Nineteenth century English political economist Walter Bagehot has made a dramatic comeback in the past decade. The twin crises of American political economy—the financial crisis and the crisis of US security policy since 9/11—have generated currents of investigation that have both, quite remarkably, ended up at Bagehot’s door. More precisely, the two currents I have in mind have taken Bagehot’s writing as the point of departure. And his thinking provides the unifying framework of analysis in both cases.
The financial crisis has inspired a Copernican revolution in macroeconomics and finance that goes under the rubric of intermediary economics/market-based credit system—a Copernican revolution in the sense that the focus has moved away from the “real economy,” hitherto the sole recipient of theoretical attention, and onto dynamics endogenous to the financial intermediary sector.
In effect, precrisis macroeconomic models, which continue to survive in economists’ toolkits, assumed away the banking system, which was considered a merely passive amplifier of monetary policy. The new macroeconomics on the other hand, is all about the macroeconomics of dealer balance sheets and financial cycles. In asset pricing models, the most effective pricing kernel (the mathematical object that governs asset price dynamics) has been shown to be a function of dealer leverage; superseding precrisis multi-factor models.
The new picture of the financial system starts with Bagehot’s description of the nineteenth century money market in Lombard Street (1873); brought back to the center of attention with the publication of Mehrling’s The New Lombard Street (2010). The nineteenth century money market is structurally identical to today’s wholesale funding market. In both systems, dealers provide liquidity by standing ready to both borrow and lend against generally accepted collateral at quoted rates and absorbing the resulting order flow on their own books. The structure of the market comes with an obvious systemic risk: During a panic, no one wants to lend even against good collateral. Bagehot suggested that the Bank of England could stabilize this system during a panic simply by providing an outside spread, that is, by lending against generally accepted collateral at punitive rates. This is called Bagehot’s principle; which hard currency issuing central banks are now being urged to follow by the best-informed.
Bagehot is also the starting point to understand the political economy of US security policy since 9/11; relayed in this case by Glennon. Bagehot observed that the “dignified” institutions which are ostensibly tasked with running the country have been silently eclipsed by the “efficient” institutions. The former is largely for pomp and show. The real action is in the latter. It is the efficient institutions that actually run the affairs of the state. In Bagehot’s England, the former was the Crown and the latter was Parliament. In the contemporary United States, Glennon argues, the former includes both the White House and Congress, while the latter is what amounts to a national security deep state. According to Glennon, this explains the unexpected continuity of US national security policies between the Bush and Obama administrations.
One could, of course, extend Glennon’s argument to the economic sphere as well. In the neoliberal era that began with the appointment of Paul Volcker to the Fed in November 1979, Congress has largely surrendered its power to manage the macroeconomy to the Federal Reserve. That is, counter-cyclical fiscal policy has become increasingly off the table, leaving monetary policy as the only game in town. Put in Bagehot’s terms, the dignified institutions have surrendered economic affairs to the efficient institutions as well.
Perhaps it’s time to read Bagehot in the original.