Bagehot's lender of last resort: A Hollow Hallowed Tradition.

• Author: Wood, John H.
• Position: Walter Bagehot

The lender-of-last-resort function of central banks frequently is defended by reference to Britain's financial stability following Walter Bagehot's persuasion of the Bank of England to "distinctly acknowledge that it is its duty" to support the market in times of panic (1873, 61). For example, Michael Bordo and Lars Jonung suggest that the smooth operation of the gold standard "for close to four decades" was facilitated by the practice that "In most cases when faced with both an internal and external drain, the Bank of England and other central banks followed Bagehot's rule of lending freely but at a penalty rate" (2000, 6). Anna Schwartz (1986) and Allan Meltzer (1986) also have attributed the absence of severe crises during this period to the Bank's newfound "precommitment": "Knowledge of the availability of credit was sufficient to allay alarm" (Schwartz, 1986, 21). Frank W. Fetter called it "The victory of the Bagehot Principle" (1965, 257-83). The New York Federal Reserve Bank's Benjamin Strong represented the "free extension of credit to institutions that need it" to be in the tradition of "Bagehot's golden rule which forty or fifty years ago effected a real revolution in banking thought in London and has since, more or less, determined the Bank of England's policy under conditions similar to the present" (1921 [1958], 174), and policymakers have invoked Bagehot's name on many subsequent occasions, including the crisis of 1931 and the bank failures of the 1970s and 1980s. (1) The International Financial Institutions Advisory Commission recommended the "hallowed traditions of lender-of-last resort operations" to the International Monetary Fund (IMF) (Meltzer and Sachs 2000).

Several writers have criticized Bagehot's rule for its self-defeating creation of moral hazard (Dowd 1993, Hirsch 1977, Rockoff 1986). My purpose in this article is not to criticize the rule itself, but to call attention to the absence of any basis for a "Bagehot tradition" in nineteenth-century practices. The Bank of England had long been viewed as more than just another "intermediate body, or power; there is no resource on their refusal, for they are the dernier resort" (Baring 1797, 19-20). Nonetheless, the Bank made no explicit commitment to unlimited support of the market. Such a policy had been debated for a generation before the publication of Bagehot's 1873 Lombard Street, was rejected from the outset, and made no headway in official policy or practice until after World War I. "Time inconsistency" and "moral hazard" were well understood in the nineteenth century, and modern policymakers appealing to the Bank of England's application of Bagehot's rule had better look elsewhere for precedents.

In the next section, I summarize the commitment debate of the 1840s and the Bank of England's responses to Bagehot's renewal of the issue. In the second and third sections, I discuss central banking after Bagehot and offer plausible reasons, unrelated to Lombard Street, for the progress of financial stability in the nineteenth century.

To Commit or Not to Commit

The Bank Charter Act of 1844 tied the Bank of England's notes to its gold reserve in the belief that although paper money was convenient and efficient, it tended to excesses if left to bankers and their customers, and it should be made to vary as a pure metallic money might vary. The currency rule soon was tested by harvest failures and the collapse of a railway boom. The loss of gold, which forced an equal reduction in Bank notes, brought a crisis, and, as usual, borrowers flocked to the Bank. But it refused credit, even to checking accounts because of their potential for conversion to notes. The government finally authorized the Bank to exceed the limit, and the panic ceased. The knowledge that Bank credit and notes were available ended the rush for them.

Might the Bank have extended credit when needed without the irresolution and suspense that promoted panics? A House of Lords committee of inquiry questioned the desirability of a "fixed and inflexible rule" for the management of the currency. Even if the rule had been defensible at its inception, its "hold on opinion" must "have been materially impaired" by the recent suspension:

The precedent is established, and its application will inevitably be called for on other occasions; and it may so happen that the principle of relaxation will be applied under circumstances less urgent and less justifiable than those which occurred in 1847. The Committee are therefore of the opinion that it is expedient for the Legislature to provide specifically for the manner and the responsibility of relaxing these restrictions in times when it can be done consistently with the perfect [gold] convertibility of the note--an obligation which should never be forgotten. (House of Lords [1848] 1969, xlv) The possibility of...