Walter Bagehot’s Lombard Street : An Interpretation

2.1. Borrowed capital

By the mid-nineteenth century the British economy was “curious and peculiar” (Bagehot 2015: 10). One curious feature is the widespread use of “borrowable capital” “to an extent of which few foreigners have an idea, and none of our ancestors could have conceived” (Bagehot 2015: 5).

The large-scale use of credit occurs once risk-taking lending institutions emerge pari passu with creditworthy capitalists. This development forges a credit system that Marx refers to as being “subordinated” to the needs of commerce (Marx 1974: 602). In Bagehot’s credit system, savings are aggregated and channeled into financial institutions which then compete to lend “borrowable money” to capitalists (Bagehot 2015: 3–4). Competition between the lenders produces a cheap supply of credit for investment (Bagehot 2015: 67–68).

Along with this development, London’s financial institutions become “the great go-between” that permits “constant and chronic borrowing” (Bagehot 2015: 6). Intermediation taps savings to allow financiers to offer an elastic supply of credit. This provides England with “an unequalled fund of floating money, which will help… any merchant who sees a great prospect of new profit” (Bagehot 2015: 7).

To meet the credit needs of capitalists, a part of the financial system takes extraordinary risks, and unwittingly puts itself in the eye of the economic storms. In Bagehot’s era, bill brokers were the high-risk lenders. Brokers lend cash for the short-term IOUs of merchant capitalists (Bagehot 2015: 124–26; Flandreau and Ugolini 2014: 78–80). Bills are “an exceedingly difficult kind of security to understand” because the “relative credit of different merchants… is shifting and changing daily.” This makes “an accurate representation of the trustworthiness of houses at the beginning of a year” to “be a most fatal representation at the end of it.” To manage these risks, brokers become specialists in only “one class” of money market instrument (Bagehot 2015: 122).

To provide financing, brokers employ a perilous business model. First, they make maturity transformations like a banker but without a banker’s reserve to cushion them (Bagehot 2015: 126). Second, they operate with small margins between their lending rate and borrowing rate, forcing them to lever to earn a healthy profit (Bagehot 2015: 27).

Being illiquid and highly leveraged makes brokers and their bankers vulnerable in “periods of alarm” and “panic.” Panics cut off their funding as there is “always a very heavy call, if not a run upon them” (Bagehot 2015: 126).

2.2. Credit-using firms

In “most great periods of expanding industry,” there are “three great causes—much loanable capital, good credit, and… increased profits” (Bagehot 2015: 65). During expansions, undercapitalized firms with profitable investment opportunities need credit. By leveraging, they can challenge their better-capitalized rivals, but only by increasing their risk. For leverage to help them compete, their prospective profit rate must exceed the interest rate they pay (Bagehot 2015: 5).

With a profit rate above the interest rate, firms that borrow obtain advantages over their rivals. Leveraged firms will earn higher profits, allowing them to “sell much cheaper” and “drive the old-fashioned trader—the man who trades on his own capital—out of the market” (Bagehot 2015: 5, 8). Established capitalists realize that they are losing markets to their leveraged competitors and respond by borrowing more. In the end, “the struggle of trade” induces all firms to use credit as a competitive weapon.

2.3. The internationalization of finance

The third development is London becoming the world’s financial center. England’s leading position in world trade turns London into a magnet for foreign capital (Bagehot 2015: 16). In addition, agglomeration economies attract financial markets—“all exchange operations are centering more and more in London” (Bagehot 2015: 15). Once financial activity finds a home there, it stays and flourishes (Bagehot 2015: 16). The consequence is: “No country has ever been so exposed as England to a foreign demand on its banking reserve” (Bagehot 2015: 20).

This inflow of foreign money introduces another condition “of a delicate and peculiar nature.” Now, Britain’s policymakers need to maintain the “good opinion of foreigners” to keep foreign capital in London. Capital flees if “the opinion may diminish or may change into a bad opinion” (Bagehot 2015: 16). A policy problem arises when “in time of panic it [foreign money] might be asked for” (Bagehot 2015: 8). In other words, England becomes vulnerable to capital flight.

Foreign holders of pounds are different from their domestic counterparts. When foreign asset holders withdraw their funds from London they demand gold—“Bullion is the ‘cash’ of international trade.” This poses a problem because the Bank cannot print gold (Bagehot 2015: 20). Thus, when the “good opinion” is lost, foreigners run on the Bank’s gold reserves, initiating a monetary crisis (Bagehot 2015: 16). If the Bank’s reserves fall to dangerously low levels, below the “apprehension minimum,” the run accelerates, and countermeasures are required to protect the pound’s convertibility (Bagehot 2015: 139).

3.1. Restoring gold

A Ricardian regime is established by legislation in 1819 and 1844. Two well-known policy debates give intellectual and political support for it (Kindleberger 1993: 63–66, 91–92). The initial debate is on the merits of reimposing a gold standard, suspended during the Napoleonic Wars (Ricardo 2012 and 2007; Laidler 1987). A run on the Bank’s gold in 1797 made the Bank’s notes inconvertible, launching “one of the world’s historic monetary controversies” (Fetter 1965: vii).

By 1810, Ricardo, a leading member of the bullionists, argues that the run in 1797 is caused by a “political alarm”—the war—and was unavoidable (Ricardo 2007: 45). The mistake made by the government, Ricardo thought, is not returning to a convertible currency once the alarm subsides. By continuing to issue inconvertible paper, the government opens a Pandora’s box, allowing the “evils attending a variable medium” to escape (Ricardo 2012: 18–19).

From 1809 to 1814, the “evils” consist of a modest inflation, the market price of gold rising above its mint price, and the pound depreciating. Those who want a hasty return to gold blame the “progressive depreciation of the paper-currency” on the overissue of notes by the Bank (Ricardo 2007: 3). Eventually, legislators restore a gold standard in 1819, creating a monetary system featuring a convertible currency.

The theory that rationalized the return to a gold standard is that it eliminates nominal instability by anchoring the currency to a metal with a stable purchasing power (Ricardo 2012: 19). A golden tether also disciplines the Bank’s ability to issue currency by forcing it to convert its notes into gold on demand (Ricardo 2012: 10–11). With an untethered currency, Ricardo warns: “There can be no limit to the depreciation which may arise from a constantly increasing quantity of paper” (2007: 26–27).

3.2. The “cast iron system”

Controversy resumes in the 1830s and 1840s. Worries of inflation and currency depreciation subside, and new concerns emerge and reveal flaws in the policy regime. The new threat is real and financial instability. The new problems make a dramatic appearance in the crisis of 1825 (Bagehot 2015: 23, 60, 68, 77–78, 87–88). The 1825 crisis is the “first proper industrial business cycle” (DeLong 2012: 1). It begins as “the first modern financial crisis” and then morphs into a banking panic (Morgan and Narron 2015: 1). Bagehot believes the panic brought England “within twenty-four hours of a state of barter” (2015: 87) and “its results are well remembered after nearly 50 years” (2015: 78). Pressure on the policy regime gains further impetus by events in 1839, when a large outflow of bullion empties the Bank’s reserve and forces the government to borrow gold from the Bank of France to stabilize the pound (Eltis 2001: 6).

In terms of policy, in 1825 the Bank refused, at first, to provide support when depositors were running on the banking system. The runs lead to payment suspensions and the “slaughter of country banks” (Kindleberger 1993: 84). What is most shocking about this episode, however, is the way the panic is stopped. Under pressure, the Bank reverses course and lends “money by every possible means, and in modes with which we have never adopted before” (Bagehot, quoting a Bank official, 2015: 88). This begins “the birth of central banking as we know it” (DeLong 2009: 6; Bagehot 2015: 87–88).

The followers of Ricardo, known as the currency school, insist that economic downturns and financial crises have monetary origins. Boom and bust cycles are a consequence of the Bank issuing too many notes, preventing the currency supply from rising and falling with changes in the gold reserve. Furthermore, the “extraordinary measures” the Bank is forced to use to douse panics would not be necessary, they argue, if the Bank does not overissue its notes (Fetter 1965: 169–70).

The passage of the Bank Act of 1844 is a triumph for the currency school. The Act places drastic restrictions on the issuing of notes. To do this, the Bank is divided into two departments, a regulated Issuing Department, for holding the gold reserve and issuing currency, and the Banking Department, a profit-seeking enterprise. Thus, by 1844 a Ricardian-inspired policy regime is created with a convertible currency, a tightly regulated issuing bank, and strict limits on the note supply.

These changes to the policy regime are intended to “solve” the problem of real and financial instability by installing what Bagehot calls the “cast iron system” (2015: 12). As a bonus, the Act makes it “unnecessary” for the Bank to engage in rescue operations to extinguish panics. The currency school’s Torrens, a “brilliant and erratic controversialist” (Fetter 1965: 167), confidently predicts that the Act “will effectively prevent the reoccurrence of those cycles of commercial excitement and depression that our ill regulated currency has been the primary cause of” (cited by Chambers 1974: 91).

However, the “cycles of commercial excitement and depression” continued. Panics strike in 1847, 1857, and 1866. In each crisis the Bank intervened. First, the Bank acted as a lender of last resort to contain the panic. For this to work, the government had to suspend the terms of the Act in each case (Bagehot 2015: 78). Second, the Bank experimented with monetary policy, changing its discount rate to defend its gold reserve and to counter downturns. By 1873, the use of monetary policy became so routine that the Bank “went in for fine-tuning… it changed its rediscount rate twenty-four times” (Kindleberger 1993: 92).

Bagehot’s interpretation is that reoccurring macroeconomic instability pushed the Bank into a new role without “guidance either of keen interests, or good principles, or wise traditions” (Bagehot 2015: 77). Instead, policy is driven by the “pressure of events” (O’Brien 2003: 1) because “practice preceded theory” (Kindleberger 1978: 162). This created a need for “guidance.” Bagehot desperately wanted to reform the regime, but in a way that did not undermine the existing order.

4.1. The Bank becomes a bankers’ bank

By mid-century, the Bank, flaws and all, becomes capitalism’s pioneer central bank by transforming into a bankers’ bank (Goodhart 1988: 5). In ordinary times, the Bank enables financial institutions to satisfy the credit needs of capitalists. An example of this is the Bank amassing a “safety fund” of reserves, which allows the financial system to become less liquid and remain secure (Bagehot 2015: 13).

This arrangement, though, creates a moral hazard. The “danger” of the “safety fund” is that “no bank in London or out of it holds any considerable sum in hard cash” (Bagehot 2015: 13). The unintended consequence “is to cause the reserve to be much smaller in proportion to the liabilities” (Bagehot 2015: 14).

4.2. The Bank and financial stability

To be a true bankers’ bank, the Bank must assume the role of a crisis manager. As it backstops the financial system in a crisis, financial stability increasingly depends “on the wisdom of the directors [of the Bank]… whether England shall be solvent or insolvent” (Bagehot 2015: 16). To keep it solvent, the Bank acts as the “trustees of the public” and uses its reserves “to meet extraordinary and unfrequent demands” on Britain’s credit and monetary system (Bagehot 2015: 17, 13).

5.1. Domestic drains

The “at home” problem is a “domestic drain” from a run on the credit system when there is a mad desire to become liquid (Bagehot 2015: 22). It arises when there is “a great demand for actual cash… in a country where cash is much economized, and where debts payable are large” (Bagehot 2015: 54). If it produces a panic, many adverse consequences will follow.

Bagehot’s panics materialize in the late stages of expansions when “hidden causes” erode “trust”—the ingredient that keeps the credit system stable—between lenders and borrowers (Bagehot 2015: 69). By surfacing, these “hidden causes” make credit “delicate” (Bagehot 2015: 54).

There are three hidden causes—the first two are mistakes and fraud. Fraud is usually “rare,” and mistakes are “ruinous.” Bagehot argues that mistakes are not only “far more common” but they are also much costlier and more dangerous (Bagehot 2015: 113).

The third is speculation: “Every great crisis reveals the excessive speculation of many houses which no one before suspected.” In the boom, lending for “gamblings” is due to “an excess accumulation [of savings] over tested investment.” In the downturn, when bubbles burst, they disrupt credit markets. However, Bagehot downplays the importance of speculation in crises (Bagehot 2015: 68, 60).

Bagehot’s views on the anatomy of panics is quite modern. The credit system becomes susceptible as the expansion proceeds because liabilities grow, and borrowers must frequently demonstrate their “instant capacity to meet engagements” (Bagehot 2015: 11). The onset of crisis is sparked by a disturbance, like the failure of a once-trusted financial institution. This calls into question the “set of promises to pay” and the ability to “meet their engagements” (Bagehot 2015: 54, 11). The disturbance also weakens the “unprecedented trust” by unleashing fears that more hidden causes will surface (Bagehot 2015: 69).

A crisis starts as an “alarm” and then becomes an “incipient panic.” An alarm is “an opinion that the money of certain persons will not pay their creditors” (Bagehot 2015: 24). Incipient panic “amounts to… a vague conversation: Is A. B. as good as he used to be? Has not C. D. lost money?” If it continues, “this floating suspicion becomes both more intense and more diffused… and attacks them all more virulently” (Bagehot 2015: 22).

In periods of growing susceptibility, a Bagehot Moment arrives. It is the moment in the crisis where two outcomes seem possible—either trust is restored and the brewing crisis fizzles, or a “terror” is unleashed. The determining factor is how agents react to their sudden vulnerability, because what they come to believe and do becomes a self-fulfilling prophesy (Obstfeld 1996). An unlikely outcome—especially if the Bank stays on the sidelines—is that counterparties continue to trust each other and refuse to succumb to their fears. The preservation of trust minimizes disruption and the crisis becomes a “pseudo-financial crisis” (Schwartz 1987).

If fear prevails, then everyone will panic. The fear is of “the destruction of credit,” and the participants respond to it by “strengthening” themselves at the expense of their counterparties (Bagehot 2015: 22). This produces “a general run, and credit is suspended.” Their beliefs are self-fulfilling because the “dread” of a “destruction of credit” produces the runs which undermines the credit system—they “beget the calamities they dread” (Bagehot 2015: 139).

“Terror” follows because the crisis becomes self-perpetuating—one adverse event leads to another (Bagehot 2015: 86; Kindleberger 1978: 161–62). As Bagehot states, “one failure makes many” (2015: 23), and “each failure would add to the discredit that caused the collapse” (2015: 84).

5.2. Foreign drains

Runs “from abroad to meet foreign payments” are a variant of a currency crisis (Krugman 1998). They start with an adverse balance of payments shock that becomes a policy problem once foreign asset holders convert their pounds into gold (Bagehot 2015: 20). As the gold reserve diminishes, it imperils the convertibility of the currency. To prevent the onset of monetary disorder, the government can suspend convertibility, or the Bank can adopt policies to manage the drain.

6.1. The Bagehot Moment and the lender of last resort

In a domestic drain, at the point which the Bagehot Moment arrives, policymakers want to avoid a financial disaster. The key to achieving this is to create a state of “diffused confidence.” This requires the Bank to convince the public that “money may be had” and “utter ruin is not coming.” If it works, “they would cease to run in such a mad way for money.” The best way to accomplish this is a “bold policy” (Bagehot 2015: 29).

A bold policy has “rules” (Bagehot 2015: 85–86). The first is to lend freely. “[T]o advance it [money] most freely for the liabilities of others… lend to merchants, to minor bankers, to ‘this man and that man’” (Bagehot 2015: 23). The second is to lend against all “good collateral.” Loans “should be made on collateral which in common times is good ‘banking security’” (Bagehot 2015: 89). And finally, the unstated “rule” is to do “whatever it takes,” to borrow Draghi’s words, to “stay the panic” and do nothing to make it “indefinitely worse” (Bagehot 2015: 85, 29).

6.2. Interest rate policy and external drains

Two policies can be used to manage external drains. The first is to accumulate a large gold reserve to make it less likely that the reserve will fall to a level that will “cause the evil that is feared” (Bagehot 2015: 140). However, holding a large reserve by itself is unlikely to work. The second is to fulfill the “first duty” of the bank—defending the gold standard—by using monetary policy (Bagehot 2015: 138). To protect the gold reserve, “an effectual instrument” is needed, “the elevation of the rate of interest.” A high interest rate policy induces: “Continental bankers and others instantly send great sums [of gold] here, as soon as the rate of interest shows that it can be done profitably” (Bagehot 2015: 21). The trick is to find the “right” interest rate before bullion outflows bring ruin to the Bank (Bagehot 2015: 140–41).

6.3. Two opposite maladies

The most dangerous crisis, Bagehot thought, is one where both an “internal panic and external demand for bullion” come at the same time. He argues that to stop a foreign drain requires “stringent remedies” and a domestic drain “large and ready loans.” He understood the dilemma in this advice, as a “rise in the rate of discount… [would] frighten the market,” and might worsen the domestic drain (Bagehot 2015: 25).