We are not accustomed to thinking of central banks, in their roles as lenders of last resort, as regulators. Regulation means financial regulation, the stuff of notices and comments and final proposed rules and enforcement letters. But while central banks don’t look exactly like other regulators, it is the exercise of governmental power deposited in it by acts of Congress. I’d argue that the case is ironclad that the Fed’s discount window is a regulatory mechanism. (Here are two papers, the first by Gillian Meztger and the second by Anne Joseph O’Connell, that look at some of these issues.) I mention this because I am going to post a two-part series that would seem to have more to do with financial history than regulation, and I want to convince you that these issues are relevant to the way we think about central banks as regulators..

Here’s a common trope you may have seen. Walter Bagehot is the father of central banking, due to his brilliant exposition of central banking in Lombard Street: A Description of the Money Market. InLombard Street, Bagehot became the first to articulate what a central bank should do to prevent a panic from becoming a crisis. It should simply follow Bagehot’s dictum: “lend freely, at a penalty rate, against good collateral.” This dictum and Lombard Street generally are the Bible of central banking, just as applicable to today’s markets as they were at the time he wrote them 140 years ago.

Except for the fact that Walter Bagehot wrote a brilliant book called Lombard Street, there’s little about the above statement that is true. People even mispronounce his name (it’s easy to do: it’s BADGE-it, not BAG-ih-hot, a not intuitive but still powerful shibboleth in central banking circles).

The rest is part of Bagehot’s mythology. Here are six problems. First, the idea of a lender of last resort did not originate with Bagehot; Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain provides a still more rigorous version of it (and, as Thornton notes on page 38, it was Francis Baring who first used the term “dernier resort” to describe the function of the Bank of England).

Second, he never wrote this dictum: a researcher who flips to Lombard Street for that citation will search in vain. Instead, Bagehot cited the three elements of the dictum over the course of a long chapter on the practices of the Bank of England, but emphasized the first element—to lend freely—at much greater length, while giving short shrift to the other two. For example, here is one of his most famous passages:

A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but 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. The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘We lent it,’ said Mr. Harman, on behalf of the Bank of England, ‘by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.’ After a day or two of this treatment, the entire panic subsided, and the ‘City’ was quite calm.

Third, “good collateral” meant something very different to Bagehot. As Carolyn Sissoko notes in her excellent paper, essentially all the collateral was good in a commercial country; a commercial bills doctrine that required self-financing bills for discount, subject to two signatures, meant the value of collateral that Bagehot had in mind was essentially taken for granted. As Bagehot notes, “[n]o advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business.”

Fourth, Bagehot never used the term “penalty rate” at all, and what exactly he meant by the “very high rate” that he does propose isn’t exactly clear. He wants the high rate to “operate as a heavy fine on unreasonable timidity.” Some say this is to penalize banks who have to come to the discount window for failure to maintain sufficient liquidity to stem the crisis on their own. Bignon, Flandreau, and Ugolini have a fascinating alternative explanation for this. They suggest that the “high rates” should be understood not as a fine on bankers’ failure to manage their liquidity—the stigma theory of Bagehotian high rates—but to penalize them for their reluctance to trust each other. As Bignon et al. put it, the high rate is “an encouragement to make use of the information they have on one another rather than seek the safety of the Bank, for this may result in a complete collapse of interbank lending and destruction of information.” Central banks need information during panics; the high rates, when themselves not destabilizing, can encourage the production of more information.

Fifth, it’s not at all obvious what Bagehot can tell us about modern central banking. In fact, as much as I love this book and the author’s clear exposition, it’s simply inaccurate to say he’s the father of central banking at all. His book is about the Bank of England as the keeper of the nation’s gold reserve, and what that means when facing times of panic. Outside of panics, Bagehot has very little to say of resonance to modern central bankers.

But even accepting this profound book on its own terms—as a book about the keeper of the central reserve—figuring out what still from Bagehot’s era to our own in the context of panics is a fairly tricky endeavor. He published his book at the very beginning of the “classic gold standard,” a period of stable prices and international cooperation in trade and finance that many still cite in their enthusiasm for abolishing central banks (and fractional reserve banking, and deposit insurance, and much of governmental participation in finance). The collateral the bank discounted has changed. The dynamic between international flights to liquidity and domestic flights to liquidity look much different than they did to Bagehot. Does Lombard Street still apply in light of these changes? That’s an open and fascinating question. I’m not exactly sure of the answer, except that it is not “yes, in every respect.”

And sixth, Lombard Street is not a fight with the Bank of England to become a lender of last resort. As the extended quote above notes, Bagehot’s prime example was citing what the Bank of England did in 1825—fifty years earlier. The point of his book was something else, something very important, with direct lessons for our central banks today.

I’ll end on that cliff-hanger. Out story will continue in a second installment.