This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: The Development of Central Banking Practice in the Mid-Nineteenth Century: Robert Peel’s Successors and “Suspension Letters”
This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Origins of Central Banking: E.M. Forster's Great Aunt Marianne

This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: The Development of Central Banking Practice in the Mid-Nineteenth Century: Robert Peel and “Moral Hazard”

In 1844 the British Parliament took a look at the system of central-bank support for the economy in a financial crisis that the Bank of England’s intervention in 1825 had left it. It held a debate on the terms on which the charter of the Bank of England should be renewed. In the end, the conclusion of the 1844 Bank Recharter debate was twofold:

  1. The Bank of England should not have the power to print unlimited amounts of money to support the banking system in a financial crisis—in fact, it should be illegal for the Bank of England to print extra banknotes in a crisis. The important principle was that bankers should be on notice that they should not expect a bailout—for that would create too great a risk of substantial losses from moral hazard.

  2. In the event of a real emergency coming--which, Prime Minister Robert Peel claimed, should not happen--then the government could and would request that the Bank of England print as many banknotes as needed to fix the financial crisis.

The reason for (1) was very clear to the Parliamentary debaters back in 1844. Any confident expectation on the part of the financial community that the Bank of England did stand behind them and would intervene to prevent large-scale bankruptcy in a financial crisis would greatly amplify the chances of such a crisis by removing fear and caution. Bankers confident that in the last analysis they were gambling with the public’s money would do what bankers tend to do in such situations. Hence, Robert Peel and his majority in the Parliament thought, it was very important to establish the principle that the Bank of England could not be relied upon to bail out the banking system. And, Peel thought, the best way to establish that principle would be to make it illegal for The Bank of England to do so. As of 1844 the worry was that a government backstop for financial markets would enable moral hazard, lead financiers confident of rescue in an emergency to gamble with the government’s and the taxpayers’ money, and in the end the expectation of rescue would bring on the financial crises that lender-of-last-resort activities were supposed to cure.

This chain of logic leads to the conclusion that, as Charles Kindleberger put it, since “if the market is sure that a lender of last resort exists, its self-reliance is weakened”. This led Kindleberger to the conclusion that:

The lender of last resort... should exist... but his presence should be doubted.... This is a neat trick: always come to the rescue in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all, so as to instill caution in other speculators, banks, cities, or countries.... some sleight of hand, some trick with mirrors... [because] fundamentalism has such unhappy consequences for the economic system...

Hence the legal prohibition of unlimited expansions of the note issue: Parliament made it illegal for the Bank of England to expand its balance sheet by buying up other assets and issuing additional Bank of England notes, unless the extra note issues were matched by additional gold reserves. The difficulty is that the supply of “outside money” is thereby rendered inelastic, and as Charles Kindleberger noted:

The difficulty in making the note issue inelastic... is that it became inelastic at all times, when the requirement in an internal financial crisis is that money be freely available...

And, much earlier, Karl Marx (1848) had complained that the Bank Recharter Act of 1844 was by its nature destructive, for it:

put into practice a self-acting principle for the circulation of paper money.... The issuing department is by law empowered to issue notes to the amount of fourteen millions sterling.... Beyond these fourteen millions, no note can be issued which is not represented in the vaults of the issuing department by bullion to the same amount.... Suppose now that a drain of bullion sets in, and successively abstracts various quantities of bullion from the issuing department.... This is not a mere supposition. On October 30, 1847, the reserve of the banking department had sunk to £1,600,000 while the deposits amounted to £13,000,000. With a few more days of the prevailing alarm, which was only allayed by a financial coup d'état on the part of the Government, the Bank reserve would have been exhausted and the banking department would have been compelled to stop payments.... Sir Robert Peel’s much vaunted Bank law does not act at all in common times; adds in difficult times a monetary panic created by law to the monetary panic resulting from the commercial crisis...

And Peel’s passing the Bank Recharter Act played a large role in generating Marx’s scorn for Peel:

Peel himself has been apotheosized in the most exaggerated fashion... One thing at least distinguished him from the European 'statesmen' -- he was no mere careerist.... [T]he statesmanship of this son of the bourgeoisie... consisted in the view that there is today only one real aristocracy: the bourgeoisie.... [H]e continually used his leadership of the landed aristocracy to wring concessions from it for the bourgeoisie... Catholic emancipation... the reform of the police... the Bank Acts of 1818 and 1844, which strengthened the financial aristocracy... tariff reform... free trade... with which the aristocracy was nothing short of sacrificed to the industrial bourgeoisie.... His power over the House of Commons was based upon the extraordinary plausibility of his eloquence. If one reads his most famous speeches, one finds that they consist of a massive accumulation of commonplaces, skillfully interspersed with a large amount of statistical data...

And, indeed, Marx’s complaints about the 1844 Bank Recharter Act would have been well-taken—if the Act had been applied.