Fascinating virtual “interview” with Walter Bagehot, Editor of Economist from 1861 until 1877.  Gilbert creatively aligned pertient questions for the current sub-prime situation, with quotes from Bagehot’s book, “Lombard Street,”
published in 1873.

Bloomberg.com: News

Bagehot Had Credit-Crunch Answers 130 Years Ago: Mark Gilbert

By Mark Gilbert

Oct. 4 (Bloomberg) — Walter Bagehot, an economist and
author writing in the 19th century, had the answers to the
current credit crunch.

In 1866, the U.K. money markets were in turmoil. The
collapse of a private bank called Overend & Co. threatened to
destroy the fragile trust underpinning the credit system.

The parallels with today are powerful, as ripples from the
crash in the U.S. subprime mortgage market threaten to swamp
parts of the financial markets. Central banks are losing control
of monetary policy, as short-term money-market rates jump and
long-term bond yields develop immunity to policy changes. Their
sovereignty is under fire, as the crisis forces them to be
reactive rather than proactive.

So what would Bagehot, who edited the Economist newspaper
from 1861 until 1877, make of the current crisis?

The following question-and-answer dialogue combines current
questions with comments culled from his book “Lombard Street,”
published in 1873; I reckon we have a lot to learn from a guy who
died 130 years ago.

1) Was the Bank of England too slow in providing emergency
finance to the banking community? Did its reticence exacerbate
the problem by making commercial banks wary of lending to each
other?

“The best way for the bank or banks who have the custody of
the bank reserve to deal with a drain arising from internal
discredit is to lend freely. The holders of the cash reserve must
be ready not to keep it for their own liabilities, but to advance
it most freely for the liabilities of others.”

“The first instinct of everyone is to the contrary. There
being a large demand on a fund which you want to preserve, the
most obvious way to preserve it is to hoard it — to get in as
much as you can, and to let nothing go out which you can help.”

“The plain problem before the great dealers comes to be
`how shall we best protect ourselves? No doubt the immediate
advance to these second-class dealers is annoying, but may not
the refusal of it be even more dangerous? A panic grows by what
it feeds on; if it devours the second-class men, shall we, the
first class, be safe?”

2) It looks very much like the U.K. government stepped in
and overruled the central bank, guaranteeing deposits and perhaps
forcing the bank to start auctioning three-month money just days
after Bank of England Governor Mervyn King had said such actions
risk sowing “the seeds of a future financial crisis.” Is that
wise?

“Banking is a trade. Nothing can be more surely established
by a larger experience than that a government which interferes
with any trade injuries that trade. The best thing undeniably
that a government can do with the money market is to let it take
care of itself.”

3) Should the government bail out mortgage companies with
unsustainable business models that rely too much on the money
markets for the finance to fund the home loans they make? Should
they let such institutions fail?

“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.”

4) Would that really be possible, given the television
pictures of people lining up to withdraw their savings from
Northern Rock Plc? Could the government and the Bank of England
really stand by and watch and do nothing?

“It might give its aid, lend Exchequer bills, or otherwise
pledge its credit for the moment, but when the exigency was
passed it might let the offending banks suffer. There would be a
penalty for their misconduct. New and better banks, who might
take warning from that misconduct, would arise.”

5) How can the central bank pump cash into the market
without risking moral hazard by rescuing lenders from their bad
decisions?

“The end is to stay the panic. These loans should only be
made at a very high rate of interest. This will operate as a
heavy fine on unreasonable timidity and will prevent the greatest
number of applications by persons who do not require it. The rate
should be raised early in the panic, so that the fine may be paid
early, that no one may borrow out of idle precaution without
paying well for it.”

6) Do we overestimate the power of central banks?

“The value of money is settled like that of all other
commodities — by supply and demand. Many persons believe the
Bank of England has some peculiar power of fixing the value of
money. It can affect the rate of discount at any particular
moment, but it cannot effect the average rate.”

7) Will the economy suffer as the credit bubble bursts?

“In so far as the apparent prosperity is caused by an
unusual plentifulness of loanable capital and a consequent rise
in prices, that prosperity is not only liable to reaction, but
certain to be exposed to reaction.”

“The mercantile community will have been unusually
fortunate if during the period of rising prices it has not made
great mistakes. Every great crisis reveals the excessive
speculations of many houses which no one before suspected. The
good times too of high price almost always engender much fraud.
There is a happy opportunity for ingenious mendacity.”

To contact the writer of this column:
Mark Gilbert in London at

magilbert@bloomberg.net

Last Updated: October 3, 2007 19:37 EDT

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