehot’s intention was finally to reconcile the Peel system with the action of the Bank as lender of last resort. As is well known, the former Bank director Thomson Hankey excoriated an article written by Bagehot in The Economist (1866). Mentioning the question of moral hazard, Hankey (The Principles of Banking, 1867) deemed that Bagehot’s rule was the “most mischievous doctrine ever broached” in Britain. But behind all the bluster, the differences between the two were not that great: Bagehot repeated that his aim was to maintain the Peel system even if it involved tweaking it here and there, while Hankey just wished to keep it intact.

Unfortunately, the sound and the fury of the Bagehot-Hankey quarrel has long distracted attention from more serious and intense theoretical debates about money and banking in Britain from the 1840 to the 1857 parliamentary inquiries, in which Thomas Tooke played a crucial role. From the 1840 to the 1857 volumes of his History of Prices, Tooke together with John Stuart Mill and John Fullarton built a unified theoretical framework of money and banking. Extending the lender-of-last-resort analysis initiated by Thornton (Paper Credit in Britain, 1802), Tooke’s contributions to political economy carried classical central banking theory forward and plainly advocated the need for a lender of last resort. While the literature on the classical theory of lender of last resort focuses on Bagehot’s analysis and includes Hankey’s response, the perspective needs to be widened to take in British monetary debates more generally.

Just as the difference between Tooke and Bagehot in terms of theory is not commonly acknowledged, correlatively the action of the Bank of England during the 1825 crisis is also disregarded. The literature on financial history often refers to the 1866 crisis as a turning point in the history of central banking in Britain. Such an interpretation supports Bagehot’s assertion that the Bank acted in the best way during the 1866 panic, while Tooke had emphasized the significance of the Bank’s intervention during the 1825 panic. Even Bagehot himself acknowledged that the “success of the Bank” in resolving the 1825 panic was owing to its complete adoption of “right principles.” Not without contradiction, Bagehot added that the management of the 1825 crisis revealed the “worst misconduct of the Bank.” In fact, Bagehot did not lose sight of his main purpose, which was to show that the lender-of-last-resort’s role was compatible with the Peel system and, in this respect, that the Bank’s conduct during the 1866 crisis had been exemplary.

“Lending freely against good collateral at a high rate” was not a doctrine that Walter Bagehot could have discovered in 1873 after decades of obscurantism. The directors of the Bank of England witnessed at the 1832 parliamentary inquiry how the Old Lady applied the policy of “lending liberally against acceptable collateral” during the 1825 crisis. The practice of lending at a high rate appeared under the Peel system from the 1847 crisis onwards. So, what appears as particular to Bagehot’s Lombard Street is the justification of the rule of a “very high” rate. Bagehot did not suggest a “penalty” rate (a term he did not use) so as to counter moral hazard, but a “very high” rate in order to force banks to exhaust market sources of liquidity before presenting at the Bank’s discount window. Like Henry Thornton and John Fullarton, Thomas Tooke was aware of the moral hazard problem and recommended banking supervision. Moreover, he suggested that the Bank rate should be set above the market rate in normal times – and not at a very high level in crisis times – so as to lean against the wind.

Actually, Bagehot’s dictum tended to accentuate the financial cycle (pro-cyclicality), while Tooke’s rule of Bank rate above/below the market rate in normal/crisis times contributed to smoothing the financial cycle (contra-cyclicality). For Bagehot, the Bank rate should be very high (that is, higher than the market rate) in order to incite banks to find liquidity first in the money market before asking for central bank liquidity, while Tooke advocated the “moderate rate” rule (that is, lower than the market rate) in order to mitigate the collapse of asset prices within financial markets, and to avoid a coordination problem within the market of funding liquidity. Furthermore, for Bagehot, the Bank should raise its rate at the beginning of the crisis in order to protect its metallic reserve, while Tooke advocated that the Bank should raise its rate only as a last resort inasmuch as the policy of fixed and above-the-market rate in normal times contributed to the building of large metallic reserves beforehand.

All in all, the Bank policy under the Peel system and Bagehot’s rule was not the only option under the classical specie regime. The Bank of England implemented the fixed rate policy under the Old system as witnessed by the Bank director Horsley Palmer at the 1832 and 1848 parliamentary inquiries. At the same time, Thomas Tooke developed the classical central banking theory two decades before the publication of Lombard Street. Then, new generations of Bank directors and writers, including Thomson Hankey and Walter Bagehot, took the Bank policy under the Peel system for granted. Hankey wanted to maintain the letter and the spirit of the 1844 Act intact, while Bagehot wanted to resort to palliatives.

There is a consensus in the literature to define financial instability as the increased volatility in equity and real-estate prices and to formulate the principle of leaning against the wind as the central bank policy aimed at reducing the amplitude of the financial cycle, to contain excessive credit growth and to limit the systemic risk of financial distress. Once such a consensus is considered, there are good grounds for thinking that the classical theory of central banking proposed by Thomas Tooke analyzed how to lean against the wind under the gold specie standard. He pointed to the necessity of coordinating monetary policy (that is, convertibility into gold specie) and financial stability policy (that is, the intervention of the lender of last resort) through the instrument of the Bank rate. This was what he called the system of union of central banking – a system far different from the separation of the issue and banking departments that featured Lombard Street.

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  1. Sound of the Suburbs

    Neoclassical economics is the economics of the Roaring Twenties, the Wall Street Crash and the Great Depression.
    Sooner or later policymakers use the Roaring Twenties economic growth model.
    The money creation of unproductive bank lending is used to drive the economy.
    This is a one way ticket to a financial crisis and Great Depression.

    The UK purchased its ticket to a financial crisis and Great Depression in 1979.
    The UK eliminated corset controls on banking in 1979, the banks invaded the mortgage market and this is where the problem starts.
    The transfer of existing assets, like real estate, doesn’t add to GDP, so debt rises faster than GDP until you get a financial crisis.
    The money creation of unproductive bank lending is used to drive the economy.

    At 25.30 mins you can see the super imposed private debt-to-GDP ratios.
    No one realises the problems that are building up in the economy as they use an economics that doesn’t look at debt, neoclassical economics.
    As you head towards the financial crisis, the economy booms due to the money creation of unproductive bank lending, as it did in the 1920s in the US.
    The financial crisis appears to come out of a clear blue sky when you use an economics that doesn’t consider debt, like neoclassical economics, as it did in 1929.
    1929 – US
    1991 – Japan
    2008 – US, UK and Euro-zone
    The PBoC saw the Chinese Minsky Moment coming and you can too by looking at the chart above.
    The Chinese were lucky; it was very late in the day.
    The Chinese had done the same thing as everyone else, but worked out what the problem was before the financial crisis.

    Nearly everyone, apart from the Chinese, had a financial crisis and is now facing the prospect of a Great Depression.

    Japan could study the Great Depression to avoid this fate.
    How did Japan avoid a Great Depression?
    They saved the banks
    How did Japan kill growth and inflation for the next thirty years?
    They left the debt in place and the repayments on that debt killed growth and inflation (Japanification)

    Any serious attempt to study the capitalist system always reveals the same inconvenient truth.
    Many at the top don’t create any wealth.
    That’s the problem.
    Confusing making money and creating wealth is the solution.
    Some pseudo economics was developed to perform this task, neoclassical economics.

    When you confuse making money and creating wealth you get into real trouble with banking.
    Banks create money, not wealth, and so lie at the epicentre of the confusion.
    You haven’t got a clue what’s really going on.

    Confusing making money and creating wealth hides rentier activity in the economy.
    A parasitic rentier capitalism develops.
    In 1984, for the first time in American history, “unearned” income exceeded “earned” income.

    In reality, money comes out of nothing.
    Private banks create money out of nothing from bank loans
    States can create money out of nothing; think Zimbabwe, Weimar Germany.

    Paul Ryan was a typically confused neoliberal and Alan Greenspan had to put him straight.
    Paul Ryan was worried about how the Government would pay for pensions.
    Alan Greenspan told Paul Ryan the Government can create all the money it wants, there is no need to save for pensions.
    What matters is whether the goods and services are there for them to buy with that money.
    That’s where the real wealth in the economy lies.

    It took them a long time to disentangle the hopelessly confused thinking of neoclassical economics in the 1930s.
    This is the second time around and it has already been done.
    The real wealth creation in the economy is measured by GDP.
    Real wealth creation involves real work, producing new goods and services in the economy.
    That’s where the real wealth in the economy lies.

    Banks – What is the idea?
    The idea is that banks lend into business and industry to increase the productive capacity of the economy.
    Business and industry don’t have to wait until they have the money to expand. They can borrow the money and use it to expand today, and then pay that money back in the future.
    The economy can then grow more rapidly than it would without banks.
    Debt grows with GDP and there are no problems
    The banks create money and use it to create real wealth
    Banks should engage in productive bank lending.

    1. athingtoconsider

      Banks should engage in productive bank lending. SoS

      “Loans” to automate jobs away count as “productive bank lending”, do they not?

      Then it’s evident that banks should be 100% private with 100% voluntary depositors lest government privilege allow the so-called “credit-worthy” to dis-employ their fellow countrymen with what is, in essence, the public’s credit but for private gain.

      Besides, inexpensive fiat means we can have all the money creation we desire but in an ethical manner.

    2. Briny

      If you follow Wolf Richter’s Wolf Street Report, he spends quite a bit of time paying excellent attention to various forms of debt in the economy and the trends involved. Wolf Street Report Link to the side as well.

  2. Sound of the Suburbs

    Financial stability arrived in the Keynesian era and was locked into the regulations of the time.
    “This Time is Different” by Reinhart and Rogoff has a graph showing the same thing (Figure 13.1 – The proportion of countries with banking crises, 1900-2008).
    Neoclassical economics came back and so did the financial crises.

    The neoliberals removed the regulations that created financial stability in the Keynesian era and put independent central banks in charge of financial stability.
    Why does it go so wrong?
    Richard Vague had noticed real estate lending balloon from 5 trillion to 10 trillion from 2001 – 2007 and knew there was going to be a financial crisis.
    Richard Vague has looked at the data for financial crises going back 200 years and found the cause was nearly always runaway bank lending.
    We put central bankers in charge of financial stability, but they use an economics that ignores the main cause of financial crises, private debt.

    Most of the problems are coming from private debt.
    The technocrats use an economics that ignores private debt.
    The poor old technocrats don’t really stand a chance.

    The FED does the best it can with an economics that doesn’t consider debt, which really isn’t very good at all.

    Greenspan and Bernanke can’t see the problems building before 2008.
    At 18 mins.
    (When you use neoclassical economics that doesn’t consider debt, the economy runs on debt and then crashes in a Minsky Moment, 1929 and 2008.)
    No one can work out what caused 2008, and afterwards and they attribute it to a “black swan”.

    Janet Yellen is not going to be looking at that debt overhang after 2008 and so she can’t work out why inflation isn’t coming back.
    It’s called a balance sheet recession Janet, you know, like Japan since 1991.
    She’ll never work it out; it’s a private debt problem.

    Jerome Powell is not looking at the debt overhang after 2008 and so thinks the US economy is fixed and raises interest rates.
    Raising interest rates with all that debt in the economy will soon cause a downturn and there is no way he will get anywhere near normalising rates.
    He soon has to backtrack and reduce rates again.

  3. Sound of the Suburbs

    Why is neoclassical economics so bad for financial stability?
    We never did learn as much as we should have done from 1929.

    Neoclassical economics produces ponzi schemes of inflated prices.
    When they collapse it feeds back into the financial system.
    Neoclassical economics still has its 1920’s problems.

    What’s wrong with neoclassical economics?
    1) It makes you think you are creating wealth by inflating asset prices
    2) Bank credit flows into inflating asset prices, debt rises faster than GDP and you eventually get a financial crisis.
    3) No one notices the private debt building up in the economy as neoclassical economics doesn’t consider debt.

    What is the fundamental flaw in the free market theory of neoclassical economics?
    The University of Chicago worked that out in the 1930s after last time.

    Banks can inflate asset prices with the money they create from bank loans.
    Henry Simons and Irving Fisher supported the Chicago Plan to take away the bankers ability to create money.
    “Simons envisioned banks that would have a choice of two types of holdings: long-term bonds and cash. Simultaneously, they would hold increased reserves, up to 100%. Simons saw this as beneficial in that its ultimate consequences would be the prevention of “bank-financed inflation of securities and real estate” through the leveraged creation of secondary forms of money.”
    Margin lending had inflated the US stock market to ridiculous levels.
    Richard Vague had noticed real estate lending balloon from 5 trillion to 10 trillion from 2001 – 2007 and went back to look at the data before 1929.
    Real estate lending was actually the biggest problem lending category leading to 1929.

    The IMF re-visited the Chicago plan after 2008.

    Existing financial assets, e.g. real estate, stocks and other financial assets, are traded and bank credit is used to fund the transfers. This money creation of bank credit inflates the price.
    You end up with a ponzi scheme of inflated asset prices that will collapse and feed back into the financial system.

    At the end of the 1920s, the US was a ponzi scheme of inflated asset prices.
    The use of neoclassical economics and the belief in free markets, made them think that inflated asset prices represented real wealth accumulation.
    1929 – Wakey, wakey time

    Why did it cause the US financial system to collapse in 1929?
    Bankers get to create money out of nothing, through bank loans, and get to charge interest on it.
    What could possibly go wrong?
    Bankers do need to ensure that money gets paid back, and this is where they get into serious trouble.
    Banking requires prudent lending.

    If someone can’t repay a loan, they need to repossess that asset and sell it to recoup that money. If they use bank loans to inflate asset prices they get into a world of trouble when those asset prices collapse.
    As the real estate and stock market collapsed the banks became insolvent as their assets didn’t cover their liabilities.
    They could no longer repossess and sell those assets to cover the outstanding loans and they do need to get the money they lend out back again to balance their books.
    The banks become insolvent and collapsed, along with the US economy.

    When banks have been lending to inflate asset prices the financial system is in a precarious state and can easily collapse.

    What was the ponzi scheme of inflated asset prices that collapsed in Japan in 1991?
    Japanese real estate.
    They avoided a Great Depression by saving the banks.
    They killed growth for the next 30 years by leaving the debt in place.

    What was the ponzi scheme of inflated asset prices that collapsed in 2008?
    “It’s nearly $14 trillion pyramid of super leveraged toxic assets was built on the back of $1.4 trillion of US sub-prime loans, and dispersed throughout the world” All the Presidents Bankers, Nomi Prins.
    We avoided a Great Depression by saving the banks.
    We left Western economies struggling by leaving the debt in place, just like Japan.
    It’s not as bad as Japan as we didn’t let asset prices crash in the West, but it is this problem has made our economies so sluggish since 2008.

    The last lamb to the slaughter, India
    They had created a ponzi scheme of inflated asset prices in real estate, but it collapsed.
    Now they need to recapitalize their banks.
    Their financial system is in a bad way, recovery isn’t going to be easy.

  4. Michael

    I have often thought JY made the correct call to start raising rates but failed to be realistic about the debt burden attached to those rates.

    Had she stopped one cut earlier with the statement that rates would remain fixed at that point for some period while everyone reset their models and the FED monitored the result of their actions, we may have been able to avoid the worst of the taper tantrum.

    Of course asking people to declare losses and shrink their balance sheets and unwind derivatives would have exposed those swimming naked and cascaded to some lower level. Not to mention how un banker like.

    When Melvin Capital got bitch slapped on their Gamestop short recently, they doubled down and got whacked again. Rescue from their financial bros treated it all as an anomaly.

    The paradigm on Wall St solidly in place. The Virus Crash of 2020 was welcome as those with massive assets and lightning speed to react made Bank! Not our fault!


    Thanks, you seems to have connected a lot of the dots.

    To summarize, would you say this is mostly an MMT analysis of money (and debt?). Combined with revisiting the actual role of banks play participating in Ponzi asset valuation inflation v the standard concept that Bank loans always create wealth by creating new assets?

  6. Telee

    Bill Black is giving a nine part series of interviews by Paul Jay on theanalysis news. The story actually goes back to the S&L crisis of the 1980s. Every president from George HW Bush to Obama is culpable. Bill Clinton’s administration was particularly damning. Obama no better. This is a fascinating story of financial fraud and criminality allied with the gutting of regulatory oversight. Felonies were committed yet the criminals were rewarded rather than punished. Government corruption was a necessary ingredient. While the Fed had the power to stop the fraudulent activity, The appointment of Ayn Rand libertarian Allen Greenspan as Fed Chairman by Clinton followed by the appointment of ultraconservative Ben Bernanke as well as Tim Geithner by Obama assured that the powers of the Fed would not be exercised and the scam would continue until meltdown. The whole story is complex and Bill Black details it beautifully. Highly recommended! https://theanalysis.news/ Look for Bill Black, The Best Way to Rob a Bank is to Own One. As of now there are 4 parts of a nine part series posted.

  7. eg

    I’m confused — what is it about the 19thC English central bank under the gold standard that is germane to 21stC central banking with fiat currencies?

      1. athingtoconsider

        The expression “elastic currency” is used to disguise the fact that fiat is being created for private interests such as for the banks and the rich, ie. “It’s just a loan!”

        Yes, we should have a fiat supply that continually expands (to accommodate population growth and to encourage investment rather than fiat hoarding) but I can’t think of a legitimate reason to ever shrink the fiat supply – anymore than blood-letting is a sound health measure.

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