"Lombard Street" is a marvelous little book

This is a review of "Lombard Street: A Description of the Money Market" by Walter Bagehot. You can find all my previous book reviews here. If you're interested in buying a copy, I hope you'll consider using my Amazon Associates referral link.

19th century Britain, like all capitalist economies before and since, suffered periodic banking panics, during which the entire banking system froze and the economy was thrown into deep recession as the population waited to see when, and indeed whether, confidence in the system would be restored.

Walter Bagehot's "Lombard Street" is a careful description of the mechanics and aftermath of these panics, written by someone who experienced several of them firsthand. It has, I think, two great virtues that make it useful to the modern reader: he was writing about an economy which was operating on the gold standard by default, rather than by intention; and most, if not all, of today's market phenomena already existed at the time of his writing, but operated at a much slower pace.

Bagehot treats the gold standard as a feature of nature, not a regulatory decision

Today any introductory economics textbook will explain to you the importance of banks in the process of "money creation." Banks create money by loaning out a majority of their deposits. When those loans are deposited in a bank (either the same bank or any other), that bank then loans out a majority of those deposits. In this way money is "created" (in excess of deposits) and entered into circulation. A bank's regulator can slow or speed the process of money creation by increasing or decreasing the proportion of each bank's deposits it is required to keep on hand.

Bagehot would reject this idea outright. Banks cannot create money. They accept deposits, and then they can loan out some portion of those deposits and accept, in exchange, some security. The total amount of "money" within the banking system cannot be increased or decreased through this process, because the total amount of gold reserves kept by the banks in reserve is fixed.

To Bagehot, cash is gold and gold is cash. He literally uses the words interchangeably.

Bagehot's panics were gold panics

The source of Bagehot's panics is obvious: the banks of 19th century England were engaged in money creation just as our fractional reserve banks are today, but unlike ours, his banks refused to admit it! So the amount of deposits redeemable on demand for gold was, in fact, far higher than the amount of gold available for redemption. If enough people suddenly sensed that the amount of gold available was inadequate to cover their deposits, they would rush to the banks and attempt to withdraw gold before everyone else beat them to it.

This happened with some regularity.

Bagehot's solution is our solution

Today the Bank of England and the Federal Reserve solve the problem of banking panics through the "discount window," where they offer liquidity to any bank in need of it to meet customer demands for cash.

This is precisely the solution that Bagehot describes, except Bagehot's Bank of England had an important limitation our modern system does not: the quantity of gold bullion held in its vaults. Thus the central banking problem of Bagehot's time was maintaining a high enough bullion reserve to meet demand in time of crisis.

In those times of crisis, Bagehot says the Bank of England should lend freely to any and all banks, accepting any "security considered good in normal times." This is, almost exactly, the legal restriction the Federal Reserve in the United States operates under, being forbidden by law from making loans to "insolvent" banks.

Economic crises used to be banking crises

One of the best chapters in "Lombard Street" is when Bagehot explains what happens when the price of a commodity increases:

"When the agriculture of the world is ill off, food is dear. And as the amount of absolute necessaries which a people consumes cannot be much diminished, the additional amount which has to be spent on them is so much subtracted from what used to be spent on other things. All the industries...are somewhat affected by an augmentation in the price of corn, and the most affected are the large ones, which produce the objects in ordinary times most consumed by the working classes. The clothing trades feel the difference at once, and in this country the liquor trade (a great source of English revenue) feels it almost equally soon. Especially when for two or three years harvests have been bad, and corn has long been dear, every industry is impoverished, and almost every one, by becoming poorer, makes every other poorer too. All tracks are slack from diminished custom, and the consequence is a vast stagnant capital, much idle labour, and a greatly retarded production." (p. 56)

This is what we would call today a "supply shock," with a sudden decrease in supply in one sector causing higher prices and a decrease in production economy-wide. But the important thing to remember here is that Bagehot is only able to describe an increase in the price of corn denominated in gold, or as he would call it, "money." Every change in supply and demand for a particular commodity is also moderated through the supply and demand for gold bullion.

That means a sudden shortage of corn, and resulting economic contraction, also results in a banking crisis as people realize their deposits were lent out to businesses who are suddenly unlikely to be able to repay them. Panic quickly sets in and each depositor is anxious to withdraw their cash before the bullion reserve is exhausted.

The only solution is a rapid increase in the interest rate to attract deposits of gold bullion from overseas, in order to meet the sudden demands on the Bank of England.

A fiat currency works on the everything standard

Developed economies today issue fiat currencies, which people sometimes claim means they are backed by "nothing." But of course dollars, pounds, and euros are backed by gold — they're backed by the amount of gold you can buy with them. They're also backed by the amount of land you can buy with them, the amount of beer you can buy with them, and the amount of refrigerator you can buy with them.

It's true that dollars and pounds used to backed by fixed amounts of gold, instead of market rate amounts of gold, but that just meant that everything else — all the stuff you actually wanted to buy — was mediated through the supply and demand for gold.

Now not just the exchange rate between euros, pounds, and dollars float based on market forces, but the exchange rate between gold, land, beer and refrigerators floats as well.

And best of all, there is not, and can never be, a shortage of the convenient, wallet-sized, digitally-accounted-for, currency units of value.


Bagehot's description of the money market is of a system that is based on the psychology, and whims, of a diverse group of market participants. It takes only the slightest rumor to send the bill brokers and private bankers dashing through the streets trying to shore up their balance sheets before complete panic sets in and the nation is ruined.

Basically, if you were alive in 2008, it will all be familiar to you. Bagehot's advantage over the chroniclers of the Great Recession is his fine prose and step-by-step analysis of the psychology and business practices of bankers of every sort, from the country banker to the Governor of the Bank of the England.