The best books that take up Walter Bagehot’s challenge

Lombard Street is the classic statement of how central banks began functioning to insure the private bank system against bank panics. Walter Bagehot wrote this at the time of a revolution in banking that came about after the Joint Stock Companies Act of 1862 allowed private banks to have limited liability. Banking then boomed in England, and the Bank of England went from being a private bank to a bank also serving the Crown of England, and finally into a central bank as we see them today. 

The Bank of England would hold reserves for the entire private banking system should they need them in times of bank panic, which were periodic in those days (and still today). At the same time, the Bank provided the money supply through note issue. This created a money and banking authority that was efficient in its practice of stabilizing the money and financial system. By “pooling” all of the private bank reserves, less reserves were held in the entire system, and more capital circulated and increased the wealth of nations, making England the center of international finance, as Bagehot argues.

Goodhart, a former head economist of the Bank of England, builds upon Bagehot to describe how modern central banks evolved to insure the private bank system.

Goodhart argues that regulations over private banks were unnecessary and that the shadow bank system (that had evolved since the Vietnam War era inflation drove banks away from the Federal Deposit Insurance Corporation in the US) would never go bankrupt. He argues that the investment banks always had sufficient reserves, so that increased regulation was undesirable.

The Crash of 2008 proved Goodhart wrong. Yet ironically, it is the exact same set of arguments that are being used today: banks do not need increased regulation since the Fed and Bank of England are now holding reserves, and private banks are also holding more reserves. Even the FDIC has argued against bringing investment banks into the FDIC system that is efficient, because it would involve increased regulation.

So, avid reader, the question is whether charging insurance premiums on deposits at a rate dependent upon the private bank’s riskiness in its assets is inefficient, which is what the FDIC does? Or is it that the huge build-up of reserves at the Fed, Bank of England, and European Central Bank are decreasing international investment while, at the same time, private banks are holding more reserves outside of the Fed?

The modern practice of central bank “after-the-crash” insurance is to hold untold “oceans of reserves” (as a Federal Reserve Bank working paper was titled) that decrease the capital that can circulate and be invested. The FDIC, in contrast, continues to insure the “retail” bank sector, basically now the small banks, in an efficient way. The problem that comes from reading Goodhart, combined with knowledge of the new world of post-2008 central banking, is that the lion’s share of capital from the large banks is now insured “ad hoc” in an inefficient manner by the Fed, Bank of England, and ECB. 

Friedman, a Nobel-winning former Economics professor, writes brilliantly and playfully, and students of economics love to read him. Yet he delves into the heart of the monetary problems that have been confronted historically. This he uses to shed light on how to conduct monetary policy today.

He ranges across the whole of American history. For example, the failure of the Continental Congress’s currency occurred since it was printed to finance the Revolutionary War when there was no federal government and no federal tax revenue. This led to the new US Constitution and the ability to raise taxes, and a stable currency that was backed by gold and silver.

With the Civil War, the US Treasury printed money called “greenbacks” and suspended conversion to gold and silver during the War, but re-established convertibility in 1879 at the pre-War rate. Friedman shows how this convertibility led to prolonged, hugely damaging deflation for more than thirty years. He explores how price stability could instead have been established.

Friedman’s ability to sort through dogma, politics, and economics is unparalleled in its insightfulness and reader popularity. Friedman turns Economics into a reader’s game of enjoyment while learning instead of learning while struggling with the concepts.

Bernholz, a renowned Swiss Economics professor, builds upon Friedman to provide an unparalleled view of how budget deficits and high government spending end up being financed by the “inflation tax” of printing money to cover the deficits.

Throughout history back some two thousand years, Bernholz describes ancient and modern monetary regimes based on metallic standards and fiat money unbacked by any metal. He analyzes how increased money supply causes moderate, high, and hyper-inflations throughout this history. He provides dozens of historical examples of money and inflation in times of crises including war.

Bernholz adds the dimension of how international exchange rates are affected during rising inflation and when deflation ultimately occurs. He shows how different “laws” regulate behavior, with good money driving out bad money until the bad money collapses in value and then good money is created or imported that drives out the bad money to its extinction. Bernholz shows how these various degrees of inflation under different monetary regimes can be ended. He details cases in which monetary reform fails and cases when a new monetary regime is successful.

This great contribution provides a full menu of food for thought as to how today’s inflation episode might be brought under control and future episodes avoided.

King was the head of the Bank of England during the financial crisis of 2008. He declared full deposit insurance for the entire United Kingdom private banking system, with no deposit premiums required. This ended the run on the banks that spilled over into the streets of the UK during the crisis, when the Bank of England at first decided not to take care of Northern Rock, a private retail bank that was headed towards insolvency.

King provides a whimsical and sharp review of the private and central bank system before and after the crisis that builds very much on Charles Goodhart and Walter Bagehot. King laudably faults economists and the Economics profession for thinking that establishing negative real interest rates worldwide is the answer to central bank crises (in his newly added Introduction to the paperback edition of his 2016 hardback by the same name). Yet King sides with Goodhart unabashedly and proports that the private bank system needs no increased regulation over its operations. Bank insurance is hardly discussed, despite King having served up FDIC-style deposit insurance to the whole UK except without the cost of premiums.

Instead, King promotes that private banks need to take better care of themselves to be ready for any crisis. He suggests that central banks should essentially allow private banks to create living wills such that assets can be offered to them in case of crisis to keep the banks from dying. Put more precisely in King’s language, the central bank should act as a “pawnbroker for all seasons” by offering up cash reserves for private bank assets even if their value is hugely discounted during crises. Despite my view of the inefficiency of private bank “self-insurance” relative to a true FDIC mold of rigorous deposit insurance with risk-based premiums, King’s boldly proposed system was essentially taken on internationally by the US, UK, and ECB by designating the largest banks as systemically important.

With that came Fed bank health check-ups after the 2008 crisis that have spread to these systematically important banks across the Western global financial system, resulting in living wills being indirectly created for these banks. This may be a second-best or worse bank insurance system, but King undoubtedly has pushed the ball forward on thinking about how central banks should provide private bank insurance, the same topic that Bagehot promulgated.