The Central Bank is not a Deus ex Machina 2

Brad DeLong muddles his history of central banking.  First he starts by discussing central bank support of government debt and then he supports his argument with evidence that the central bank was lender of last resort to the private sector.

The Bank of England was founded in the 1690s to fund the British debt.  In 1711 the Bank was required by law to discount exchequer bills on demand.  As North and Weingast observed in their seminal paper, the Bank’s support of government debt (e.g. through discounting exchequer bills) was crucial to the British ability to finance (and win) the Napoleonic Wars.  This is indubitably an important role of a central bank — but then every British county wasn’t issuing its own debt and the Bank certainly wasn’t buying the debt of the counties.   The modern European situation is more complicated than the early British case.

The lender of last resort role that DeLong claims “got its start” in 1825 was played by the bank in 1763 at end of the Seven Years War, in 1772 not altogether willingly after causing the collapse of the speculative activities of Alexander Fordyce’s bank, in 1783 at the end of the American Revolution (anticipating the normalization of trade the Bank in fact conserved gold reserves that fell to 8% by favoring private credit and restricting discounts of exchequer bills) and of course in 1797 when the strains of financing the wars led the Bank to seek authority for an emergency suspension of gold payments from the Privy Council (later confirmed by Parliament).  (See Clapham’s history of the Bank of England and Jacob Price’s articles on the Bank.)

Finally, once again we see that DeLong grossly misinterprets the point of Lombard Street.  Bagehot most definitely did not support lending against assets independent of the quality of their origination.  He states explicitly:

The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

It happens, however, that in 19th century England the combination of personal liability of the banker and capital calls on shareholders to honor the debts of bankrupt joint banks was sufficient to ensure that origination practices were extremely careful.  Needless to say when origination practices are sound, a central bank’s practices do not need to be “over-nice.”  However, when rot has been allowed to grow in the financial system to the degree that the largest banks are being sued for fraud over their origination practices of their loans, central bank practices will have to be more careful than those of the19th c. Bank of England — at least if the goal of the central bank is to preserve financial stability (and not simply to bail out the banks).


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