Back to Lombard Street

by Ramesh Ponnuru

While working on an article on monetary policy I came across this passage, which is not quite relevant to what I’m doing but still pretty interesting, in an essay by George Selgin:

The Bank of England was the first central bank to assume the role of last-resortlender. During the crises of 1857 and 1866, it did so informally and reluctantly; atlength, however, under public pressure it came to acknowledge a duty to rescue otherbanks threatened by cash shortages, though otherwise solvent.The chief architect of this newfound understanding was Walter Bagehot,best known today as the second and most illustrious editor of The Economist.

In Lombard Street (1873), Bagehot outlined what is now known as the “classical” lender-of-last-resort doctrine, according to which central banks, during times offinancial distress, ought to continue to lend freely, though at “penalty” rates aimedat attracting capital from abroad and at discouraging borrowing by insolvent (asopposed to merely illiquid) banks. Although many economists are aware of Bagehot’s role in developing the modernlender-of-last-resort doctrine, few appreciate his position as one of the foremost critics of central banking. Indeed, some even imagine that Bagehot, in recommending that the Bank of England be held responsible for last-resort lending, actually meant to endorse its monopoly privileges and (at least implicitly) to recommend that all nations create similar institutions. In fact, as even a casual perusal of Lombard Street will attest, nothing can be farther from the truth.

On the contrary, Bagehot believed that central banks were financially destabilizing and hence undesirable institutions and that itwould have been far better had England never created one. He offered his lender-of-last-resort formula not as an ideal, but as a first aid to what was, in his view, a fundamentally unhealthy arrangement, the healthy alternative to which was free banking, with numerous banks issuing their own notes and maintaining their own reserves,as in the pre-1845 Scottish banking system. England needed a lender of last resort not to rescue it from crises inherent in competitive banking, but to limit the severity of crises that were inevitable consequences of the monopolization of currency.

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