by Felix Martin
Walter Bagehot, the supreme explainer of the “concrete realities” of the money market.
(illustration credit 12.2)
This simple change of perspective on the fundamental nature of money, Bagehot argued, implied not only a different understanding of how the economy worked, but alternative policies to avoid crises and recessions. The first step here was to understand that although all money is transferable credit, there is one issuer of money whose obligations are, under normal circumstances, more creditworthy and more liquid than all the rest: the sovereign, which in the modern financial system had delegated its monetary authority to the Bank of England. This dominant role of sovereign authority in the monetary system was no fluke, Bagehot warned. Money depends on social trust, and “[c]redit in business is like loyalty in government,” wrote Bagehot in a famous comparison, “[it] is a power which may grow, but cannot be constructed.”45
This clear view of how sovereign money is, in normal circumstances, qualitatively different from private money, allowed Bagehot to explain the continuing importance of the Great Monetary Settlement and its practical implications for the modern economy. Though the modern monetary system, he explained, was now vastly expanded from the day of the Bank of England’s establishment, it continued to work on the identical principle. The Bank had married the commercial acumen of one privileged set of private bankers with the public authority of the sovereign to render the Bank’s money both creditworthy and universally transferable. And in the subsequent century and a half, the Bank itself had struck the same marriage time and time again with an ever-widening harem of other private bankers. Just as the sovereign had lent its unique authority to the Bank, so the Bank had over time got into the practice of lending its authority to the universe of other banks; and, until the policy reversal of 1858 that had heralded the beginning of the end for Overends, to the bill brokers as well. The result was a modern monetary economy in which “[o]n the wisdom of the directors of one Joint Stock Company, it depends whether England is solvent or insolvent … [a]ll banks depend on the Bank of England, and all merchants depend on some banker.”46
Here was the reason, Bagehot explained, that Lombard Street was the money market of the entire global economy: the place where more banks were able to issue more money than ever before in the history of the world. Just as the Bank’s money had originally gained its currency from its settlement with the sovereign, so now the moneys issued by the banks and bill brokers of Lombard Street gained theirs from the Bank, and the moneys of the country banks gained their currency from the banks and brokers of Lombard Street. Country and London banks attracted deposits from the savings of entrepreneurs and rentiers; merchant banks and bill brokers sourced investment opportunities from company promoters in which to place them. Modulating, and thereby enabling, the constant flux and reflux of payments to and from depositors and entrepreneurs was the great bill broker at the apex of the pyramid—the Bank of England, the first modern central bank. In a crisis, its pivotal role was clear for all to see. The Bank became all of a sudden the bill broker and banker of last resort, because it alone was always able to discount bills even if no one else would.
This remarkable monetary infrastructure was, Bagehot explained, the operating system of the Industrial Revolution, and what distinguished Britain from every other country in the world. That was the good news. But by the same token, if it was allowed to malfunction, the effects could be catastrophic. And the greatest temptation of all—the temptation for which the abstract economics of the classical school showed an insuperable weakness—was to forget that the central bank, as the delegate of the sovereign, is uniquely able to support the trust and confidence on which the monetary system depends; and is therefore uniquely responsible for the health not just of the City, but of the entire economy, in both normal and crisis times. “We must not think,” wrote Bagehot, “that we have an easy task when we have a difficult task, or that we are living in a natural state when we are really living in an artificial one. Money will not manage itself, and Lombard street has a great deal of money to manage.”47 The crisis of 1866 had ruthlessly exposed the governance and policy of the Bank of England as an anachronistic relic at the heart of what had become the largest financial centre in the world. The time had come for reform.
Bagehot had two sets of proposals—both of which remain at the heart of modern central-banking practice. The first concerned reforms of the governance and status of the Bank itself. The Bank of England remained a private company, and the agreement according to which it topped the monetary pyramid was implicit, intermittent, and entirely at the whim of its privately appointed management. Despite the facts that “[t]he directors of the Bank are … in fact, if not in name, trustees for the public … so far from there being a distinct undertaking on [their] part … to perform this duty, many of them would scarcely acknowledge it, and some altogether deny it.”48 And as for higher political oversight, “[n]ine-tenths of English statesmen, if they were asked as to the management of the Bank of England, would reply that it was no business of theirs or of Parliament at all.”49 This situation was no longer tenable. The central bank was an essential element—the essential element—of the modern monetary system. This fact should be acknowledged in the open, rather than honoured in the breach.
So much for the institution of the central bank. Even more important was its policy. In the crises of 1847, 1857, and after Overends itself, it had ultimately deployed its unique powers to save the financial system from disaster. But on each of these occasions, the Bank had acted only when catastrophe was imminent. As Winston Churchill once said of the United States, it could always be counted on to do the right thing—after it had exhausted all other possibilities. A large part of the problem, Bagehot argued on the basis of the testimony of the Bank’s directors following the Overends crisis, was simply that they had no properly articulated principles of monetary policy. So Bagehot supplied them—and he kept them simple enough for policy-makers to grasp.
His first and most basic prescription was that the central bank’s role as the lender or broker of last resort should be made a statutory responsibility, rather than left to the directors’ discretion. When faith in the safety or liquidity of private money faltered, the Bank of England should stand ready to lend sovereign money without any specified limit. By offering to exchange its own obligations for those of the now discredited banks and businessmen, the Bank could and should stay a panic before it becomes self-fulfilling. Bagehot therefore established the rationale for a proactive monetary policy, and his first rule explained what the essential substance of this policy should be: “in time of panic [the Bank] must advance freely and vigorously to the public out of its reserve.”50
Bagehot’s second and third rules then set out two important aspects of how such a policy should be applied. The second was that in its role as lender of last resort, the bank should not try to make nice distinctions between who is insolvent and who merely illiquid in the heat of a crisis. It should lend “on all good banking securities, and as largely as the public ask”; with a good banking security being any that “in ordinary times is reckoned a good security.”51 The point of the operation is “to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer.”52 There is always the risk, if a lender of last resort is waiting in the wings to assuage a panic, that private banks and merchants will become over-exuberant in their speculation—that there will arise a problem of “moral hazard” as insurers and economists call it. Bagehot therefore proposed his third principle to ward off this risk. Emergency lending “should only be made at a very high rate of interest … [to] operate as a heavy fine on unreasonable timidity, and … prevent the greatest number of applications by persons who do not require it.”53
Why was it that these ideas of Bagehot’s were so controversial? Why was it that Bagehot felt the need to apply himself so zealously to such a polemical tract? If all this was s
o obvious to the practitioners, then why all the fuss? The reason was that there was in wide circulation a quite different view of the nature of money and of how the economy worked. This was the view of the dominant, classical school of economics—the school that had been inaugurated by Adam Smith’s Wealth of Nations, refined by men like David Ricardo and Jean-Baptiste Say, and systematised by John Stuart Mill in his great 1848 textbook, The Principles of Political Economy. Bagehot was simply bringing logical rigour to the folk wisdom of the money market and the rules of thumb of the central bank. In the background, however, remained the orthodox church of classical economics, with clear doctrines and a precise catechism on matters monetary and economic. And the disparity between its teachings and Bagehot’s could not have been starker, both in their understanding of the economy and in their implications for policy.
13 … and Why It Is a Problem
WHAT ECONOMICS GOT DISTRACTED BY
At the root of these differences between Bagehot and his classical forebears was the way they conceived of money and finance. For there was a ghost haunting the pages of Smith and his classical followers: the ghost of John Locke and his monetary naturalism. Money, the classical economists held with unswerving devotion to Locke, was nothing but gold or silver. As such, it was a commodity subject to the same laws of supply and demand as every other commodity. “[M]oney, or specie, as some people call it,” wrote the French economist Jean-Baptiste Say in 1803, “is a commodity, whose value is determined by the same general laws, as that of all other commodities.”1 “Money,” pronounced John Stuart Mill forty-five years later, “is a commodity, and its value is determined like that of other commodities.”2 Private credit instruments, by contrast, were not money—they were just substitutes for money, and had value only insofar as there was real gold or silver available to redeem them.
The conventional understanding of money led the classical economists to diverge dramatically from the views of Bagehot in three areas. The first was the correct principles for monetary policy in a crisis. If the classical conception of money was correct—if money was gold and silver alone—then although everyone might want it in a crisis, there was only so much to go round. The Bank of England should therefore protect its hoard by refusing access, or raising the rate of interest at which the Bank would lend out its gold. Such was the policy recommended by the classical economists—a policy which Bagehot had no hesitation in calling “a complete dream,” “a delusion,” and “too absurd to be steadily maintained.”3 In reality, he explained, this was the very worst policy to pursue, because it was the one most likely to exacerbate the panic. What was in short supply in a crisis was not gold, but trust and confidence—which the central bank had a unique ability to restore by standing ready to swap the discredited bills of private issuers for its own sovereign money. Such was the solution to which the Bank Directors always in the end groped their way reactively in any case. Grasp once that money is not a commodity but credit, and the rationale for making it explicit policy was clear.
These diverging views of appropriate policy in a banking crisis were put in the shade, however, by a broader disagreement over the need for government policy, and especially monetary policy, to manage the macroeconomy more generally. The conventional view of money as a commodity medium of exchange was one of the pivotal assumptions behind perhaps the single most famous proposition associated with the classical school—an alleged economic law of nature as practically important as it was counter-intuitive, articulated by Jean-Baptiste Say in his Treatise on Political Economy in 1803. If money was a commodity, Say wrote, then there was no real distinction between sovereign and private money: gold is gold, whether minted or not. What is more, since the choice of commodity which serves as the medium of exchange is quite arbitrary, there can never be any danger of a shortage of money, since the enterprising mercantile class will always be able to improvise an alternative.
So far, so familiar. But combine these acknowledged facts with Smith’s theory of the market and one had a key that unlocked the canonical question of macroeconomics: what is the origin of slumps? Smith had shown how the interaction of supply and demand will, in the absence of interference, generate a price that will clear the market. Since money is just a commodity subject to the same laws as other commodities, Say explained, this argument about how individual markets work can be generalised across all markets at once—including the market for money. Grant the conventional view of money, in other words, and Smith’s theory implies that the uninhibited market mechanism will generate a set of prices that will clear all markets in the economy at once, so that everything which is produced is consumed. This in turn implies, as Say put it, “a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products”; or in the more familiar modern version, that supply creates its own demand.4
This result, known as Say’s Law, became enormously influential as a central organising principle of classical macroeconomics. If Say’s Law holds, then recessions cannot be caused by a shortfall of demand. They must instead derive from problems on the supply side: natural disasters that wipe out harvests; unexpected factory outages; striking workers; the discovery of disruptive new production technologies; and so on. The popular explanation—indeed, the evidence of first appearances—that it is a shortage of money that causes a downturn must be an illusion. The fact that buyers do not have enough money with which to buy can only mean that they do not have enough produce to sell. Supply creates its own demand: so naturally if there is an interruption to aggregate supply, then—and only then—aggregate demand will flag to the same extent. The result will be a fall in the overall value of the economy’s output; in other words, a slump.
So Bagehot’s monetary economics implied a radical divergence from the precepts of the classical school not just over the correct policy to stem financial crises, but over the correct policy to prevent recessions. The basic policy implication of Say’s Law was that there is no point in attempting to boost aggregate demand per se. Since the origins of recessions must necessarily be on the supply side, it is on policies to improve supply that anti-recessionary policy should concentrate—if it should do anything at all. Regulations that hinder hiring should be repealed; taxes and tariffs reduced; and so on. Attempting to bolster national output through monetary policy, however, would be putting the cart before the horse. It is because production increases that more money is demanded and will be supplied—not the other way round. And in fact, given that most recessions creep up on the economy unawares, and are over fairly rapidly, the policy that Say’s Law really recommends for the government finding itself in the teeth of a recession is even simpler. Since supply-side conditions generally can’t be changed much over the short term, it is really best to do nothing at all.
Bagehot’s economics, by contrast, implied that the commonly held view that recessions are the result of people not having enough money was, to be blunt, quite right—and that Say’s Law, therefore, was the economics of clever fools. When the economy fell into a crisis, the demand for sovereign money did not obey the same rules as the demand for commodities. It did not collapse as output flagged and confidence wilted. Quite the opposite: sovereign money’s unique character meant that the demand for it increased. The paradox had been understood by practitioners at least since the crisis of 1825, when the prosperous Newcastle timber merchant and economic pamphleteer Thomas Joplin had summed it up concisely: “[a] demand for money in ordinary times, and a demand for it in periods of panic,” he had written, “are diametrically different. The one demand is for money to put into circulation; the other for money to be taken out of it.”5 The correct remedy for an incipient recession is therefore not the policy fatalism implied by Say’s Law. It is a larger supply of sovereign money to meet the excess demand and restore confidence. And fortunately, as Bagehot pointed out, the supply of sovereign money is in the real world a matter of central-bank policy.
There was one final consequence
of the haunting of classical economics by Locke’s view of money that was to prove in the long run even more influential than its implications either for central-bank policy in a financial crisis or for the right macroeconomic policy to combat a recession. Indeed, it was this consequence of the conventional view of money that would ultimately lead to the great distraction to which Lawrence Summers referred. For the intellectual debt the classical economists owed to Locke was much larger than just the idea that real money is gold and silver. It also included the most fundamental feature of Locke’s understanding of money: the idea that economic value is a natural property, rather than a historically contingent idea.
This proposition had a profound consequence for the nature of classical economic analysis. In essence, it vastly simplified the task of understanding the economy. For if it was possible to take the concept of economic value for granted then economic analysis could, indeed should, proceed without worrying about money at all. Economic value had, after all, existed in the state of nature, long before the invention of money, or banks, or any of the other complications of modern finance. Money itself is simply one out of the universe of commodities which has been chosen to serve as a medium of exchange and so minimise the inconveniences of barter. As such, no one wants money itself: what is really wanted is the commodities that can be bought with money. This being the case, the simplest and best method of analysis is to begin by ignoring money. Economic analysis should proceed in what economists learned to call “real” terms. Money can then be added on afterwards, if it is a subject of interest for its own sake—or not, if it isn’t.
