Walter Bagehot (1826-1877) was an English banker, journalist and essayist.

He was 18 years old when Parliament passed the 1844 Bank Charter Act. He studied mathemat­ics in London, obtained a master’s degree in 1848 and joined his father’s bank in 1852. In 1857 he published his first article in the influential newspaper, The Economist, which was founded by James Wilson, his father-in-law and a supporter of the Banking School.

As an economist, Bagehot’s formative years were characterised by the controversy between the Banking and the Currency Schools. When he was 22 years old, in 1848, he published two articles in the Prospective Review. One concerned the rules governing the issue of banknotes enacted by the 1844 banking reform; Bagehot argued in favour of the currency principle, but approved the 1847 suspension of the rules. The second paper was a laudatory review of John Stuart Mill’s Principles of Political Economy. From 1857, he published articles on several contemporary economic topics: international bimetallism, finance in France, India and the United States, and the British banking crises of 1857 and 1866. Lombard Street was published seven years after the 1866 crisis. This book was inspired by the financial consequences of the Franco-Prussian War (1870-71), which, according to Bagehot, could have undermined the functioning of the British banking system.

Bagehot provided Ricardian monetary doctrine with a theory of the lender of last resort. The challenge was a difficult one. Ricardo’s “Plan for a National Bank” and the currency principle introduced a separation between credit and currency, between the granting of credit and the issue of banknotes. This led to the division of the Bank of England into two departments in 1844: the Banking Department that granted credit but could not issue banknotes, and the Issue Department that could not grant credit but did issue banknotes. Banknotes could be issued or withdrawn only in exchange for gold; and the gold reserve of the Issue Department was not available to the Banking Department for lending. This had been established in accordance with Hume’s price-specie flow mechanism, whereby every inflow of gold into the country indicates that additional cur­rency is needed, and symmetrically, that every outflow of gold indicates that there is an excess of currency. Bagehot agreed with this.

However, for Bagehot, while the banking reform made sense with respect to the rules governing the issue of banknotes by the Issue Department, it misinterpreted the activity of the Banking Department. Contrary to the understanding of the governors

of the Bank of England, the Banking Department was not a bank like any other. Historically, the Banking Department had acquired the function of sustaining the British credit system. British banks were accustomed to working with low levels of shareholder funds and a low cash reserve, and having access to loans from the Bank of England in the event of a credit crisis on the money market.

For Bagehot, a credit crisis was a situation where traders and banks are reluctant to lend because they fear that they will not be able to borrow. If the Banking Department was to act like an ordinary bank and refuse to increase its loans when this occurs, it would feed the credit crisis. According to him, the Banking Department has to act as the lender of last resort, following three rules: first, to lend freely in order to re­establish confidence in the availability of loans on the money market; second, to lend only against bona fide collateral, to ensure that it only lent to solvent banks; and third, to lend at a high rate to deter banks from unnecessary borrowing. However, in order to achieve these goals, Bagehot did not suggest that the Banking Department should issue banknotes or borrow banknotes from the Issuing Department, or that the Issuing Department should grant credit on the money market. These are Banking School ideas. Bagehot’s proposal was that the Banking Department should increase its shareholders’ funds, in order to increase the reserve of legal tender that it could loan to the banks.

Bagehot’s main contribution was not stating the three rules for acting as a lender of last resort: lending freely, to solvent banks, at a high rate. The first rule was already present in Henry Thornton (1802) and Thomas Tooke (1844, 1848); the second in Thornton, Tooke and the 1873 Coe Report of the New York Clearing House (in Sprague 1910: 91-103); and the third in Tooke (1844, 1848), but with a balance of payments argument.

It is worth noting that Bagehot did not use the phrase “lender of last resort”. Nor did Thornton. Francis Baring (1797 [1968]) qualified the Bank of England on two occasions as the “dernier ressort” (last resort). The expression is absent from Ricardo’s writings and from those of the Banking School. However, the expression “the bank of last resort in panic” can be found in a Parliamentary report of 1858. The first explicit and signifi­cant use of the phrase “lender of last resort” appeared in Hawtrey’s book, The Art of Central Banking, in 1932.

Jerome de Boyer des Roches

See also:

Balance of payments and exchange rates (III); Banking and currency schools (II); Bullionist and anti-bullionist schools (II); Ralph George Hawtrey (I); Money and banking (III); Henry Thornton (I); Thomas Tooke (I).