This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Aggregate Demand and Aggregate Supply: Say's Law


I. Introduction

At the spring 2011 INET Conference in Bretton Woods, New Hampshire, Financial Times correspondent and columnist Martin Wolf asked:

[Doesn’t] what has happened in the past few years simply suggest that [academic] economists did not understand what was going on?...

Former U.S. Treasury Secretary Lawrence Summers, in the course of his long answer, said:

There is a lot in [Walter] Bagehot that is about the crisis we just went through. There is more in [Hyman] Minsky, and perhaps more still in [Charles] Kindleberger...

Walter Bagehot (1826-1877) refers to his Lombard Street, published in 1873. Hyman Minsky (1919-1996) is a twentieth-century observer and theorist of financial crises best approached not through his books or his collected essay volume—Can “It” Happen Again?—but rather through the use that economic historian Charles Kindleberger (1910-2003) made of his work in Kindleberger’s 1978 Manias, Panics, and Crashes: A History of Financial Crises.

Asked to name where to turn in the works of economists to understand what was going on in 2005-2011, Summers cited three dead economists—one of them long dead. Summers did then enlarge his answer to include living economists, starting with the economic historian Barry Eichengreen and then moving on to mention “[George] Akerlof, [Robert] Shiller, many, many others...”. Summers stressed the success of empirical work in aiding understanding, in contrast to the failure of modern “macroeconomic [theory to] keep up with [the] revolution” in finance “as it was realized that asset prices show large volatility that does not reflect anything about fundamentals”.5

How is it that Walter Bagehot (1873), Lombard Street: A Study of the Money Market, a book written 150 years ago  is still state-of-the-art in economists’ analysis of episodes like the one that we hope will be dated as ending next year, in 2013? And what, exactly did Bagehot say that is still useful?

There are three reasons that Bagehot (1873) still has considerable authority:

The first reason is that modern academic macroeconomics has long possessed two drives. It has possessed a drive toward analyzing empirical issues that can be successfully treated statistically. It has possessed a drive toward analyzing theoretical issues that can be successfully modeled on the foundation of a representative agent possessing individual rationality. These drives are often very useful: most of the successes of modern macroeconomics as a policy science are built on top of them. These drives, however, become positive disabilities in analyzing episodes like major financial crises. Major financial crises come too rarely for statistical tools to have much bite. Given that a major ex post question asked of wealth holders and their portfolios after a crisis is “just what were they thinking?”, a baseline assumption of individual rationality forecloses too many issues—as does any assumption of a representative agent.

The second reason is that, while the causes of financial collapses are diverse, the effects are pretty much constant across time. Since 1825 we have seen a single mechanism transmit financial distress to the real economy of production and employment. transmission mechanism, in the form of the flight to liquidity and/or safety in asset holdings, and the consequences for the real economy, in the freezing-up of the spending flow and its implications for employment and production, looks much the same in episode after episode. The transmission mechanism and the consequences have typically been very similar since at least the first proper industrial business cycle in 1825.

Thus a nineteenth-century author like Walter Bagehot is in no wise at a disadvantage in analyzing the causes and spread of the downward financial spiral, or in analyzing its consequences for the real economy.

The basic story is simple. Through the arrival of new information, through sheer panic, or through the effects of government policies, wealth-holders lose their confidence that a good chunk of the financial assets that they had thought were safe, liquid stores of value and potential means of payment are in fact safe and liquid. Such assets thus lose their attractiveness as safe stores of value and liquid potential means of payment. This causes wealth-holders to attempt to dump their holdings of such now-impaired assets to try to rebalance their portfolios with respect to safety and liquidity. But the dumping of the now-impaired assets makes them even less safe and less liquid. The recognition of reality (or the simple panic) triggers an attempted shift of portfolios in the direction of holding more safe, liquid stores of value just at the moment that the value of assets that count as such declines. This was the story in 2007-9. And this was also the story in 1825-6. Thus it is not surprising that a good analysis of 1825-6 and like financial crisis-driven downturns like Bagehot (1873) is still a (nearly) state-of-the-art analysis of 2007-9.

Bagehot’s (1873) key relevant insight was that expansionary policies affect both the demand for and the supply of safe, liquid stores of value. When households and businesses are convinced that they need to hold more safe, liquid stores of value, they will try to push their spending on currently-produced goods and services below their incomes. But since economy-wide incomes are nothing but spending on currently-produced goods and services, the net effect is only to push incomes, production, and spending down until households and businesses feel so poor that they forget about building up their stocks of safe, liquid stores of value.

Thus brings us to the third reason, the additional feature of the situation that Bagehot saw back in 1873. The natural cure for the financial system and for the real economy is for something to lead households and businesses to lower their demand for or something to expand the supply of safe, liquid savings vehicles. If this is accomplished so that desired safe and liquid asset holdings at full employment are once again equal to asset supplies, the economy will recover. Bagehot (1873) saw aggressive expansionary policies as desirable both to increase the supplies of the safe, liquid stores of value that households and businesses wish to hold and to damp down demand for such assets by demonstrating that risks will be managed and reduced. And those are still the policies, in many different flavors it is true, advocated today.

Thus Walter Bagehot (1873) is remarkably close to the best we can do, even today.