Episode 6 - Lombard Street
Welcome to the Bankster podcast, my name is Alexander Bagehot and I’ll be your host today. This is Episode 6 - Lombard Street. Every episode I dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse. The Centralverse being the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support. As you listen you’ll become more and more versed in Centralverse language/lingo/and history. On today’s episode, after the news, we will take our first look at a central banking figure outside of the United State, one Walter Bagehot (yep, my namesake), and how his quintessential book, published in 1873, still shapes one of the fundamental principles upon which central banks operate today.
But first some exciting news about the podcast. Last week I looked a little deeper into how people listen to podcasts. The highest traffic and recognition of podcasts come from Apple’s iTunes; however, there are a number of other popular platforms that I have overlooked until now. So starting this week, in addition to iTunes, you will be able to find The Bankster Podcast on: Soundcloud, Stitcher, Google Play Music, Pocket Casts, Overcast, Poddirectory, and Tunein. This will also help you share the podcast with anyone, no matter what platform they use to listen to their podcasts. You can search for The Bankster Podcast in any of the platforms mentioned, or you can find links on my website, www.thebanksterpodcast.com. Now on to the news.
Remember back in Episode One when I described my phone buzzing with notifications on a Friday morning? Well, this past Friday it did it again. All of the buzzing had to do with the monthly unemployment statistic that the Bureau of Labor Statistics publishes. This time the number was, in the words of Janet Yellen, the Chairwoman of the FOMC, “concerning”. The unemployment rate fell to 4.7%. But this was mainly due to a decrease in the number of people looking for work - bad news. Now, last time we talked about the unemployment rate we said that it had increased. Which on the surface should be a bad thing, but wasn’t. This time the rate decreased. Which on the surface should be a good thing, but isn’t. That’s why it’s so important to have more than a shallow understanding of how the economy works and how that affects the Federal Reserve.
If you really want to understand what is happening in the economy I would challenge you to actively listen to the news regarding the economy and central banks. For example, when you hear the announcement about the unemployment number, I encourage you to ask yourself, “Ok, so there were X number of jobs added to the economy last month, and the new unemployment rate is Y%. What does that actually mean? And how might the central bank reasonably respond?” Or, in regards to the past few episodes, when you hear the announcement about an actual change or talk of a change in interest rates by the FOMC (or the monetary policy committee of any of the central banks around the world), you should ask yourself, “How will the central bank do this? What does this say about how the central bank views the current state of the economy?” By asking yourself these questions, and looking up the answers if you can’t think of them immediately, you will gain true understanding with time. Otherwise, passively listening to all of the news will just come in one ear and out the other.
But back to the disappointing unemployment numbers for the month of May 2016. This will weigh heavily on the FOMC as they approach their meeting next week.
Remember that the Fed has two main goals: (1) maximize employment and (2) hit 2% inflation. As they go into the meeting next week they will be thinking about how the labor market, as a whole, has made significant progress this year, yet last month was disappointing. They will also be thinking about the inflation rate, which has consistently come under the 2% target. But beyond the current statistics they will be thinking about where they think the economy is going over the next few months. Because remember, it takes nearly 6 months for the policy to have an effect on the economy. I’m sure you’ll hear about the results of the FOMC’s meeting before the next episode, so when you hear what action they took (raised rates, lowered them, or let them be) think about what implications that has. If you need to, review episodes three and five for refreshers.
Now let’s take a step back. The news today was in the trees, so to transition to the history segment of today’s episode, let’s first zoom out to the forest for a moment and remind ourselves what this is all about. The Federal Reserve influences interest rates and closely watches the unemployment numbers because they are concerned about the wellbeing of the people of the country. Congress established the Fed to control the monetary policy of the United States. The Fed uses this responsibility to try and keep the economy running smoothly. But, there is an infinite quantity of variables in the economy.
Think of a variable in the economy as being every economic decision being made by every single person in the country. And even beyond that, to every economic decision made by anyone that has an economic connection with the United States, which in today’s globalized world, is nearly everyone on the planet. In an equation with that many variables, it’s easy to see how challenging it is to figure out what to do. Because of the complexity of the global economy, and the limits of monetary policy, sometimes the world economy falters, and crisis arise. Ideally, central banks would always be ahead of the curve and prevent every single crises from happening, but that is simply impossible.
So the true question then becomes, what can central banks do when they find the economy stumbling, panic setting in, and the wellbeing of the people they serve falling out from under them? Well, there is something central banks can do. It’s an idea that was eloquently described by Walter Bagehot, in 1873, and the principles he outlined are not only implemented today, but Bagehot is directly quoted over and over by leading central bankers around the world. I’ll have a list of 7 quotes on the website if you want to read what has recently been said about Walter Bagehot. (1) (2) (3) (4) (5) (6) (7). But for the moment, let’s wind the clocks back.
Market Street in San Francisco. Marunouchi in Tokyo. Wall Street in New York. LaSalle in Chicago. BFS in Beijing. Rothschild Boulevard in Tel Aviv. Do you recognize these streets? Chances are you’ve heard of at least a few of them, and if you work in the Financial Industries these streets are as easily recognizable as the names of the international airports that take you from one to the other. These streets represent financial districts across the world. Most major cities have one street or one neighborhood that is home to the city’s large financial institutions and regulators. But above them all one stands unique. It is one of the oldest, and most famous for more than one reason. I am speaking of Lombard Street in London.
This bustling city served as the financial capital of the world during the time of the Industrial Revolution, and the beginning of the great globalization. Lombard Street is only a few blocks long, but like other financial streets around the world it is home to some of the city’s most important institutions, including the Bank of England (the United Kingdom’s central bank). And today, on this episode, Lombard Street is important because of a book that was published in 1873 that bears its name. The book was written by Walter Bagehot.
(Most of the information about Bagehot’s life comes from an excellent essay by the Encyclopedia Britannica) Bagehot was born, the son of middle merchants in the Victorian era. It was the mid 1800’s and Britain was at the height of its empire. Bagehot was raised in the classic fashion of the time for a child of his socio-economic level. He was enrolled in Langport Grammar School and then Bristol College where he built his educational foundation upon the studies of his day: philosophy, Mathematics, and Literature.
He was described by one of his childhood friends as a “lanky youth, rather thin and long in the legs with a countenance of remarkable vivacity and characterised by...large eyes that were always noticeable”. Little did this school boy friend of his realize but that lanky youth would go on to write one of the most important books in central bank history.
After Bristol College Bagehot decided to pursue further studies in law. However, upon graduation and taking his first position as a lawyer he found he was never truly content, so it didn’t take long before he had moved on to other aspirations. After university he found himself in Paris. By this time it was 1851 and Louis Napoleon (nephew of the infamous Napoleon Bonaparte) had just staged a coup d’etat. Bagehot wrote a few articles in an English journal in favor of Napoleon that stirred quite the controversy back home. While working on these articles he found a love for writing. Not long after his time in France, Bagehot accepted a position back in England at his uncle’s bank (one of the largest in the empire). While employed at the bank he continued to write about philosophy, politics, and economics.
A number of his economic essays caught the eye of the then financial secretary to the treasury, James Wilson. Wilson had previously started the magazine, The Economist, which is one of the highest regarded in financial news to this day. Wilson invited Bagehot to write a series of essays for The Economist. Bagehot readily accepted and found substantial audience for his thoughts in the magazine’s readership.
A few years later, in 1859, Wilson resigned as financial secretary and took the position of Finance Member for the Council of India and moved out of London. He left Bagehot and another fellow joint directors of The Economist until he returned. But unfortunately Wilson would never make it back; he died from dysentery contracted during a hot summer shortly after arriving in India. Within a year Bagehot would take full charge of The Economist, work as its chief editor, and write a weekly headline article.
To take the helm of the magazine he moved into London from the smaller town in southwestern England where he had managed his uncle’s bank. Living in London and constantly analyzing and writing about the financial and political climate of the international city put Bagehot in a unique position to view the inner workings and connectedness of the economy. From this vantage point he began writing on a tract about the amount of reserves held by the Bank of England. Remember that a bank’s reserve is the money that they have ready to give to depositors if depositors come asking.
At the time the Bank of England was often viewed, by those working inside and out, as just a regular bank with responsibilities and business practices similar to that of any other bank on Lombard Street. Bagehot, on the other hand, argued that the central bank was indeed different and the principle that he outlined would become of the utmost importance to central bankers for years and years to come. What started as an idea for a tract to encourage the Bank of England to hold more bank reserves (which on a basic level just means hold more money for a rainy day) turned into a three year project and a 200+ page book. So what was this principle? And when does it apply?
Well, the principle says that the central bank should serve as The Lender of Last Resort. Let’s use the name of the principle to break down what exactly it means and when it should be applied. A lender is someone that extends credit or offers loans. And of Last Resort refers to the timing - when no one else will. So Lender of Last Resort simply means the bank should offer loans when no one else will. I am going to base the rest of my comments on today’s episode on Bagehot’s own words from Lombard Street.
First, let’s listen to how Bagehot described how a certain panic of his day began. The sentiments he describes here may remind you of how we now look at events leading up to the Great Recession. “...we do not always manage [credit] with discretion. There is the astounding instance of Overend, Gurney, and Co. to the contrary. Ten years ago that house stood next to the Bank of England in the City of London; it was better known abroad than any similar firm known, perhaps, better than any purely English firm. The partners had great estates, which had mostly been made in the business. They still derived an immense income from it. Yet in six years they lost all their own wealth, sold the business to the company, and then lost a large part of the company’s capital. And these losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better.” (Pg 14). He provides this example not to pick on one institution or another, but to provide a basis for the next quote.
“I am by no means an alarmist. I believe that our system, though curious and peculiar, may be worked safely; but if we wish so to work it, we must study it. We must not think we have an easy task when we have a difficult task, or that we are living in a natural state when we are really living in an artificial one. Money will not manage itself, and Lombard street has a great deal of money to manage.” (Pg 15). There are many parallels to today’s financial world. There is an unfathomably large sum of money being managed, and it’s incredibly complex and interwoven. But central banks must study it, and work to make it as safe as possible.
So why is it that central banks must do this? Bagehot says, “No other bank holds any amount of substantial importance in its own till beyond what is wanted for daily purposes. All London banks keep their principal reserve on deposit at the Banking Department of the Bank of England. This is by far the easiest and safest place for them to use. The Bank of England thus has the responsibility of taking care of it. The same reasons which make it desirable for a private person to keep a banker make it also desirable for every banker, as respects his reserve, to bank with another banker if he safely can. The custody of very large sums in solid cash entails much care, and some cost; everyone wishes to shift these upon others if he can do so without suffering. Accordingly, the other bankers of London, having perfect confidence in the Bank of England, get that bank to keep their reserve for them.” (Pg 22). So basically, the central banks are the end of the line. Just like banks may be the end of the line for individuals like you and I.
If we want to buy something big, maybe we have enough cash to buy it outright. But what if we don’t? Then maybe we go to a family member or very trusted, wealthy friend for a favorable loan. However, if that doesn’t go through we know we can go to a commercial bank (assuming we have good credit).
A similar process works with banks today. They go to each other for loans first. But if they can’t acquire good loans from other banks, then they know they can come to the central bank of the country. Because the central bank controls the currency they are the final stop. Or as Bagehot puts it, “They [commercial banks] are dependent on...the Bank of England in a day of difficulty and at a crisis for the spare money they keep to meet the difficulty and crisis.” (Pg 22).
But this begs the question, Should central bank’s just lend out to anyone and everyone that comes to their door asking for a loan? Well, naturally Bagehot has a response for this as well. And this is where we get into the central tenets of the principle, which is now known as Bagehot’s rule. But first, Bagehot reminds us of the ramifications of this rule and the influence that the central bank plays in the economy. “All banks depend on the Bank of England, and all merchants depend on some banker...The directors of the Bank [of England] are, therefore, in fact, if not in name, trustees for the public, to keep a banking reserve on their behalf.” (Pg 27).
And one more important qualifier, “Such a reserve as we have seen is kept to meet sudden and unexpected demands…[due to] sudden apprehension or panic arising in any manner, rational or irrational” (Pg 33).
Now, finally we arrive at the climax - the principle itself. Bagehot says that in times such as these the central bank is to, “lend freely” (Pg 36). He warns that, “The first instinct of everyone [else] is to the contrary” (Pg 36). He explains that if “there [is] 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” (Pg 36). This is what happened during the financial panic with commercial banks all around the world in 2007-09’. Banks froze up. In most cases not because they ran out of money, but because they were afraid that they were going to run out of money. Bagehot describes the phenomenon this way, “A hundred people are talked about, and a thousand think, - ‘Am I talked about, or am I not?’ ‘Is my credit as good as it used to be, or is it less?’ And every day, as a panic grows, this floating suspicion becomes both more intense and more diffused; it attacks more persons; and attacks them all more virulently than at first” (Pg 37).
So to reiterate, what must the central bank do when panic sets in and begins to spread like a contagion? “The holders of the cash reserve [aka the central bank] must be ready...to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them” (Pg 39). The central bank “ought to know that this bold policy is the only safe one, and for that reason they ought to choose it” (Pg 49).
This is exactly what the Federal Reserve did after the terrorist attacks of 9/11 when the financial markets froze. The Vice Chairman of the FOMC (Chairman Greenspan was out of the country) issued a concise statement, “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” That’s in classic central banking lingo. We’ll talk about what the Discount Window is in a future episode. But for now the statement basically means, that the Fed is willing to make loans to banks that need it - just like Walter Bagehot recommended over a century before. And in the time of panic after 9/11, the banks needed it.
The Federal Reserve and central banks around the world reacted similarly to the Financial Panic of 2007-09’. They opened their books and ‘leant freely’.
The Bagehot rule can be summarized as follows. During times of panic, no matter the root cause, central banks are to lend freely (1) to solvent but illiquid institutions (meaning they are fundamentally sound but don’t have the cash to pay immediate bills, just like you may be worth $500K but $300K of that money is not really accessible on short notice because it is tied up as equity in your home), (2) on good collateral (meaning the banks have to provide good collateral such as healthy assets on their books), and (3) at a penalty rate (meaning they have to charge them a higher interest rate).
This is one of the foundational principles upon which all central banks are now built. It was using this playbook that the world’s central bankers combatted the terrible economic situation of the past decade. It was complex and troubling but the principle that Bagehot outlined nearly 150 years ago still stands today, and the countries that stuck to this principle during the recent crisis are better off today than those that did not.
Just a few years after the publication of Lombard Street Bagehot contracted pneumonia. He moved back to his home town of Langport and passed away just four days later. At the time he was working on an extensive economic work that was to be three volumes. He died at the tragically early age of 51.
There is much more to his life and influence that I haven’t gotten to today, but I will conclude with the man’s epitaph written by President of the United States, Woodrow Wilson, in the Atlantic, “Occasionally, a man is born into the world whose mission it evidently is to clarify the thought of his generation, and to vivify it; to give it speed where it is slow, vision where it is blind, balance where it is out of poise, saving humor where it is dry, - and such a man was Walter Bagehot.”
As always send in your comments, recommendations, or questions about the The Bankster Podcast or the Centralverse in general. You can email me, firstname.lastname@example.org. Find me on twitter at the handle alexbagehot. At my website www.thebanksterpodcast.com you can find a transcript of today’s episode with links to all of the sources I used in creating the content. All of the quotes from Walter Bagehot today came from chapter 2 of his book, Lombard Street, which you can download for free on the Apple Bookstore or read online as a google book.
I’d like to thank those of you that wrote a review last week. Thanks to JetMeistro who said, “If you’re only going to listen to one podcast a week like me, make sure it is this one.” Keep sending in your reviews via whatever podcast app you use.
Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to the great Walter Bagehot. And to all of you, thanks for listening. I’ll see you next time on The Bankster Podcast!