by James Grant
The more gold on the balance sheet, the less interest income on the profit-and-loss statement. What supposedly rendered the directors fearless was the Bank’s status as a limited-liability company.
In one of the most famous passages in Lombard Street, Bagehot prescribes—for the benefit of the numerous, dim Thomson Hankeys on the Court of Directors of the Bank—how to treat a panic. Our twenty-first-century central bankers have taken it as their motto:
A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.17
In an earlier essay on the occasion of the centennial of The Wealth of Nations, Bagehot wrote that Adam Smith “evidently hurries over the abstract part of it, because he thinks his readers will not attend to it”; so does Bagehot scurry by the abstractions of central banking in Lombard Street. He wrote to change minds, not to expound theories, though the Bagehotian description of boom and bust suggests many fine theoretical possibilities. Thus, for example,
The good times too of high prices almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while, and long before discovery the worst and most adroit deceivers are geographically or legally beyond the reach of punishment. But the harm they have done diffuses harm, for it weakens credit still further.18
Perhaps Bagehot was the one to nudge John Kenneth Galbraith, who coined the concept of the “bezzle” in 1955, to contemplate the pregnant interval between the commission of an embezzlement and the victim’s discovery of his loss. Money could be two places at once, or at least in two minds at once, before anyone noticed it was missing.
IN 1915, THE THIRTY-TWO-YEAR-OLD John Maynard Keynes reviewed the works of Walter Bagehot in a new volume edited by Bagehot’s biographer—and Eliza Bagehot’s youngest sister—Emilie Barrington. Turning to Lombard Street, Keynes described it “in form and intention” as a “piece of pamphleteering,” designed to knock some sense into the titans of the Bank and City. Keynes gave the book two cheers only. In it, he observed, Bagehot was dealing with the psychology of finance, not the theory of finance. The writing was luminous, but it had not held up well over time; much of the narrative dwelled on “obsolete facts” and “obsolete controversies.”
The Great War would mark the end of the classical gold standard, though no one could predict that historical fact. So in one sense, Keynes was more correct than he knew. Gold convertibility, suspended in 1914, was only partly restored in 1925; it stopped for good in 1931, much to the dismay of the governor of the Bank of England, Montagu Norman (grandson of our George W. Norman). Thus, the controversy over the cost of holding the British gold reserve might seem dusty. As for Bagehot’s other injunction, that the Bank should lend in a crisis—unreservedly, against good collateral and at a high rate of interest—that counsel has become almost proverbial, though the part concerning the high rate of interest is, these days, honored more in the breach than the observance.19 “The best way to avoid a panic is to meet the situation like lions,” Walter Cunliffe, governor of the Bank in 1914, announced to a Treasury colleague on the first day of the fighting.¶
By the second half of the twentieth century, bank runs seemed to belong to the unlamented past. In Britain, there had been no run of consequence since the collapse of the City of Glasgow Bank in 1878, the year after Bagehot’s death, so the long-drawn-out Victorian debate over the role of a central bank in a crisis had itself come to appear irrelevant. But the developments of 2007–09 showed how misconceived that assumption was. A century after Keynes passed judgment, Lombard Street is fresh again. So, too, is The Principles of Banking, by Thomson Hankey.
BAGEHOT AND HANKEY, WHO agreed on so little, did achieve a meeting of the minds with respect to the business of commercial banking. It was not so very difficult to manage, they independently decided. It was in fact as easy, claimed Hankey, as understanding the difference between a bill of exchange, against which one could safely lend, and a mortgage.
“Banking is a watchful, but not a laborious trade,” Bagehot concurred, perhaps thinking of how relatively little time he devoted to Stuckey’s, yet how plump was the Stuckey’s P & L.
A banker, even in large business, can feel pretty sure that all his transactions are sound, and yet have much spare mind. A certain part of his time, and a considerable part of his thoughts, he can readily devote to other pursuits. And a London banker can have the most intellectual society in the world if he chooses it. There has probably very rarely ever been so happy a position as that of a London private banker, and never perhaps a happier.20
If the business was a simple one, and if it required little capital—as Bagehot observed—to what did a rich London banker owe his wealth and spare mind? In some measure, he was beholden to the lender of last resort. As long as the government’s bank bore the cost of holding the gold, and as long as that golden hegemon acknowledged a duty to lend in times of stringency, a bank could deploy the Stuckey’s business model of heavy leverage: many safe and low-yielding assets piled on a small base of capital. His affairs so structured, the banker could pursue an avocation in authorship, like Bagehot, or in archeology, like Sir John Lubbock.
Bagehot saw nothing unwarranted in this state of things, and in none of his writings that I have seen did he address Hankey’s contention that the mere existence of the doctrine of the lender of last resort was an incitement to financial recklessness.
The second printing of The Principles of Banking appeared almost simultaneously with the publication of Lombard Street. In it, Hankey objected to any law that would allow the Bank to slip the constraints of the Act of 1844. “I cannot conceive anything more likely to encourage rash and imprudent speculation,” he began.
All commercial and financial panics are caused by an excessive use of a system of credit, so valuable to commerce when carefully and prudently used; and any statutory enactment which encourages a belief that, under any circumstances, credit is equal to capital, is, in my opinion, a retrograde step, and most injurious to the best interests and prosperity of the whole community.21
Bagehot could hardly object to Hankey’s description of the danger of over-borrowing—he shared it. What he rejected was Hankey’s idea of how to run a central bank. There must be a lender of last resort, and that lender must be the Bank of England.
BAGEHOT, IN LIFE, stood for conservative banking and the gold standard. No more than Hankey would he have approved of the practices and institutions that crystallized the Great Recession. In 1909, long after Bagehot’s death, Stuckey’s sold out to Parr’s Bank, thereby coming to form part of the corporate family tree of the National Westminister Bank.** In 2000, NatWest was acquired by the immense, fast-growing, thoroughly modern Royal Bank of Scotland Group. In 2008, RBS Group—overextended, mismanaged, illiquid, and caught up in what its management admitted was “a bull market culture”—spectacularly failed. It did not, however, go out of business, but continued to operate as a high-cost ward of the United Kingdom. The ultimate charge to British taxpayers has been reckoned at £45.5 billion.
The RBS balance sheet of 2008 bore no closer resemblance to the Stuckey’s balance sheet of Bagehot’s day than the twenty-first-century paper pound does to the pre-1914 gold pound. Neither Bagehot nor Hankey could have foreseen such seismic change. Still, it was Hankey, and not Bagehot, who grasped the risk of the unintended consequences of a collective gold reserve and of a dependable, openhanded lende
r of last resort—along with the modern corollary that very large financial institutions should be treated as quasi-public property. A century and a half after Bagehot and Hankey stopped quarreling, it is the great author’s obscure, rhetorically overmatched adversary whose foresight shines brighter.
IN 1873, BAGEHOT’S NEW BOOK found its way into the hands of at least one Bank director. William Lidderdale, who had joined the Court in 1870 at the relatively advanced age of thirty-eight and whose formative financial experience was watching his father lose his money in a Scottish bank failure,22 set down his impressions of the Bagehot–Hankey controversy in a letter to a Liverpool business partner. We can all agree, said Lidderdale, that the English monetary and banking system is complex and interconnected, thus introducing what has come to be called systemic risks. The practice of taking
enormous sums on deposit at call or short notice, on which interest has to be paid & which there is almost a necessity to employ if serious losses are to be avoided, is one which carries risk on its face. Mr. Bagehot says things are so & that it is useless trying to change the system & then throws upon the Bank of England the onus of providing a reserve adequate to the needs of all its competitors as well as regular customers.23
There is no better short-form summary of Bagehot’s position. The gold question would not go away—Lombard Street failed to convince anyone to lay in more cash, as the Economist’s own figures would shortly prove. In 1879, the liabilities of eleven big banks, excluding the Bank of England, totaled £126 million; against these notes and deposits, the eleven showed £16.2 million in cash on hand or on deposit at the Bank of England. In 1889, liabilities had jumped to £170 million, against which cash and deposits at the Bank had increased by only £1.3 million.24 Far from adding to their rainy-day cash positions in proportion to the growth of their liabilities, the leading banks made do with less.
In 1906, George Goschen, by now Viscount Goschen, made an after-dinner speech in the City of London. He put it to his friendly audience: Someone must hold the reserve, and a larger reserve, too, than the worryingly inadequate one on hand. Should that someone be you, the banks; the Bank of England; or the government? The Financial News reported the results:
It was significant that there was dead silence, in an audience largely composed of bankers, when he spoke of the possible duty of the joint-stock banks in this connection, loud applause when he suggested the Bank of England as an alternative sufferer; and vehement cheers when the Government was mentioned as a last resort.25
It would take another century, and another system of monetary organization, but the government—many governments, along with their reluctant taxpayers—did finally bear the cost.
* Stuckey’s remained liquid and immensely profitable. In 1868, profits weighed in at £79,000, representing a 2.14 percent return on assets and a 29.6 percent return on book equity. Capital of £266,708 represented 7.2 percent of assets of £3,675,274, of which more than 40 percent comprised government securities, India bonds, railroad debentures, short-term loans in London on bills and other securities, and cash on deposit at banks. Such assets were either marketable or, in the case of short-dated commercial bills, liquid by their nature; barring fraud or commercial catastrophe, they would automatically turn into cash on their maturity date.
† Bagehot seems not to have mentioned that the gold standard itself was a democratic institution. To all was accorded the equal right of converting notes into cash and cash into notes, and to each at the same universal rate.
‡ On the June 30, 1873, statement date, there is a line item for “Cash” in the sum of £235,505. The word almost certainly signified bank deposits and notes of the Bank of England more than gold coin. From Vincent Stuckey to Walter Bagehot, the management of Stuckey’s had expressed a preference for paper money over sovereigns.
§ Later in the book, as was his wont, Bagehot made the case for a changed system of banking in which each bank looks after its own reserve. Self-interest would ensure adequate and informed provisioning. Yet, “the law and circumstances” have created a very different system, and England was stuck with it. Bagehot, Lombard Street, 104.
¶ Bagehot urged the Bank to employ senior permanent staff, knowledgeable in banking, to augment the twenty-six directors, of whom not one was a London banker by trade. At this writing, the senior professional staff of the Bank of England numbers 170, at the head of which sits a permanent governor, an office that Bagehot hoped would never be created: “Everybody in business would bow down to him and try to stand well with him, for he might in a panic be able to save almost anyone he liked, and to ruin almost anyone he liked.” This proved a prescient warning. Bagehot, Lombard Street, 98, 213.
** As did, in an earlier consolidation, Jones, Loyd & Co., Lord Overstone’s bank.
CHAPTER 17
“I WONDER WHAT MY EMINENCE IS?”
Bagehot saved his money; his friends smiled at his reluctance to spend it. He seemed not to speculate, and his only known investment was Stuckey’s Banking Company. The branch of financial journalism that least engaged him was the securities-selection branch, which he identified with venality. He said—not in a boastful way, but as a matter of fact—that the Economist was the only financial periodical that didn’t take bribes.
In the summer of 1873, with Lombard Street now on the bookstalls, Bagehot briefed the Wilson sisterhood on their financial position. James Wilson had left the Economist in trust to his family and named Bagehot a trustee under his will, and his favorite son-in-law was, likewise, as Bagehot modestly described his role, “Manager, Editor and principal-writer on business subjects” of that publication. He was, in fact, its voice, guiding spirit, and the principal writer on all subjects, though assisted in his present state of reduced health by Robert Giffen.
Wilson, who had died in 1860, left an estate worth £24,576, exclusive of the Economist. By year-end 1872, the value of the financial assets over which Bagehot and his co-trustees kept watch had climbed to £43,679. The portfolio was evenly divided between fixed-income securities—Indian railway bonds, among others—and Stuckey’s common stock. It was the Stuckey’s shares that produced most of the £19,000 in mark-to-market appreciation.
In income generation, too, the Wilson estate was flourishing, though here the source of growth was the journalistic asset. Of the £3,486 in distributions in 1862 and £5,142 in 1872, the family newspaper contributed 43 percent and 54 percent, respectively. The Wilson sisters loved Bagehot dearly, and they loved him no less for producing the figures that he did.
Banking was inherently precarious, Bagehot reminded them. As for Stuckey’s, its owners—“the proprietary”—formed a kind of club. For now, the sisters were members of that club, admitted as beneficiaries of the Wilson estate. It was Bagehot who must have secured the permission of the directors to allow the estate to hold the shares; if something were to happen to him, the directors might or might not allow the estate to continue to invest.*
Turning now to the Economist, Bagehot observed that its profits were unpredictable and sometimes nonexistent. The paper had earned little or nothing in the four consecutive years following the Overend Gurney failure; “[p]rogressively unprosperous” was how the editor described that dry spell.
Seeking a reason, Bagehot had first blamed rising competition, then thought again. The competition was not, in fact, rising, at least not in quality, and it had made no inroads on the Economist. The Wilsons’ paper languished because the money market was dead. And when the financial currents quickened with the Prussian boom of the early 1870s, so did the Economist’s profits. In 1872, the stars came into alignment: a full-bodied 7 percent Bank Rate coincided with a record-high Economist circulation.
Of course, the Economist’s competitors did not employ Bagehot, who was banker and essayist rolled up into one. “Being in a Bank which always has large sums in London,” the editor allowed, “I have better means of knowing than a mere writer what is happening and what is likely to happen; and it is a great d
eal in consequence of these opportunities that the Economist has been able to deal with the changes in the money market better than other papers.” Competing journals had neither his talent (not that Bagehot put it that way), nor his probity (he did say that).
People read the Economist for its financial coverage, he advised the heiresses. The battle for free trade was over—the victory had been decisive—and there was no commercial legislation of consequence on the horizon. Political articles served their purpose only if they told “the men of business” the practical things they needed to know.
Bagehot was not averse to building the paper. For instance, he had created a supplementary investment publication, Investors Monthly Manual (no tips, just facts), which produced a “small profit.” What he would not do was drum up advertising. “No attention must be paid to advertisements as an isolated source of income,” he advised his wife and her sisters; if the Economist stayed true to itself, the ads would walk in the door. (In the councils of for-profit publishing, such a remark is rarely heard, but the editor of the Economist did say it.)
Just as Overstone had observed, Bagehot had his notions. To the sisters he laid it down that no hireling could faithfully succeed him in the editor’s chair, because an employee, as distinct from an owner, could be bribed to puff shares. “The property is a delicate one and might easily be ruined by a person who had no interest in it before the parties interested were aroused to prevent it.”