Bagehot, Walter

Walter Bagehot was born in Langport, Somerset, on 3 February 1826, and died on 24 March 1877. He studied at Bristol College and then University College, London, where he met Richard H. Hutton. They founded the National Review together in 1855 (see Buchan, 1959) and it was through Hutton that Bagehot came into contact with The Economist, becoming its editor-in-chief in 1860.

Scholars generally regard Bagehot as a practical economist. Keynes (1915, p. 369) thus describes him in his review of Barrington's work (Barrington, 1915) as "a psychologist - a psychologist analyser, not of the great or of genius, but of those of a middle position, and primarily of business men, financial, and politicians". This view is mainly due to the somewhat psychological nature of the business cycle in Bagehot's thoughts and the psychological nature of the effects of the monetary policies (see below) that he suggests in order to ensure confidence in the monetary institutions. Bagehot did indeed always take a pragmatic approach to economic issues, and tried in particular to draw from economic science ideas and methods capable of combining theory and practice (see Berta, 1986, p. 31).

This particular method also led him to address monetary and financial questions, as can be clearly seen in his well-known work Lombard Street: A Description of the Money Market, published in 1873 (see Bagehot, 1873). The title itself suggests a relativistic approach to monetary matters, which are addressed in historical and institutional terms. Bagehot then develops a monetary theory by examining different features of money, especially its effects on the stability of economies. The functioning and limitations of the money market are described in normative terms, the main concern being the identifica- tion of the best monetary practices serving to ensure monetary stability and confidence in the monetary institutions. He makes essentially two recommendations in this connec- tion, and both regard the central bank. The first, which is known in the literature as the Bagehot rule (see Goodhart, 1999), states that the central bank must act as the lender of last resort to ensure the solvency of the credit system. In short, the rule requires the central bank to be accommodating towards organizations that lack liquidity but are nevertheless solvent: "loans should [. . .] be made on all good banking securities, and as largely as the public asks for them" (Bagehot, 1873, p. 198). The second is that discretion- ary mechanisms should rule the level of reserves: "That the amount of the liabilities of a bank is a principal element in determining the proper amount of its reserve is plainly true; but that it is the only element by which that amount is determined is plainly false [. . .]. I am satisfied that the laying down such a 'hard and fast' rule would be very dan- gerous; in very important and very changeable business rigid rules are apt to be often dangerous" (ibid., pp. 302, 315).

This normative analysis is supported by a positive investigation of the business cycle, which is seen as primarily subject to panic and euphoria, variables that Bagehot treats sometimes as exogenous and sometimes as endogenous. In his perspective, the cycle starts when banks lend a "surplus of [. . .] capital" (ibid., p. 148) to firms in order to expand their production. As credit causes a rise in prices, firms expect higher profits, which prompts them to seek additional credit in order to increase production again. This expansive phase is, however, combined with increasing fragility of the system, and growth ceases when firms start to make mistakes in their evaluation of expected demand and/or when a section of the community will no longer accept the rise in prices. The result is a fall in production leading to crisis. At the same time, a crisis can take place when a "sudden event [. . .] creates a great demand for actual cash" with which the banks are unable to cope (ibid., p. 122). The banking system is struck by a liquidity crisis that then moves into the real sector through the resulting credit squeeze. In developing this theory, Bagehot (ibid., pp. 196-7) focuses on the role of monetary policy and advocates a discretionary approach, especially during recessions, as "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".

Different economists took a positive view of Bagehot's work. Jevons, for example, judged it "the best account which we have of the working of our banking system" (quoted in Barrington, 1915, p. 418). At the same time, however, Jevons was sceptical about the possibility that cycles could be "ruled" by monetary policy when business is not carefully managed.

Various aspects of Bagehot's theory have since been reconsidered in a more critical light. Garcia (1989), for example, refutes Bagehot's rule in factual terms by showing that for a long time in the United States the Federal Reserve, acting as a lender of last resort, favoured just one type of organization, namely commercial banks, and operated "behind closed doors" (see Selgin, 2012). Goodhart (1999, p. 339) criticizes some associated myths, in particular "that it is [. . .] possible to distinguish between illiquidity and insol- vency [and] that [lender-of-last-resort] capacities are unlimited". Finally, the most recent literature addresses Bagehot's rule at the microeconomic level by studying the effective- ness of the lender of last resort when market failures occur (see for example Bordo, 1990; Freixas et al., 2000; Martin, 2009).

See also:

Bagehot rule; Financial crisis; Financial instability; Lender of last resort.