A 19th Century British Economist Could Have Saved the World in 2008

The Bagehot Rules and Financial Crisis

A Financial Crisis shook the world in 2008. That’s common knowledge. The housing credit market bubble had been growing for years, but barely anyone saw it coming. In 2008, it reached its Minsky moment. Then, it collapsed, the bubble burst, derailing into an economic crisis that would drag the whole world into a painful recession from which still today we suffer consequences. Nonetheless, I highly doubt one would be surprised to learn neither boom and bust cycles nor financial crisis are inventions from the 21st Century. Inversely, one should be amazed to discover what a brilliant Englishman from the 19th century had to say about the economy, monetary policy, and more crucially financial crisis.

I suggest we start our Historical journey precisely around the time the protagonist of this storyline was born. The journalist and businessman William Bagehot – that is right, I was not referring to John M. Keynes! – took his first breath in 1826. Just the year before, the first modern economic crisis had kickstarted with a stock market crash in the UK. The Panic of 1825 had its roots in a bubble fueled by risky speculative investments in South America, including the imaginary country of Poyas. A run on deposits was triggered resulting in the closure of 12 banks in the country.

At first, the Bank of England only exacerbated the crisis by tightening credit, diminishing the liquidity of the markets. The instability felt was greatly exacerbated as [am1]?the BoE arbitrarily granted credit to some institutions whilst others saw their requests being denied. The issue was solved when its shareholders finally started lending freely and conducting other market operations. Later, Bagehot criticized the Bank for its slowness. Other financial crises followed suit with similar responses. During the Panic of 1837, the BoE refused assistance, allowing banks to fail once again.

It was not until 1873 that Bagehot stepped into the spotlight with his book Lombard Street: A Description of the Money Market. His work gained track and recognition due to the financial crisis that sparked in that very year. Fueled by a miscellaneous bundle of reasons, namely the vivid period of speculation which followed the German unification of the 1870s or the Coinage Act in the US. Once again, the events brought the role of a central bank to the public eye. Notwithstanding not being the first to regard the topic – recall Hamilton and his prolonged and unsuccessful fight for an American central bank in the dawn of the century –, Bagehot expanded his predecessors’ idea of what a LLR (Lender of Last Resort) is and its duties during a crisis. He drafted three rules to guide such behavior.

First, the central banking authority must lend extensively. Not acting accordingly results in bank runs and distrust in the system which itself fuels more distrust and rush to withdraw money “while there is still some there”, generating a vicious cycle. If economic agents are aware of the existence of an LLR, they should have little incentive to rush to their respective bank. But what about zombie institutions? Lending money to inefficient and insolvent banks would exacerbate the issue, would it not?

Second, the central bank should solely lend against good collateral. There is a crucial difference between an insolvent and an illiquid bank. Analyzing the financial statement and an institution’s economic fundamentals allows one to understand whether monetary life support is viable or not. That is why Bagehot argued in favor of strongly backing the loans, creating an incentive for banks to tendentially hold liquid assets. Even so, it feeds yet again hypothetical unsound investment decisions, as it significantly diminishes the risk for those in charge, does it not?

Third, the central bank should charge preferably high interest rates. This penalty rate would reduce the moral hazard aforementioned. Furthermore, it should stimulate interbank lending, for more sound banks could provide loans at more friendly rates. Additionally, the value of the country’s currency could be maintained, avoiding twin crises arising from a currency devaluation on top of the banking panic. To better comprehend the currency concern, it is important to remember that the purpose was to remain inside the gold standard, which was paradigm back then.

In many European countries, the years that followed the Panic of 1873 are still wildly known as the Long Depression, whereas in the US it was generally called the Great Depression until 1929. However, the UK did not experience the same financial turmoil as the rest of the countries. The BoE lent extensively while raising the interest rate to 9%. A new consensus was born. During the crises that would unfold, the BoE would become increasingly more interventionist, eventually starting to bailout insolvent and irresponsible banks – as was the case with Baring in the 1890s – establishing a dangerous precedent. It was the beginning of “too big to fail”.

Fast forward a couple of years and the bailout policies had reached new proportions. During 2008’s financial crisis, the BoE – alongside many other central banks, such as the Fed in the US – indeed lent extensively. Its expenses amounted to ￡1 trillion, quadrupling the Bank’s balance sheet. However, they did it at lower rates rather than at a penalty rate. Not only that but they also accepted a broad range of assets as collateral, including the same risky mortgage-backed securities that prompted the whole bubble in the first place.

Overall, besides the financial turmoil, it led to widespread discontent towards governments and the so-called “establishment”. The people saw themselves having to restrain their spendings due to the recession which soon unfolded, whilst the rich hedge fund managers had their poor and risky operations being rewarded. A moral hazard was yet again fueled, as banks were “too big to fail”.

Were Bagehot rules not lost in the mists of time, there would have been limited backlash against the main banking authorities and governments all over the world. More importantly, while it is far from a magic flawless solution, it could have prevented 2008’s crisis from happening and, crucially, future financial crises as well. Businesses would be more liable towards their own risky actions, perhaps taking it deeply into consideration. But one thing is certain: the LLR was asserted and became the financial paradigm, for in comparison the number of bank runs – e.g. Northern Rock in the UK – was significantly shorter than what it used to be in previous crises.

Jo?o Dias