WALTER BAGEHOT: FINANCIAL CRISES

Walter Bagehot (pronounced BAD-jit)

(3 February 1826 – 24 March 1877)

was a British businessman, essayist

and journalist who wrote extensively

about literature, government and

economic affairs.

Lombard Street (1873), explains the world of finance and banking and focuses particularly on issues in the management of financial crises

Formative years

Bagehot was born in Langport, Somerset, England. His father, Thomas Walter Bagehot, was managing director and vice-chairman of Stuckey’s Banking Company. He attended University College London, where he studied mathematics and in 1848 earned a master’s degree in intellectual and moral philosophy.[1].

Career

Bagehot was called to the bar but preferred to join his father in 1852 in his family’s shipping and banking business. He wrote for various periodicals, then for seventeen years edited The Economist newspaper which had been founded by his father-in-law (James Wilson). Becoming editor-in-chief in 1860, Bagehot expanded The Economist’s reporting on the United States and on politics and is considered to have increased its influence among policymakers. In honor of his contributions, the paper’s Britain section retains a column named for him.

In 1867, he wrote a book called The English Constitution that explored the nature of the constitution of the United Kingdom, specifically the functioning of Parliament and the British monarchy and the contrasts between British and American government. The book is considered a classic and has been translated into many languages.

Bagehot also wrote Physics and Politics (1872), in which he coined the still-current expression, “the cake of custom,” to describe the tension between social institutions and innovations. Lombard Street (1873), explains the world of finance and banking and focuses particularly on issues in the management of financial crises. In his contributions to sociological theory within historical studies, Bagehot may be compared to his contemporary, Henry James Sumner Maine.

Collections of Bagehot’s literary, political, and economic essays were published after his death. Their subjects ranged from Shakespeare and Disraeli to the price of silver.

Every year, the British Political Studies Association awards the Walter Bagehot Prize for the best dissertation in the field of government and public administration. The Economist regularly publishes a commentary on current affairs in the UK, entitled “Bagehot,” just as its “Lexington” addresses the US and “Charlemagne” Europe.

Works

• The Collected Works of Walter Bagehot: Volumes 1-15, ed. Norman S. John-Stevas, New York, Oxford U. Press, (1986) ISBN 0850580390

• Emily (Mrs Russell) Barrington, ed., The Works and Life of Walter Bagehot, in 10 vols. London, Longman, Green (1915) On line.

• The Postulates of English Political Economy, with a Preface by Alfred Marshall, London, Longmans Green & Co. (1885); Google Books, online

• Economic Studies, ed. Richard Holt Hutton, London, Bombay and Calcutta, Longmans, Green (1879); New York, Augustus M. Kelley (1998) ISBN 0678008523

Quotes

“The greatest pleasure in life is doing what other people say you cannot do.”

References

1. Richard Holt Hutton, “Memoir” and “Second Memoir” (from Dictionary of National Biography), in Mrs Russell Barrington, ed., The Works and Life of Walter Bagehot, London, Longman, Green (1915)

Literature

Brian Hanley, “‘The Greatest Victorian’ in the New Century: The Enduring Relevance of Walter Bagehot’s Commentary on Literature, Scholarship, and Public Life”, Papers on Language and Literature, (Spring 2004)

The Pursuit of Reason: The Economist 1843-1993, Harvard Business School Press, Boston, Massachusetts ISBN 0-87584-608-4 This article incorporates public domain text from: Cousin, John William (1910). A Short Biographical Dictionary of English Literature. London, J.M. Dent & sons; New York, E.P. Dutton.

Bagehot’s Rule

Bagehot called a seizing up of internal markets “a domestic drain” (of gold), and the flight of capital abroad “an external drain.” He wrote that “The two maladies – an external drain and an internal – often attack the money market at once.” And what, he asked, should be done when this happens?

Think backward 135 years to 1873, when Walter Bagehot, the eminent Victorian institutional economist and constitutional scholar, wrote “Lombard Street.”

The London capital market was the center of world finance under the gold standard. Bagehot described the intricacies of how money markets worked, including counterparty risks and all that – but he also prescribed how the Bank of England should confront major financial crises.

Bagehot called a seizing up of internal markets “a domestic drain” (of gold), and the flight of capital abroad “an external drain.” He wrote that “The two maladies – an external drain and an internal – often attack the money market at once.” And what, he asked, should be done when this happens?

“We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm. . . . And at the rate of interest so raised, the holders – one or more – of the final bank reserve must lend freely.

“Very large (domestic) loans at very high rates,” Bagehot advised, “are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness. But though the rule is clear, the greatest delicacy, the finest and best skilled judgment, are needed to deal at once with such great and contrary evils.”

How does Bagehot’s Rule apply to today’s credit crunch? Bagehot was worried about gold losses to foreigners that would cause domestic credit markets to seize up even more and, worse, weaken the pound in the foreign exchanges. Now, foreigners are disinvesting from private U.S. financial assets, which itself worsens conditions in American markets. Additionally, foreign central banks, to stem the appreciations of their currencies against the dollar, are building up large dollar exchange reserves – much of which are invested in U.S. Treasury bonds.

But U.S. Treasurys are the prime collateral for borrowing and lending in the multitrillion dollar U.S. interbank markets. Thus there is a foreign “drain” of prime collateral from the already-impacted private U.S. markets. The depreciating dollar also greatly exacerbates inflation in the U.S.

Consequently, there is a strong case for raising the fed funds rate as much as is necessary to strengthen the dollar in the foreign exchanges – as Bagehot would have it – and to cooperate with foreign governments to halt and reverse the appreciations of their currencies against the dollar.

By slashing interest rates too much in 2007-2008, the Fed has accentuated the foreign drain and thus made the alleviation of the domestic drain more difficult. Yet, despite this mistake, Bagehot would approve of other actions the Fed has taken to deal with the domestic drain by unblocking specific impacted domestic markets. These include (1) swapping Treasury bonds for less safe private bonds, (2) opening its discount window to shaky borrowers, and (3) maybe even rescuing Bear Sterns. He would also approve of the relaxation of capital constraints on Fannie Mae, Freddy Mac and so on, for mortgage lending. Yet these measures will be insufficient if the foreign drain continues.

To repeat Bagehot’s Rule: “very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.”

Walter Bagehot (pronounced BAD-jit)

(3 February 1826 – 24 March 1877)

British businessman, essayist, and journalist who wrote extensively about literature, government, and economic affairs.

Bagehot’s Lombard Street (1873), explains the world of finance and banking and focuses particularly on issues in the management of financial crises.