Walter Bagehot and the Problem of the "Lender of Last Resort"
“If an archeological seeker of the origins of the socialization of risk in high finance wants to find clues, let him or her begin with an excavation of Lombard Street.”
-- James Grant, Bagehot, p. 268
In August of 2019, the amount of global debt yielding negative returns hit $15 trillion. How did we get here, and where will it lead? The latter question is impossible to answer because we have never been in a situation like this before: global negative returns are a new phenomenon across the thousands of years of recorded interest rate history.
How we “got here,” on the other hand, is another story altogether and, significantly, it is a story that can be told, especially how it all began.
Several years ago, I was having lunch with financial journalist/historian/analyst James Grant. I asked him what he was working on, and he mentioned a biography of Walter Bagehot, who was a nineteenth-century financial journalist, long-time editor of the Economist, and author of what many consider “the bible” of central banking, the book Lombard Street: A Description of the Money Market (1873). It was the perfect pairing of subject and author.
By way of background, a reason why Lombard Street is considered the central banking bible is “the rules” it propounds; namely, that banks in distress should be provided with emergency loans against good collateral only “at a very high rate of interest.” A second reason is the experiences of the infamous Panic of 1907 where the late J.P. Morgan — the actual banker, not the modern firm named after him — halted the panic by lending money to distressed financial institutions against good collateral only “at a very high rate of interest.” Morgan’s actions lead directly to the creation of the U.S. Federal Reserve System in the year 1913.
Mr. Grant’s recently published book, Bagehot: The Life and Times of the Greatest Victorian, is a biography so it “begins at the beginning” of Walter Bagehot’s story, which is important because Bagehot was very much a product of his time (as we are a product of ours). And what a time it was! Grant observed that, “Bagehot wrote in the context of the gold standard: of fixed foreign exchange rates, balanced budgets, convertible currencies, and the personal responsibility — either limited or unlimited — of bank shareholders for the solvency of the institutions in which they were invested. His world was one of institutionalized discipline” (pp. 293-294).1 Indeed, the following were “Bagehot’s favorite institutions — the gold standard, cabinet government, free trade” (p. 292). Oh, how times have changed!
Walter Bagehot was born into a banking family, and he followed his father into that profession. However, “literature was the love of Bagehot’s life” (p. 56) as his writing clearly reflects; indeed, he “was a banker and essayist rolled up into one” (p. 285).
Bagehot’s father-in-law was James Wilson, an impressive man in his own right who started a newspaper called, the Economist: or The Political, Commercial, Agricultural, and Free-Trade Journal. Upon Mr. Wilson’s death, Walter Bagehot became editor, and a legend was born.
I admittedly moved very quickly across Bagehot’s life, and thus have clearly not done it justice. I am also not going to profile Bagehot’s journalistic career, including his incredible reporting of the foreign-government bond craze of the late 1860s (p. 250). Both his life and his career had its ups and downs, which Mr. Grant masterfully chronicles.
In the time we have left, I am going to profile Bagehot’s Lombard Street, and comment on where we find ourselves monetarily today. First, though, some context: the most significant banking act of Bagehot’s time—the Victorian Age—was The Bank Charter Act of 1844 (or Peel’s Act; p. 26). This act recognized the Bank of England as the central note-issuing authority, and as the lender of last resort (in other words, as England’s central bank). Like many modern financial regulations, Peel’s was a reaction to disruptive financial volatility; specifically, the financial crisis of 1838-39.2
Peel’s Act, like many such acts across history, was challenged during periods of financial volatility; the acts of legislating and regulating being generally backward-looking. A key volatile event of Victorian finance was the failure of Overend, Gurney & Co., which helped to trigger the Panic of 1866. During the panic, Peel’s Act was suspended as officials struggled to cope with panic-driven financial volatility that pushed short-term interest or bank rates up to 10%, which was the highest rate of the century according to Table 23 of, A History of Interest Rates 4th Ed.
The British economy recovered from the panic’s disruptive volatility, and as volatility dissipated bank rates came down. Indeed, the very next year they traded between 2.51% and 3.5%. No negative rates needed in Victorian England, but what to do to prevent future financial volatility?
In answering this question, Grant compares and contrasts Bagehot’s Lombard Street with another work of the period, Thomson Hankey’s The Principles of Banking, Its Utility and Economy; with Remarks on the Working and Management of the Bank of England. It is an insightful strategy, and one that illuminates the “mystery” of central banking in both Bagehot’s time and ours.
In short, Bagehot’s position is that, “The money market could not take care of itself” (p. 267) and therefore the banking system needs a “lender of last resort” that will provide troubled banks with emergency loans against good collateral only “at a very high rate of interest,” as noted above. Hankey’s position, on the other hand, is that, “A good banker had no need of a central bank and a bad banker had no claim on a central bank” (p. 164).
The ensuing debate between these two extremes makes for both fascinating history and thought-provoking contemplation in this era of $15 trillion of negative yielding global debt.
Central to Bagehot’s position is an assumption of systemic preparation — or the accumulation of ready cash, which in Victorian times meant gold and claims on gold—during periods of low volatility that could be deployed during volatile periods. This position seems exceedingly reasonable — in both Bagehot’s time and ours—and yet, according to Grant, “ Lombard Street failed to convince anyone to lay in more cash, as the Economist’s own figures would shortly prove. … Far from adding to their rainy-day cash positions in proportion to the growth of their liabilities, the leading banks made do with less” (pp. 281-282). And thus, exactly as his rival Hankey contended, “the mere existence of the doctrine of the lender of last resort was an incitement to financial recklessness” (p. 279). Such recklessness would, of course, not end there.
One hundred and fifty years later we have transitioned from a world of institutionalized discipline. “Today’s world — one of paper currencies, floating exchange rates, enormous budget deficits, and governmental policies to protect both investors and depositors against the consequences of a bank’s mismanagement — is largely one of institutionalized indiscipline” (p. 294).
Walter Bagehot, of course, intended none of this, but that is the point: the long-term consequences of a policy rarely reconcile with the expected intentions of the policy. This is a lesson that should have been learned by now — or perhaps not. Either way, Bagehot: The Life and Times of the Greatest Victorian is a scintillating read that will both entertain and inform in these most troubling financial times.