L Street: Bagehotian Prescriptions for a 21st-Century Money Market

Abstract

In Lombard Street, Walter Bagehot (1873) offered his famous advice for reforming the Bank of England’s lending policy. The financial crisis of 1866, and other factors, had convinced Bagehot that instead of curtailing credit to conserve the Bank’s own liquidity in the face of an “internal drain” of specie, and thereby confronting the English economy as a whole with a liquidity shortage, the Bank ought to “lend freely at high rates on good collateral.” Bagehot’s now-famous advice has come to be known as the “classical” prescription for last-resort lending.Largely forgotten, however, is Bagehot’s belief that his prescription was but a second-best remedy for financial crises, far removed from the first-best remedy, namely, the substitution of a decentralized banking system — such as Scotland’s famously stable free banking system — for England’s centralized arrangement. Bagehot’s excuse for proffering such a remedy was simply that he did not think anyone was prepared to administer the first-best alternative: “I propose to maintain this system,” he wrote, “because I am quite sure it is of no manner of use proposing to alter it...You might as well, or better, try to alter the English monarchy and substitute a republic” (Bagehot 1873: 329–30).Like Bagehot, I offer here some second-best suggestions, informed by recent experience, for improving existing arrangements for dealing with financial crises. Unlike Bagehot, who merely recommended changes in the Bank of England’s conduct, I propose changes to the Federal Reserve’s operating framework. And although, like Bagehot, I consider my proposals mere “palliatives,” I do not assume that we cannot ultimately do better: on the contrary, I doubt that any amount of mere tinkering with our existing, discretionary central banking system will suffice to protect us against future financial crises. To truly reduce the risk of such crises, we must seriously consider more radical reforms (see, e.g., Selgin, Lastrapes, and White 2010).