From Practice Back to Theory: Walter Bagehot’s Lombard Street: The Great Depression

How effective are these rules? How necessary are these rules? They are a systematization of nineteenth-century British central-banking practice. They do have theoretical banking in John Stuart Mill’s observation that deficient aggregate demand—planned total economy-wide spending less than expected income—is the flip side of excess demand for financial assets or for some subset thereof. They do, at least in Peel’s formulation, attempt the sleight of hand and tricks with mirrors, the “ambiguity, verging on duplicity... promis[ing] not to rescue banks and merchant houses... to force them to take responsibility for their behavior, and then rescu[ing] them... for otherwise trouble might spread...” that Kindleberger calls for in the hope of minimizing ex ante moral hazard. But are there alternative public-policy strategies that would do as well?

We do not really know. We do however, know that the one major time in a deep financial crisis that Bagehot’s rules were not followed turned into the Great Depression.

In part this was because of the sovereign-debt aspect. In Europe there was no actor large enough to be a lender of last resort. The United States did not want to step in and serve as a lender-of-last-resort for Europe. In part this was because there was no visible shortage of “liquidity”. Money remained very cheap, in the sense of very low safe short-term interest rates. So how could there be a role for the central bank? What point in swapping cash for short-term government bonds when both are indistinguishable zero-yielding government assets? We today would presumably distinguish between a shortage of liquidity pure-and-simple—a situation in which investors are dumping interest-earning assets at almost any price in order to build up their stocks of means of payment—and a shortage of safe assets—in which investors are dumping risky assets in order to build up their stocks of safe assets. We would say that there is a strong case for the central bank to rebalance the economy by increasing the money supply in the first case and by increasing the safe asset supply in the second.31 But interwar policymakers did not make that leap.

In part it was because of the rising Austrian tide. The 1920s and 1930s saw the heyday of the doctrine that business-cycle depressions are the necessary breathing of the economic mechanism.32

In part it was out of a fear that large deficits and rising government debt would shake business confidence and add to uncertainty, and raise fears of destructive inflation.33 Monetary experts like R.G. Hawtrey could denounce those who called for fiscal austerity to fight the danger of inflation as “Crying ‘Fire! Fire! in Noah’s Flood”. But they had little effect on policy at the end of the 1920s, and less effect on policy in the post-trough 1930s than they wished.

Kindleberger’s judgment was that Bagehot’s rules are applied because they had, more often than not, worked reasonably well:

Whether there is a theoretical rationale for letting the market find its way out of a panic or not, the historical fact is that panics that have been met most successfully almost invariably found some source of cash to ease the liquidation of assets before prices fell to ruinous levels…

The fact remains that when policymakers and commentators confronted the financial crisis of 2008-9, they almost invariably reached for the rules of Walter Bagehot. It is in that sense that Lawrence Summers was correct when he said that “there is a lot in Bagehot that is about the crisis we just went through...”