Rethinking Finance: New Perspectives on the Crisis: A Conference I Am Going to
From Practice Back to Theory: Walter Bagehot’s Lombard Street: The Great Depression

This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Conclusion: From 1873 to 2009

It is traditional for economic historians and historians of economic thought to lament productive research programs of the past that were then only little further developed, with many threads left dangling for decades if not longer. And it is indeed a fact that the number of economists whose work makes it into the graduate curriculum who build on Bagehot is relatively small: Minsky (1982, 1986) is present to a small degree. Kindleberger (1978, 1984) is present to a somewhat larger one. Eichengreen (1992, 2008) is present in economic history courses. Otherwise, Bagehot (1873) remains remarkably good preparation for reading modern works that attempt to pick up the same or similar threads like Richard Koo (2003, 2009) or Carmen Reinhart and Kenneth Rogoff (2008).

One reason that Bagehot (1873) still has considerable authority is that the tools of modern academic macroeconomics are not of a great deal of help in weaving together the threads trailing off from Bagehot. Rare and complex events like large financial crises that produce deep and lengthy downturns are not frequent enough for statistical methods to have much purchase. Financial crises are generated when leveraged agents make large bets and get them wrong, while modern economics has a hard time sustaining models in which agents make bets at all: it is difficult to construct economic actors who are both believable and who fail to realize that they know less than their potential counterparty, and any deal that their potential counterparty is willing to offer is not one that they should accept. Academic macroeconomics can and has made progress on lots of issues,but working in the tradition of Bagehot goes against the grain.

Alongside the lack of comparative advantage of the analytical tools of modern economics in making progress on Bagehot-type issues is the fact that, qualitatively, our knowledge base is little better than his. As of his writing, Bagehot or his predecessors had seen the industrial-economy financial crises of 1825-6, 1847-8, 1857, and 1866. Since then we have seen global-scale crises in 1873, 1884, 1893, 1907, 1929-33, and 2008-9, alongside a host of local-scale crises. However, the qualitative mechanism has remained the same. Since 1825 we have seen a single mechanism transmit financial distress to the real economy of production and employment. It takes the form of a recognition that previous confidence in the liquidity or safety of assets was built on sand, of an attempted flight to liquidity and/or quality in asset holdings, and the consequent excess demand for financial assets generating, via Walras’s Law, deficient demand for currently-produced goods and services. The freezing-up of the spending flow and its implications for employment and production looks much the same in episode after episode. Thus a nineteenth-century author like Walter Bagehot is at little disadvantage in analyzing the causes and spread of the downward financial spiral, or in analyzing its consequences for the real economy.

While it would certainly have been helpful and productive had the threads left dangling by Lombard Street been woven further over than they have been over the past 140 years, that failure to make more rapid progress was not a great disability for economics. What was a great disability for economics was a failure to pick up the toolkit of Lombard Street and use it to its full effect over the past five years. And here I do not have answers: I have only questions. Specifically:

  1. Why were economists so confident that highly-leveraged money-center banks—banks that had just switched from a partnership to a corporate structure—had effective control over their risks?

  2. Why were economists so confident that the Federal Reserve had both the power and the will to easily stabilize the growth path of nominal GDP?

  3. And what happened to economists’ effective consensus on the technocratic goals of macroeconomic policy? The presumption since at least 1936 was that it was the business of government to intervene strategically in asset markets to stabilize the growth path of nominal GDP, and so to attempt to attain both effective price stability and maximum feasible employment and purchasing power.

Yet when the crunch came in late 2008, the technocratic policy consensus on even the goal of maintaining the flow of spending proved to be fragile and ephemeral.

Bagehot, however, was very clear and vocal on the root cause of the problem:

Any sudden event which creates a great demand for actual cash may cause, and will tend to cause, a panic in a country where cash is much economised, and where debts payable on demand are large.... [S]ome writers have endeavoured to classify panics according to the nature of the particular accidents producing them. But little, however, is, I believe, to be gained by such classifications. There is little difference in the effect of one accident and another upon our credit system. We must be prepared for all of them, and we must prepare for all of them in the same way.... [O]wners of savings not finding, in adequate quantities, their usual kind of investments, rush into anything that promises speciously.... The first taste is for high interest, but that taste soon becomes secondary. There is a second appetite for large gains to be made by selling the principal which is to yield the interest. So long as such sales can be effected the mania continues; when it ceases to be possible to effect them, ruin begins...

And on what needed to be done in response:

Ordinarily discredit does not at first settle on any particular bank... [it] amounts to a kind of vague conversation: Is A. B. as good as he used to be? Has not C. D. lost money?... A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man’.... The problem of managing a panic must not be thought of as mainly a 'banking' problem. It is primarily a mercantile one.... At the slightest symptom of panic many merchants want to borrow more than usual; they think they will supply themselves with the means of meeting their bills while those means are still forthcoming. If the bankers gratify the merchants, they must lend largely just when they like it least; if they do not gratify them, there is a panic. On the surface there seems a great inconsistency.... First, you establish in some bank or banks a certain reserve.... And then you go on to say that this final treasury is also to be the last lending-house; that out of it unbounded, or at any rate immense, advances are to be made when no one else lends. This seems like saying—first, that the reserve should be kept, and then that it should not be kept. But... the ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for certain essential purposes, and one of those purposes is the meeting a demand for cash caused by an alarm within the country...