A Counterproposal to “Shifts and Shocks”

Martin Wolf in Shifts and Shocks does a remarkable job of taking a comprehensive view of all the moving parts that have played a role in creating our current financial malaise and ongoing risks to financial stability. He also does a wonderful job of laying them out clearly for readers. Furthermore, I am entirely convinced by his diagnosis and prognoses of the Eurozone’s problems. When it comes to the question of the financial system more generally, however, even though I’m convinced that Wolf understands the symptoms, I don’t think he’s on target with either his diagnosis or his solutions. In fact, I think he too shows signs of being hampered by the problem of intellectual orthodoxy.

This post is therefore going to combine commentary on Shifts and Shocks with an introduction to my own views of how to understand the boondoggle that is the modern financial system. (I have nothing to say about the Eurozone’s grief except that you should read what Martin Wolf has to say about it.) For the long form of my views on the structural reform of the financial system, see here.

First, let me lay out the many things that Wolf gets right about the financial system.

  • The intellectual failures are accurately described:
    • orthodox economics failed to take into account the banking system’s role in creating credit, and thus failed to understand the instability that was building up in the system.
    • this has led to a dysfunctional and destabilizing relationship between the state and the private sector as suppliers of money
  • His basic conclusion is correct:
    • the system is designed to fail because banks finance long-term, risky and often illiquid assets with short-term, safe and highly liquid liabilities.
  • The inadequacy of the solutions currently being pursued is also made clear. Combining macro-prudential policy and “unlimited crisis intervention” with resolution authorities
    • just worsens the dysfunctional relationship between the state and the private sector
    • forces rulemaking that is designed to preserve a system that the regulators don’t trust and that is so complex it is “virtually inconceivable that it will work” (234)
  • His focus on the need for more government expenditure to support demand instead of attempts to induce the private sector to lever up yet again is correct.
  • The key takeaways from his conclusion are also entirely correct (349)
    • The insouciant position – that we should let the pre-crisis way of running the world economy and the financial system continue – is grotesquely dangerous.”
    • “leveraging up existing assets is just not a particularly valuable thing to do; it creates fragility, but little, if any, real new wealth.”

I think Wolf makes a mistaking in diagnosing the problem, however. One can view our current financial system as simply exhibiting the instability inherent in all modern economies (a la Minsky), or as exhibiting an unprecedented measure of instability even taking Minsky into account, or something in between. Wolf takes the hybrid position that while the basic sources of instability have been present in financial systems since time immemorial, “given contemporary information and communication technologies, modern financial innovations and globalization, the capacity of the system to generate complexity and fragility, surpasses anything seen historically, in its scope, scale and speed.” (321) This, I believe, is where the argument goes wrong.

To those familiar with financial history the complete collapse of a banking system is not a particularly unusual phenomenon. The banking system collapsed in Antwerp in the mid-15th century, in Venice in the late 16th century, in France in the early 18th century, and in Holland in the late 18th century. What is remarkable about 19th and 20th century banking is not its instability, but its lack of total collapse.

Indeed, the remarkable stability of the British banking system was founded in part on the analysis of the reasons behind 18th century financial instability on the continent. (There is no important British banking theorist who does not mention John Law and his misadventures in France.)  In particular, a basic principle of banking used to be that money market assets — and bank liabilities — should not finance long-term assets; capital markets should have the limited liquidity that derives from buyers and sellers meeting in a market. Thus, when Wolf finds that our modern system is “designed to fail” because money market assets are financing risky long-term assets, and that market liquidity is a dangerous illusion that breeds overconfidence and is sure to disappear when it is most needed (344), he is simply rediscovering centuries-old principles of what banks should not do.

By arguing that the structural flaws of modern finance are as common to the past as to the present, Wolf embraces the modern intellectual orthodoxy and sets up his radical solution: that our only option for structural reform that stabilizes banking is to take away from banks the ability to lend to the private sector and require that all debt be equity-financed. Thus, Wolf obfuscates the fact that the 19th and 20th century solution to banking instability was to limit the types of lending to the private sector that banks were allowed to engage in. Britain had a long run of success with such policies, as did the U.S. from the mid-1930s to the 1980s. (Recall that the S&Ls were set up in no small part to insulate the commercial banks from the dangers of mortgage lending — as a result the S&L crisis was expensive, but did not destabilize the commercial banks, and was compared to 2007-08 a minor crisis.) Thus, there is another option for structural reform — to stop viewing debt as a single aggregate and start analyzing which types of bank lending are extremely destabilizing and which are not.

The real flaw, however, in Wolf’s analysis is that he doesn’t have a model for why banking lending is important to the economy. Thus, when he acknowledges that it is possible that the benefits of “economic dynamism” due to banking exceed the massive risks that it creates (212-13), he doesn’t have a good explanation for what those benefits are. As a result, Wolf too is intellectually constrained by the poverty of modern banking theory.

19th c. bankers were far less confused about the benefits of banking. When everybody is willing to hold bank liabilities, banks have the ability to eliminate the liquidity constraints that prevent economic activity from taking place. The merchant who doesn’t have enough capital to buy at point A everything he can sell at point B, just needs a line of credit from the bank to optimize his business activities. This problem is ubiquitous and short-term lending by banks can solve it. Furthermore, because they solve it by expanding the money supply, and not by sourcing funds from long-term lenders, the amount of money available to borrow can easily expand. Of course, there are problems with business cycles and the fact that the incentives faced by banks need to be constantly monitored and maintained, but these are minor issues compared with the asset price bubbles that are created when banks get into long-term lending and that destabilized the financial system in 2007-08.

Overall, banks can do a lot to improve economic efficiency without getting into the business of long-term lending. And a recipe for financial stability should focus on making sure that long-term lending, not all bank lending, is funded by equity.

On “How the world economy shifted”

This is a commentary on Chapter 5 of Martin Wolf’s book, The Shifts and the Shocks.

Martin Wolf’s explanation of the euro zone crisis, and of the problems created for the currency union by countries that are determined to run a surplus is clear and convincing. (Indeed, if my memory serves me correctly, his reasoning echoes the initial rationale for the IMF, with its deliberate penalties for countries that run a surplus.)

The discussion of the savings glut is however less effective. The problem is that there are two aspects to this story: first the policies of emerging market countries that undervalue their currencies and make it easy for them to run current account surpluses and, second, the uncharacteristic movement of the U.S. business sector into surplus around the same time period.

Wolf makes it clear that the latter played an important role in the savings glut. The problem faced by Wolf and other advocates of the savings glut view is, however, that there is a coherent explanation for the surplus only in the case of the emerging market countries. Not surprisingly the text focuses on the explainable aspects of the glut and restricts its discussion of the U.S. business sector surplus mostly to remarks on the significance of its size.

This omission is extremely important, because Wolf makes it clear that an important factor in the crisis was the dysfunctional manner in which U.S. markets responded to both the savings glut and the subsequent reduction in the federal reserve’s policy rate which was designed to stimulate the U.S. economy and offset the adverse effects on U.S. employment of the combination of a huge trade imbalance and a deficit of business borrowing. U.S. financial markets responded to these two phenomena by creating unsustainable leverage and balance sheet deterioration in the household sector.

My concern is with the causality that Wolf assumes. Let me propose an alternative interpretation of the facts. We know that when a bubble pops there is a transfer of resources away from those who purchased at the peak and to those who buy at the nadir. One function of the massive extension of credit to households was to ensure that there was a lot of underinformed, “dumb” money buying into the peak of the bubble. To the degree that corporate decision-makers have access to investment funds where knowledgeable financiers either can navigate the bubble successfully or are just successful at convincing the decision-makers that they can do so, a profit maximizing corporate decision maker may prefer to invest in financial assets than to risk money on the production of products that need to be marketed to the already over-extended household sector. In short, the possibility that (i) the U.S. business sector was the important factor in the savings glut “at the margin,” and that (ii) the causality for the U.S. business sector’s participation in the savings glut runs from the overindebtedness of the U.S. household sector and a general tendency of the modern financial sector to misallocate resources to the financialization of the U.S. business sector’s use of funds, at least needs to be entertained and evaluated.

In short, I am uncomfortable with the assumption of causality implied by sentences like the following: “What the market demanded the innovative financial sector duly supplied . . . By creating instruments so opaque that they were perfectly designed to conceal (credit) risk.” (at 172). Given how difficult it is to establish causality, should we not be asking whether financial innovation, and in particular the ability of the financial sector to create assets that one side of the transaction did not understand, drove a demand to take the other side of transactions with such “dumb” money (of course, giving a substantial cut of the returns to the innovators and originators of these assets)?

Thus, while Wolf argues that household leverage and balance sheet deterioration were necessary to offset the massive demand deficiency created by the savings, he doesn’t really address the problem that a big chunk of this demand deficiency was endogenously created by the business sector itself. Blaming the crisis on foreign lenders who were only interested in riskless assets is too easy. Any genuine explanation of what was going on needs to include an explanation of the behavior of the U.S. business sector, and Martin Wolf does not offer such an explanation.

Overall, this chapter does a very good job of describing the trends that fed into the financial crisis. This careful description, however, is what made this reader see a gap in the explanation that made me question the causal story as it was presented. On the other hand, Wolf also draws the conclusion that a financial system capable of such extraordinary dysfunction is in need of serious reform. So perhaps my criticism of this chapter will turn out to be only a quibble with the full book. I’ll let you know.

A question for Martin Wolf: Was the crisis “unprecedented”?

In the acknowledgements to The Shifts and the Shocks (which I am currently reading) Martin Wolf has stated that friends like Mervyn King encouraged him to be more radical than initially intended, and I suspect, as I read Chapter 4, “How Finance Became Fragile,” that this was one of the chapters that was affected by such comments. In particular, I see a contradiction between the initial framing of financial fragility which focuses on Minsky-like inherent fragility, and the discussion of regulation. Was this a crisis like that in the U.K. in 1866 or in the U.S. in the 1930s, or was this an “unprecedented” crisis that was aggravated by the elimination of legal and regulatory infrastructure that limited the reach of the crisis in 1866 and the 1930s? I am troubled by Wolf’s failure to take a clear position on this question.

Because Martin Wolf understands that the government intervention due to the crisis was “unprecedented” (at 15), I had always assumed that he understood that the nature of the 2007-08 crisis was also unprecedented. He appears, however, to be of the opinion that this crisis was not of unprecedented severity. Martin Wolf really surprised me here by taking the position that: “The system is always fragile. From time to time it becomes extremely fragile. That is what happened this time.” And by continuing to treat the crisis as comparable to the 1930s in the U.S. or 1866 in the U.K. (at 123-24).

His treatment of how regulation played into the crisis could be more thorough. He concludes that “the role of regulation was principally one of omissions: policymakers assumed the system was far more stable, responsible, indeed honest, than it was. Moreover, it was because this assumption was so widely shared that so many countries were affected.” (at 141). Wolf is undoubtedly aware of the many changes to the legal framework that protected the U.K. financial system in 1866 and the U.S. financial system in the 1930s that were adopted at the behest of the financial industry in both the U.S. and the U.K. (Such changes include the exemption of derivatives from gambling laws, granting repurchase agreements and OTC derivatives special privileges in bankruptcy, and the functional separation of commercial banking from capital markets.) Is the argument that these changes were not important? or that these changes fall in the category of omission by regulators? Given the preceding section of this chapter, it would appear that he believes these changes were not important, but given the conclusion of the chapter, I am not so sure.

In the conclusion, Wolf takes a somewhat more aggressive stance than he does in the body of the chapter: “The crisis became so severe largely because so many people thought it impossible.” (at 147). So maybe the crisis is unprecedented compared to 1866 and the 1930s. (In 1866 at least the possibility of financial collapse seems to have been recognized.) He also adds two more points to the conclusion that I didn’t see in the body of the chapter: the origins of the crisis include “the ability of the financial industry to use its money and lobbying clout to obtain the lax regulations it wanted (and wants)” and the fact that “regulators will never keep up with” the ability of the financial industry to erode regulation (at 147).

Thus, once I reached the conclusion of the chapter, it was no longer clear that Wolf views this crisis as primarily an example of inherent fragility. He has laid out the argument for how the financial industry successfully removed the legal and regulatory protections that were in place in 1866 and the 1930s. So this is my question for Mr. Wolf: Was the crisis itself “unprecedented” in the course of the last two centuries of Anglo-American financial history, or was this just a Minsky moment like many that have come before?

Golden Fetters, Legal Fetters

The interconnectedness of the international financial system is built on limitations.  In the 1920s these were the limitations set by the gold standard.  Nowadays these are the limitations created by the legal status of derivatives.  It is these limitations, which are perceived to protect the value of cross-border contracts, that make it possible for closely intertwined financial markets to develop.

Interconnectedness:  Golden Fetters

In the 1920s and early 30s cross border transactions depended on the operation of the gold standard.  Many cross-border contracts were denominated in sterling, though the dollar was growing in importance.  After the Dawes plan and the stabilization of the German currency, the flow of private sector funds from the US to Germany – denominated in marks – grew dramatically.  Thus, one of the reasons the gold standard was viewed as essential to the stability of the international financial system, was that the decision to go off gold by Britain, the US or Germany was sure to generate an international insolvency crisis.

Because of the structure of international trade, for the key countries whose currencies were used in foreign trade contracts the act of going off gold functioned as a means of transferring equity from the balance sheets of foreign banks and firms to the balance sheets of domestic banks and firms.  In short, one thing was certain:  the day Britain (or the US or Germany after Dawes) went off gold, that action would trigger an international insolvency crisis.

Needless to say, nobody could tell what would be the consequences of an international insolvency crisis and everybody who understood the consequences of leaving the gold standard was fearful that not only would formerly prosperous economies suffer immensely, but that the political consequences could also be disastrous.  This fear of a coming apocalypse drove central bankers – for the most part with the support of their governments – to do everything they could to avoid going off gold and triggering the subsequent insolvency crisis.

The problem with the effort to defend the gold standard was that in order to be successful the defense required universal cooperation.  And in the post World War I environment, there were many contentious issues that precluded genuine cooperation:  not only were differences over war debts and reparations almost impossible to resolve, but countries such as France were very jealous of the key role sterling had played in the world economy over the previous decades and sought to bolster their own position in the world of international finance – even as Britain was determined not to give up its leading role.  Thus, the measure of cooperation that was necessary to preserve the gold standard was unachievable in practice.

For this reason, the attempt to preserve the gold standard was an optimist’s boondoggle.  In retrospect, we know that going off gold was inevitable.

If the central bankers of the mid-twenties had known that their efforts at developing a cooperative solution to the problems they faced were doomed to failure, they might not have postponed the insolvency crisis, but instead let it break earlier.  Just imagine how different European history might be, had Britain chosen in 1925 – after the Dawes plan had opened a window for European recovery – to devalue before returning to gold.  If the financial world had not been struggling through the latter half of the 20s to carry on despite seriously undervalued and overvalued currencies – while at the same time building up cross-border obligations which would collapse in value in the 30s, it is possible that (i) the solvency crisis would have been smaller and (ii) Europe would have found its way to reasonably stable growth.

Interconnectedness:  Legal Fetters

Today we still have the problem of interconnectedness, but instead of being tied by a gold standard, in our flexible exchange rate world the ties are created by a complex web of derivative contracts – designed to protect against movements in exchange rates (amongst other things) just as the gold standard was.

Now we face a similar problem to that of abandoning the gold standard:  The bankruptcy of a major derivatives dealer will result in an international solvency crisis – thus it must be prevented at all costs – just as going off gold had to be prevented.  The question we face is the question that Europe faced in the mid-20s.  Do we protect the solvency of the international financial system via bailouts and economic hardship – or do we let the crisis that is upon us break?

We know now that for the 20s, the crisis was going to break in the end, and can speculate that it might have been smaller if it had broken earlier.  Unfortunately we cannot know whether today’s bailouts will succeed, or just like the 1929 government financed takeover of the Bodencredit Anstalt (Austria’s second largest bank) by the Credit Anstalt Bank – simply lead to a larger collapse a few years down the line.  By 1931 the Austrian bailout had failed.  The losses overwhelmed the Credit Anstalt bank – which was too big to save.

In the 20s, bailouts delayed the crisis, they didn’t prevent it.  Today we are faced with the question:  Can a bailout of the major derivatives dealers succeed?  Or will we find – as the best minds of the 1920s found – that the insolvency crisis will break, if not today, than a few years from today.

The worst mistake would be to treat the current financial structure as legal fetters and listen too closely to claims that any change in legal regime will trigger a crisis of confidence.  People who make these claims sound just like defenders of the gold standard in the 1920s.  History proved them wrong.  The current consensus of historians is that “Breaking with the dead hand of the gold standard was the key to economic revival.”  (Ahamed’s Lords of Finance p. 477)

While the collapse of derivatives markets would – for obvious reasons – create its own insolvency problems, the experience with the gold standard was that it is better to recognize early that the market is breaking down – and to be prepared to rewrite contracts so that they can be honored and so that systems of international trade become operational again (without government support).  Trying to prop up an old system without making the changes necessary to put it on firm foundations is a fool’s game.

On Lords of Finance 2

Having finished Lords of Finance over the holidays, I conclude that it is an excellent introduction to the role of reparations and war debts in the problems of the 1920s and 30s.  While I have always been told that reparations played a crucial role in the unravelling of Europe’s economies and polities, because these are problems of macroeconomic payment flows, the level of abstraction at which they are usually discussed has always left me in a state of incomprehension muddled with disbelief.

That Ahamed manages to present the problems of reparations in a down to earth manner that simply makes sense is an achievement in itself.

In short, despite its faults I would recommend Lords of Finance to students of the Depression because it presents the big picture of the interrelated macroeconomies with the full gamut of complex payments issues in a very accessible manner and thus can be used as a framework in which to place the pieces of a more careful study of the period.

In one sentence:  First read Lords of Finance; then you’ll be ready to absorb the overwhelming detail of Eichengreen’s Golden Fetters.

On Lords of Finance

I’ve just started reading Lords of Finance (about 1/3 through) and unfortunately I’m really put off by character descriptions that seem to belong more to the world of fiction than to non-fiction.  I just don’t understand how it is possible in a work of non-fiction to have an omniscient narrator make statements like:  “He displayed an astounding self-confidence.  This was not a facade.”

I have rarely met anybody who was outwardly confident without being inwardly insecure.  In fact, I would say that it is precisely those who present themselves as uncertain who have the deepest confidence — that is, they are confident enough to display openly that there’s a lot they don’t know and don’t worry about how the world judges them.  In short, I would argue that the character of someone who died some sixty years ago is in some sense unknowable.

That’s why biographers use lengthy quotes.  What a man’s wife has to say about him always says something about the man — even if it’s only about the kind of wife he chose.   But surely this issue:  whether a character description says more about the speaker or the object of the description is for the reader to decide.   Thus, the introduction of an omniscient narrator into a work of non-fiction is problematic — the reader has difficulty judging whether the character descriptions say more about Liaquat Ahamed or about the character he’s describing.

Given my discomfort with Ahamed’s approach to the subjects of his book, I can’t help but wonder what evidence the author has for his diagnosis of Montagu Norman as suffering from “severe manic depression“.  This reads to me as an outrageous case of pop psychology, which may be supported by nothing more than Carl Jung’s diagnosis in 1913 of GPI and death within months  (Norman lived until 1950) and episodes of moodiness.  There seems to be strong evidence that Norman suffered from more than one “nervous breakdown”, but conflating a reaction to excessive stress with mental illness strikes me as one of those decisions that says far more about Ahamed than about Norman.

On an alternate note in Ahamed’s takedown of the competence of the governors of the Bank of England (whom he notes in the same pages made the best decisions) he derides the real bills doctrine as “clearly fallacious” — and goes on to explain why it held true:  because it was espoused in an environment with a gold standard.  The author shows no awareness whatsoever that the purpose of the real bills doctrine was to protect the economy from inflation caused by speculative bubbles and frauds.

Despite the preceding criticism, I am learning a lot about finances throughout Europe during World War I and the interwar period.  And it appears to me that when Ahamed focuses on factual information he is generally careful to be accurate.

19th v 21st c. banking: What has changed …

There’s one last quote from Lombard Street that I want to record. In reference to the Bank of England’s lender of last resort activities, Bagehot writes:

No advances indeed need to made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimal small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.

Is anybody else wondering whether it’s still true that: “the amount of bad business in commercial countries is an infinitesimal small fraction of the whole”?

(cross posted here)

Why Bagehot wrote Lombard Street

A recent exchange made me think for the first time about the events preceding the publication of Lombard Street. The financial crisis of 1866 had rocked the financial system dramatically without really destabilizing it. But Bagehot saw in that crisis the possibility of total financial collapse. (A detailed description of financial collapse takes up much of Chapter 7, part II of Lombard Street.) For this reason he thought it was important to explain what made it possible for the British economy to survive such brutal storms — and thus to make it clear to politicians and to the Governors of the Bank of England what their obligations were in a crisis.

After 1844 politicians played an important role in the Bank of England’s lender of last resort activities. The Banking Act of 1844 (Peel’s Act) restricted the issue of Bank Notes. It was, however, written with an escape clause, allowing the law to be suspended by executive order (i.e. bypassing Parliament). And in every subsequent crisis 1847, 1857, 1866, the law had to be suspended in order for the Bank of England to act as lender of last resort to the banking system. That is, without suspension of the law the Bank would have run out of Bank Notes.

Peel’s Act was so controversial that Bagehot states: “Two hosts of eager disputants on this subject ask of every new writer the one question — Are you with us or against us? and they care for little else.” For this reason Bagehot chooses not to take sides in the debate, but instead to explain clearly (without condemning the law itself) why Peel’s Act had to be suspended in 1847, 1857 and 1866.

Bagehot’s main concern in Lombard Street is to put an end to any controversy over:
(i) the importance of suspending Peel’s Act in a financial crisis
(ii) the importance of copious lending by the Bank of England in a crisis.
Chapter 7 is dedicated to explaining that public uncertainty about either of these two actions in a crisis is dangerous. He concludes:

The best palliative to a panic is a confidence in the adequate amount of the Bank reserve, and in the efficient use of that reserve. And until we have on this point a clear understanding with the Bank of England, both our liability to crises and our terror at crises will always be greater than they would otherwise be.

Note the subtle reference to Peel’s Act in the first sentence. Bagehot avoids controversy, but makes his point clear. In the second sentence he calls on the Bank to publicly acknowledge its role as lender of last resort to the financial system.

One thing needs to be emphasized: Bagehot is concerned about uncertainty — but that uncertainty references explicitly whether or not a lender of last resort exists and will step in to provide liquidity in a crisis. Thus Bagehot wants the Bank of England to reduce uncertainty in the financial system, but only by promising to lend copiously against high quality assets.

He is entirely at ease with the fact that the Bank of England allowed Overends Gurney, a systemically important bill broker, to fail despite the fact that the failure rocked the financial system with uncertainty, as illustrated by the following two quotes:

In 1866 undoubtedly a panic occurred, but I do not think that the Bank of England can be blamed for it. They had in their till an exceedingly good reserve according to the estimate of that time—a sufficient reserve, in all probability, to have coped with the crises of 1847 and 1857. The suspension of Overend and Gurney—the most trusted private firm in England—caused an alarm, in suddenness and magnitude, without example.

… no cause is more capable of producing a panic, perhaps none is so capable, as the failure of a first-rate joint stock bank in London. Such an event would have something like the effect of the failure of Overend, Gurney and Co.; scarcely any other event would have an equal effect.

Thus, Bagehot does not argue that the lender of last resort should act to eliminate general uncertainty, he argues only that a lender of last resort should eliminate uncertainty about the actions it will take in the midst of a financial panic.

(cross posted here)

Learning from the Crises of 1857 and 1866

I’ve been rereading Lombard Street, this time reading it as a history of the money market in mid-nineteenth century England. There are some very, very interesting parallels to the current crisis.

In particular, the period (after the passing of the Bank Charter of 1844) was one of remarkable financial innovation. On the one hand, banks that had initially issued circulating notes adapted to the new environment by converting to deposit banks and eventually offering checking accounts. On the other hand, new bank like financial intermediaries were developing. Bagehot calls these financial intermediaries bill brokers, and elsewhere they are called discount houses. In any case, as Bagehot makes clear bill brokers, that in the past were pure brokers matching savers with credit-worthy borrowers, had become intermediaries who guaranteed the bills that they placed in large quantities with banks. This was a tight margin business where the “brokers” borrowed most of their capital from these same banks and thus they were essentially earning money on spreads and the value of their highly specialized knowledge of the quality of commercial bills. Aggressive competition meant that it was not profitable for these brokers to maintain reserves (i.e. capital) to back up their guarantees. Instead the bill brokers relied on the Bank of England’s discount policy: Even in the worst of crises the Bank was expected to discount good bills at Bank rate.

In the crisis of 1857, the Bank of England advanced more than £9 million to the bill brokers and only £8 million to bankers. After the crisis, the Bank stated a new policy which restricted the Bank tranactions of the bill brokers to advances which were only offered on a quarterly basis. Should the brokers need discounts at any other time, they would have to ask for an exception to the Bank’s policy. The stated goal of the policy was to make the brokers “keep their own reserve.”

Needless to say, the bill brokers were unhappy with the new policy. Gurneys, which controlled more than half of the commercial bill market and was in many ways a competitor of the Bank of England, apparently tried to start a run on the Bank in April of 1860 by withdrawing from its deposit account an outrageous sum of money all at once. (While Bagehot claims the sum was £3 million, other sources cite a figure of £1.65 million.) This action was roundly condemned in the press.

In the meanwhile Gurneys was being poorly run by a second generation of the family. As badly underwritten bills went into default, the company advanced money on mortgages and even ended up running a fleet of steamships — also unsuccessfully. By matching short term obligations with long term assets, Gurneys violated one of the most fundamental principles of 19th century banking. This explains the strong words Bagehot uses to describe the company:

The case of Overend, Gurney and Co., the model instance of all evil in business, is a most alarming example of [the] evil [of a hereditary business of great magnitude]. No cleverer men of business probably … could well be found than the founders and first managers of that house. But in a very few years the rule in it passed to a generation whose folly surpassed the usual limit of imaginable incapacity. In a short time they substituted ruin for prosperity and changed opulence into insolvency.

In 1865 before all of Gurney’s problems were public knowledge, the partners took the firm public, creating Overend, Gurney and Co. While this action required the Gurney family to guarantee the new firm against losses on the business of the old, presumably it was hoped that new capital would save the firm. Unfortunately the losses were so great that the Gurneys had to liquidate their personal property and news of this event caused a run on the Company. Those who had bought shares in 1865 ended up losing £2.9 million. (Because they had only paid 30% of the face value of their shares, they had the misfortune to face a capital call in order to satisfy obligations to creditors — who were paid in full.) The lawsuit that followed this failure found the Gurneys’ actions to be incompetent rather than fraudulent and they were acquitted. (Ackrill and Hannah, 2001, Barclays: The Business of Banking, 1690-1996, p. 46-7)

Because many London banks were exposed to Gurneys, there was a run on the London banks and many solvent banks, such as the Bank of London, failed. Wikipedia claims that in the crisis that followed there were a total of 200 bank and commercial failures. By any standard the crisis was severe. In particular because London held large foreign deposits that were slow to return after the run, the Bank of England was forced to keep the Bank Rate elevated for a full three months — which undoubtedly aggravated the domestic consequences of the crisis.

It was, however, a watershed because for the first time the Governor of the Bank of England publicly acknowledged “a duty … of supporting the banking community”, that is, he acknowledged that the bank was the lender of last resort to the banking system. (While the Bank had been playing this role for almost a century, it often did so with reluctance and heretofore had never publicly recognized the role as an obligation.)

For this reason, Bagehot repeatedly treats the Bank of England’s actions in 1866 as the model for a lender of last resort. A few points are worth mentioning:

(i) In Bagehot’s time, it was exceptional for lender of last resort activities to last more than a few weeks. Frequently the simple fact that they were available (e.g. a lifting of government restrictions) was enough to end the panic.

(ii) A lender of last resort is not expected to prevent the failure of a systemically important bank. On the contrary, Overend, Gurney and Co. was systemically important, but it was also so badly managed that the Bank of England could not be expected to discount its paper.

(iii) A successful lender of last resort action will leave the bulk of the financial system standing (i.e. at least say 75% to 90% of the banks). Bank failures — even large numbers of bank failures — are part of a typical lender of last resort activity.

(iv) The government should never support a bad bank; such action could only serve to prevent the development of good banks.

So long as the security of the Money Market is not entirely to be relied on, the Goverment of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. 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.

Now let’s address the parallels between 1857/66 and today. First of all note that in 1857 Gurneys was a huge player in the money market and thus in 1857 when the Bank of England lent £9 million to the bill brokers, you can expect that at least £2 million and possibly as much as £4 million went to Gurneys.

In other words the Bank of England probably saw evidence that in a crisis the line of credit it was giving to an individual firm was becoming unreasonably large. Even if all the bills discounted at the Bank by Gurneys were good quality bills at this particular time, the Bank was opening itself to a future problem where reliance on the careful management of Gurneys allowed low quality bills to be discounted at the Bank and thus exposed the Bank to significant credit losses. As the Bank was a private institution, it had an obvious interest in limiting it’s exposure to the credit risk of a single firm or to the credit judgment of a single underwriter of commercial bills.

In fact, it was precisely the ultra-conservative management of the Bank of England that created the trust necessary for the Bank to be relied on as a lender of last resort:

The great respectability of the directors, and the steady attention many of them have always given the business of the Bank, have kept it entirely free from anything dishonorable and discreditable. Steady merchants collected in council are an admirable judge of bills and securities. They always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions; and no sophistry will persuade the best of them out of their good instincts. You could not have made the directors of the Bank of England do the sort of business which ‘Overends’ at last did, except by a moral miracle—except by changing their nature. And the fatal career of the Bank of the United States would, under their management, have been equally impossible. Of the ultimate solvency of the Bank of England, or of the eventual safety of its vast capital, even at the worst periods of its history, there has not been the least doubt.

Thus, in 1858 the Bank put in place a policy that only allowed bill brokers access to emergency credit by exception. The purpose of the policy was to force bill brokers to keep their own reserve, or in other words to be prepared to act as their own lenders of last resort.

Thus, faced with financial innovation and the growth of an extremely large, highly leveraged firm closely intertwined with the banking system, the Bank of England immediately made it clear that it did not support the growth of this firm. It set a policy: if financial innovation was going to allow huge firms to develop, then those firms should be prepared to support themselves through a crisis.

One obvious consequence of this policy is to push the bill brokers to reduce their leverage ratios and thus reduce the likelihood that they will (i) need the services of a lender of last resort and (ii) cause a financial crisis by failing. In short, even though the Bank of England had no regulatory authority whatsoever over the financial system, the fact that it was the lender of last resort meant that its policy decisions affected the stability of the financial system by affecting the leverage in the financial system.

Contrast the behavior of the Bank of England in 1857-8 with the behavior of authorities in the US after the 1987 investment banking crisis. In 1987 the stock market crash could have led to the complete collapse of the investment banking industry were it not for the actions of the New York Federal Reserve President (who basically told the commercial banks to give the investment banks unsecured loans). Notice that at the moment of the 1857 and the 1987 crises both central banks took aggressive action. The difference is in their behavior after the crisis was over. The Bank of England immediately acted in a manner that would push the firms that were endangering the financial system to reduce their leverage ratios and be less reliant on the Bank of England in the future. By contrast, the Federal Reserve stood by without objection when Congress extended it’s authority to permit it to lend directly to the investment banks in the 1991 FDICIA law.

In other words the two Banks took diametrically opposed actions: that of the Bank of England would tend over the long run to decrease the leverage of financial institutions and thus decrease the risk of financial instability, whereas that of the Fed tended to increase leverage and increase instability over the long run. Observe, however, that the short run effects of these different policies were precisely the opposite of their long run effects.

The willingness of the Bank of England to let a bill broker fail was tested within a decade. Overend and Gurneys actually made the decision easier by being the subject of rumors (which turned out to be well founded) for over a year before they finally turned to the Bank of England for aid in 1866. (The Economist wrote at the time “the failure of Overend, Gurney and Co. Ltd. has given rise to a panic more suitable to their historical than to their recent reputation.” Victor Morgan, 1943) Despite their size, the Bank of England did indeed refuse to discount their bills — and the result was a financial crisis that matched the worst in living memory.

On the other hand, no further failures threatened to rock the market until 1890, when Barings’ exposure to South American loans could have resulted in failure and a major crisis. The potential losses were so great that the Bank of England refused to intervene directly, but it did broker a joint support from the other large banking houses. Overall, however, England’s financial system was remarkably stable from 1866 up through 1914 (the year which marked the beginning of the end of the gold standard).

By contrast the Federal Reserve’s policy of bringing the investment banks under their wing forced the Fed in 1998 to extend the safety net even further. When the Fed brokered a bailout, it was not a bailout of a systemically important bank, it was the bailout of a hedge fund. In hindsight it’s extremely easy to see that the fact that a hedge fund had grown large enough to be systemically important was a clear sign that the financial system was dangerously overleveraged.

If the Fed had been a private bank like the Bank of England in 1857, at this juncture it would have made it clear to all members of the financial system that its balance sheet could not support the liabilities that were growing. It would have told them that they needed to start paying attention to their own reserves by dramatically reducing their leverage ratios.

Instead, the calming effects of an endless sequence of government bailouts of the banking system (Continental Illinois in 1984, Brady Bonds in 1989, low interest rates to ease the burden of bad debts in the early 90s, the late 90s and early noughts) left the Fed with the illusion that financial instability was no longer a problem that needed to be addressed, while at the same time fostering an accumulation of dead wood in the financial system that ensured that the resulting conflagration would be beyond all imagination.

In short, while the Bank of England in 1858 was willing to precipitate a crisis in order to foster stability, the Fed in the 1980s and 90s fostered the illusion of stability, while at the same time creating an environment where crisis was inevitable. Thus, just as the forest manager is better off allowing small fires to flare up regularly, so a central banker is better off precipitating small crises to avoid a disastrous and uncontrolled burn.

(cross-posted here and here)