Money (30 page)

Lombard Street
deliberately set out to be short, polemical, and lively—“a piece of pamphleteering, levelled at the magnates of the City and designed to knock into their heads, for the guidance of future policy, two or three fundamental truths,” as Keynes called it.
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Yet it was also a brilliant work of economic exposition and analysis. Two features in particular distinguished it from the works of Mill and the classical school. The first was that Bagehot’s economics started explicitly from money, banking, and finance—which Bagehot saw as the governing technology of the modern economic system. The second was that Bagehot insisted that theory should be constructed
to fit the reality of the monetary economy, rather than the other way round. The very title and opening sentences of
Lombard Street
proudly advertised these departures from the abstract economics of Bagehot’s classical forebears. “I venture to call this Essay ‘Lombard Street,’ and not the ‘Money Market,’ or any such phrase,” wrote Bagehot, “because I wish to deal, and to show that I mean to deal, with concrete realities.”
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And what Bagehot saw as the most basic reality to be grasped about the modern monetary economy was that the conventional understanding of money as gold and silver—the understanding adopted by habit by the man in the street, and the one promoted by the academic economists of the day—was confused. The slightest acquaintance with Lombard Street revealed that the money overwhelmingly used by businessmen was by and large private transferable credit: above all, bank deposits and notes. “[T]rade in England,” he explained, “is largely carried on with borrowed money.”
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This simple and apparently innocent fact, Bagehot argued, had profound ramifications for understanding the modern economy’s cycles of boom and bust, and how to moderate them. If money is in essence transferable credit—rather than a commodity medium of exchange, as the academic economists insisted—then fundamentally different factors explain the economy’s demand for it. Meeting demand for commodities is a simple matter of ensuring a sufficient supply on the market. When it comes to transferable credit, however, volume alone is not enough: the creditworthiness of the issuer and the liquidity of the liability come into play. And both these factors are determined not technologically or physically but by the general levels of trust and confidence. “The peculiar essence of our banking system,” wrote Bagehot, “is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”
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It was from this starting point alone that a proper understanding of the modern economy could be constructed, Bagehot argued. The central importance of the intrinsically social properties of trust
and confidence called for a quite different focus for economic analysis than that of Mill and the classical school. “The main point on which one system of credit differs from another is ‘soundness,’ ” wrote Bagehot. “Credit means that a certain confidence is given, and a certain trust reposed. Is that trust justified? And is that confidence wise? These are the cardinal questions.”
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And the answers to these cardinal questions were, he was sorry to disappoint his academic elders, not amenable to mechanical theorising. “Credit is an opinion generated by circumstances and varying with those circumstances,” so that genuine insight into the functioning of the economy requires an intimate familiarity with its history, its politics, and its psychology—“no abstract argument, and no mathematical computation will teach it to us.”
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Walter Bagehot, the supreme explainer of the “concrete realities” of the money market.

(
illustration credit 12.2
)

This simple change of perspective on the fundamental nature of money, Bagehot argued, implied not only a different understanding
of how the economy worked, but alternative policies to avoid crises and recessions. The first step here was to understand that although all money is transferable credit, there is one issuer of money whose obligations are, under normal circumstances, more creditworthy and more liquid than all the rest: the sovereign, which in the modern financial system had delegated its monetary authority to the Bank of England. This dominant role of sovereign authority in the monetary system was no fluke, Bagehot warned. Money depends on social trust, and “[c]redit in business is like loyalty in government,” wrote Bagehot in a famous comparison, “[it] is a power which may grow, but cannot be constructed.”
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This clear view of how sovereign money is, in normal circumstances, qualitatively different from private money, allowed Bagehot to explain the continuing importance of the Great Monetary Settlement and its practical implications for the modern economy. Though the modern monetary system, he explained, was now vastly expanded from the day of the Bank of England’s establishment, it continued to work on the identical principle. The Bank had married the commercial acumen of one privileged set of private bankers with the public authority of the sovereign to render the Bank’s money both creditworthy and universally transferable. And in the subsequent century and a half, the Bank itself had struck the same marriage time and time again with an ever-widening harem of other private bankers. Just as the sovereign had lent its unique authority to the Bank, so the Bank had over time got into the practice of lending its authority to the universe of other banks; and, until the policy reversal of 1858 that had heralded the beginning of the end for Overends, to the bill brokers as well. The result was a modern monetary economy in which “[o]n the wisdom of the directors of one Joint Stock Company, it depends
whether England is solvent or insolvent
 … [a]ll banks depend on the Bank of England, and all merchants depend on some banker.”
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Here was the reason, Bagehot explained, that Lombard Street was the money market of the entire global economy: the place where more banks were able to issue more money than ever before
in the history of the world. Just as the Bank’s money had originally gained its currency from its settlement with the sovereign, so now the moneys issued by the banks and bill brokers of Lombard Street gained theirs from the Bank, and the moneys of the country banks gained their currency from the banks and brokers of Lombard Street. Country and London banks attracted deposits from the savings of entrepreneurs and rentiers; merchant banks and bill brokers sourced investment opportunities from company promoters in which to place them. Modulating, and thereby enabling, the constant flux and reflux of payments to and from depositors and entrepreneurs was the great bill broker at the apex of the pyramid—the Bank of England, the first modern central bank. In a crisis, its pivotal role was clear for all to see. The Bank became all of a sudden the bill broker and banker of last resort, because it alone was always able to discount bills even if no one else would.

This remarkable monetary infrastructure was, Bagehot explained, the operating system of the Industrial Revolution, and what distinguished Britain from every other country in the world. That was the good news. But by the same token, if it was allowed to malfunction, the effects could be catastrophic. And the greatest temptation of all—the temptation for which the abstract economics of the classical school showed an insuperable weakness—was to forget that the central bank, as the delegate of the sovereign, is uniquely able to support the trust and confidence on which the monetary system depends; and is therefore uniquely responsible for the health not just of the City, but of the entire economy, in both normal and crisis times. “We must not think,” wrote Bagehot, “that we have an easy task when we have a difficult task, or that we are living in a natural state when we are really living in an artificial one. Money will not manage itself, and Lombard street has a great deal of money to manage.”
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The crisis of 1866 had ruthlessly exposed the governance and policy of the Bank of England as an anachronistic relic at the heart of what had become the largest financial centre in the world. The time had come for reform.

Bagehot had two sets of proposals—both of which remain at
the heart of modern central-banking practice. The first concerned reforms of the governance and status of the Bank itself. The Bank of England remained a private company, and the agreement according to which it topped the monetary pyramid was implicit, intermittent, and entirely at the whim of its privately appointed management. Despite the facts that “[t]he directors of the Bank are … in fact, if not in name, trustees for the public … so far from there being a distinct undertaking on [their] part … to perform this duty, many of them would scarcely acknowledge it, and some altogether deny it.”
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And as for higher political oversight, “[n]ine-tenths of English statesmen, if they were asked as to the management of the Bank of England, would reply that it was no business of theirs or of Parliament at all.”
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This situation was no longer tenable. The central bank was an essential element
—the
essential element—of the modern monetary system. This fact should be acknowledged in the open, rather than honoured in the breach.

So much for the institution of the central bank. Even more important was its policy. In the crises of 1847, 1857, and after Overends itself, it had ultimately deployed its unique powers to save the financial system from disaster. But on each of these occasions, the Bank had acted only when catastrophe was imminent. As Winston Churchill once said of the United States, it could always be counted on to do the right thing—after it had exhausted all other possibilities. A large part of the problem, Bagehot argued on the basis of the testimony of the Bank’s directors following the Overends crisis, was simply that they had no properly articulated principles of monetary policy. So Bagehot supplied them—and he kept them simple enough for policy-makers to grasp.

His first and most basic prescription was that the central bank’s role as the lender or broker of last resort should be made a statutory responsibility, rather than left to the directors’ discretion. When faith in the safety or liquidity of private money faltered, the Bank of England should stand ready to lend sovereign money without any specified limit. By offering to exchange its own obligations for those of the now discredited banks and businessmen, the Bank could and should
stay a panic before it becomes self-fulfilling. Bagehot therefore established the rationale for a proactive monetary policy, and his first rule explained what the essential substance of this policy should be: “in time of panic [the Bank] must advance freely and vigorously to the public out of its reserve.”
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Bagehot’s second and third rules then set out two important aspects of how such a policy should be applied. The second was that in its role as lender of last resort, the bank should not try to make nice distinctions between who is insolvent and who merely illiquid in the heat of a crisis. It should lend “on all good banking securities, and as largely as the public ask”; with a good banking security being any that “in ordinary times is reckoned a good security.”
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The point of the operation is “to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer.”
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There is always the risk, if a lender of last resort is waiting in the wings to assuage a panic, that private banks and merchants will become over-exuberant in their speculation—that there will arise a problem of “moral hazard” as insurers and economists call it. Bagehot therefore proposed his third principle to ward off this risk. Emergency lending “should only be made at a very high rate of interest … [to] operate as a heavy fine on unreasonable timidity, and … prevent the greatest number of applications by persons who do not require it.”
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Why was it that these ideas of Bagehot’s were so controversial? Why was it that Bagehot felt the need to apply himself so zealously to such a polemical tract? If all this was so obvious to the practitioners, then why all the fuss? The reason was that there was in wide circulation a quite different view of the nature of money and of how the economy worked. This was the view of the dominant, classical school of economics—the school that had been inaugurated by Adam Smith’s
Wealth of Nations
, refined by men like David Ricardo and Jean-Baptiste Say, and systematised by John Stuart Mill in his great 1848 textbook,
The Principles of Political Economy
. Bagehot was simply bringing logical rigour to the folk wisdom of the money market and the rules of thumb of the central bank. In the background,
however, remained the orthodox church of classical economics, with clear doctrines and a precise catechism on matters monetary and economic. And the disparity between its teachings and Bagehot’s could not have been starker, both in their understanding of the economy and in their implications for policy.