The Unwisdom of Crowds

...Glamour, prestige, ?lan, sprezzatura, cutting a fi gure . . . that is what the economy is made of...

...Market Miscalculates), called Bagehot’s lender-of-last-resort views “the most mischievous doctrine ever broached in the monetary or banking world in this country...

...The basis of the bank’s operating procedure—and of its soundness— was the Bank Act of 1844...

...Any regulatory system will reveal its vulnerabilities over long use...

...So the “cultural contradictions of capitalism” run deeper than we thought...

...Nothing could be more foolish than to assume that this process of spiraling speculation is unleashed by “greed,” unless by greed you mean human nature...

...the schooling of one’s children...

...Centralizing a society’s cash reserves is complicated, reckless, and artifi cial: A republic with many competitors of a size or sizes suitable to the business, is the constitution of every trade if left to itself, and of banking as much as any other...

...I should hardly say too much if I said its danger...

...Decent, puritanical Suffolk farmers want to put their money in a safe place...

...Bagehot saw that a speculative mania eventually sweeps up everyone in its path...

...The situation required what we would now call “strategic ambiguity”—both Hankey’s doctrine and Bagehot’s practice, which contradicts it...

...Christopher Caldwell is a senior editor at THE WEEKLY STANDARD...

...In fi nance, once you can have leverage, you must have leverage...

...When depression looms, you had better realize that the rain falls on the just and the unjust...

...That is why, even in democracies, the instruments of monetary policy tend to be kept far from the infl uence of voters, and even hidden from view...

...One’s quality of life is determined not just by one’s purchasing power but also by one’s relative economic standing...

...In a crisis, banks—like everyone else— refl exively hoard their money...

...This line of argument peaked at the turn of the decade, when Americans elected a president who had argued that the public was foolish for not launching its retirement savings onto the open seas of the stock market...

...It is curious that Bagehot, a contemporary of Marx, came to the opposite (and false) conclusion about how fi rms evolve...

...The power, delicacy, and danger all have the same source...

...One line of argument was that people who did not have a ton of money in stocks, as well as those who rented rather than bought the houses they lived in, were foolish...

...Thanks to London bankers, both can follow their wishes and make a profi t in the process...

...But just as many of them are not...

...English investors must have longer memories than American ones...

...And sometimes, when banks enter the game insuffi ciently scared, it will be played out to the end...

...Lombard Street was published in 1873, seven years after the sudden collapse of Overend, Gurney & Co., a bank that lost ?11 million, spread panic among investors, sparked a run, and became “the model instance of all evil in business...

...Rather than shred their campaign strategies, they played it safe, as most politicians would have...

...This was not a question of moral failing, it was just the way a modern economy worked...

...Is that just...

...The classic idea, as laid out in their different ways by the economist Joseph Schumpeter and the sociologist Daniel Bell, is that capitalism rewards diligence...

...Central banking is thus often a high-stakes game of chicken...

...Not just that...

...To modern eyes, Bagehot is, as a factual matter, simply wrong...

...Among rich people, how one entered the present decade had more to do with how one had done in the stock market than with how one had done in the labor market...

...In the same way, no matter how good the content of a regulatory regime, it must change periodically if big market players are to be kept from profi ting off it...

...Stranger still, never did the Bank of England acknowledge its duty as the lender of last resort...

...Just as society can be improved by the uncoordinated action of the selfi shly motivated, an economy can collapse for reasons having nothing to do with anybody’s cupidity...

...Unless there was a real, credible threat that a bank would be allowed to fail, the guarantee of rescue would simply get priced into any fi nancial bubble that developed, making things worse when the bubble popped...

...In his ideas of company size, Bagehot harkened back to the 18th century rather than ahead to our own...

...Indeed, at more than one juncture in Lombard Street, Bagehot framed the problem of booms and busts as part of the “increasingly democratic structure of English commerce...

...We have an idea that the Suffolk dairyman is the “moral” party here (he’s saving) and the Lancashire speculator the “immoral” one (he’s gambling...

...The crisis made such a deep impression on British fi nance and government that the country did not have another bank run for 141 years—not until Northern Rock collapsed in the summer of 2007...

...it can only be known by trial and inquiry...

...the size, location, elegance, and comfort of one’s house—relative standing is more important than absolute wealth...

...It was the Bank of England that took charge of averting panic, during the Overend, Gurney crisis and thereafter...

...Because it is on Wall Street, alas, that “the state of credit” is to be determined: The state of credit at any particular time is a matter of fact only to be ascertained like other matters of fact...

...In exact proportion to the power of this system is its delicacy,” he wrote...

...As Bagehot outlined his system, he was conscious that the practical realities of banking required him to heap paradox upon paradox...

...What a wicked irony...

...Otherwise, credit tends to spiral...

...The worst was that the bank could carry out its necessary duties as a lender of last resort only by breaking the law...

...In good times you are welcome to mouth the folkloric clich...

...You can draw an analogy with antidepressant drugs...

...Where Bagehot would agree with Marx is in his belief that there is something predictably destabilizing about modern economies...

...His punishment is as much for his long and wise forbearance as for his momentary weakness...

...Every great crisis reveals the excessive speculations of many houses which no one before suspected,” he wrote, “and which commonly indeed had not begun or had not carried very far those speculations, till they were tempted by the daily rise of price and the surrounding fever...

...You don’t need banks to have a precarious economy, or one liable to speculation— Bagehot noted that there were no banks, as we would understand them, in 1720, at the time of the South Sea Bubble and the Mississippi Scheme...

...The real capitalist virtues appear to be optimism and luck...

...The problem with central banking is that it reacts to a system that has been mismanaged by rewarding the managers...

...It must lend freely...

...Bagehot described London’s fi nancial district as “a sort of standing broker between quiet saving districts of the country and the active employing districts...

...But they are effective...

...wealth begets idleness...

...In practice, Bagehot was right and Hankey was wrong...

...So the law on which the solvency of the British nation rested was ironclad, except when someone felt a need to break it...

...The Republicans who nearly derailed the Treasury’s Troubled Assets Relief Program in September played a similar role...

...Without credit, they would be ruined, and the ruin would spread to those to whom they owed money...

...Once you have some leverage, getting more of it than your competitors is a matter of survival...

...To be blunt, credit is successfully reestablished when fi nancial elites say, “When...

...And when governments and central banks debate whether to loosen or tighten up money, they face a constant clamor from the fi nancial world to permit more leverage still...

...Ninety-nine percent of the time, common sense is a synonym for practicality...

...they can only have acquired that information in present business, and such business may very possibly be affected for good or evil by the policy of the Bank...

...Bagehot approved of this...

...Everyone is always hollering for clear rules and transparency...

...Bagehot was no populist...

...In principle, Hankey was right and Bagehot was wrong...

...The natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it...

...A monarchy in any trade is a sign of some anomalous advantage, and of some intervention from without...

...But when, as now, push comes to shove, we can ask whether there is really anything particularly capitalist about the virtues of diligence and self-restraint...

...This was the most basic affront to common sense that the Bank of England presented, but it was not the worst...

...The banker can no more choose not to lend than the merchant can choose not to borrow: The bill-broker has, in one shape or other, to pay interest on every sixpence left with him, and that constant habit of giving interest has this grave consequence: the bill-broker cannot afford to keep much money unemployed...

...If it addresses economic problems in a predictable way, savvy investors will fi nd a way to “game” that predictability...

...When it comes to the very goods people deem most essential—the proper mate...

...Bubbles result...

...In fact they are just different names for the same thing: leverage...

...Viewed as Bagehot viewed it, from the perspective of a central bank in a crisis, an advanced economy looks an awful lot like a primitive economy...

...Credit spirals are a darker aspect of the world Adam Smith described in The Wealth of Nations and Bernard de Mandeville did in the Fable of the Bees...

...Bagehot sometimes contradicted himself on this point, noting also that “a large bank always tends to become larger, and a small one tends to become smaller,” but his application of the word unnatural to a large central bank was frequent and must be taken as his settled view...

...We would call it a regime of sound money...

...Although he would surely fault Treasury Secretary Hank Paulson for many things, the criticism most often heard at present—that Paulson is too close to former colleagues on Wall Street, where he worked for years as CEO of Goldman Sachs—would strike Bagehot as misplaced...

...He was comfortable with the idea that what some people think should be more important than what other people think: Almost all directors who bring special information labor under a suspicion of interest...

...Some of its governors even denied that any such duty existed...

...If you want small fi rms, you must protect them through government—whether this means Teddy Roosevelt-ian trust-busting, French-style subsidies to tobacconists, the EU’s hounding of Microsoft, or the NIMBY anti-Wal-Mart campaigns aimed at preserving Mom-and-Pop stores...

...But you must not on this account seal up the Bank hermetically against living information...

...At the very opening of the book, Bagehot illustrates with exquisite simplicity how, at least in a boom economy, traders on margin can “harass and press upon, if they do not eradicate, the old capitalist...

...Lancashire entrepreneurs want money to put to work...

...This was a catastrophe in terms of Bagehot’s practice, but it will produce benefi ts in terms of Hankey’s principle...

...Later, Bagehot showed that this need for leverage is no different for those selling money than it is for those selling dry goods...

...The natural tendency under free-market conditions is towards consolidation, and even monopoly...

...This was the great discovery of Walter Bagehot, the prolifi c 19th-century essayist and journalist, who was editor of the Economist from 1860 to 1877...

...Ron Paul, in almost every speech he made during the Republican primaries, spoke of bubbles, reckless credit growth, and the “unsustainability” of present policy...

...Thomson Hankey, a Bank of England director whom Bagehot much admired (and to whom the fi nancial writer James Grant devotes an admiring essay in his new book Mr...

...To say an economy is based on credit is to say it is based on animal mysteries...

...He has become a banker owing large sums which he may be called on to repay, but he cannot hold as much as an ordinary banker, or nearly as much, of such sums in cash, because the loss of interest would ruin him...

...The old capitalist in question is the poor sap who believes all this stuff about neither-aborrowernor-a-lender-be and is foolish enough to be using his own cash: If a merchant have ?50,000 all his own, to gain 10 per cent on it he must make ?5,000 a year, and must charge for his goods accordingly...

...Most of our own noxious subprime mortgages were contracted, and the securities built on them concocted, after Enron became our own model instance of evil in 2001...

...but if another has only ?10,000, and borrows ?40,000 by discounts (no extreme instance in our modern trade), he has the same capital of ?50,000 to use, and can sell much cheaper...

...They are trapped, as surely as fi nancial institutions are, in a system based on wild borrowing...

...The bank was beyond question the lender of last resort...

...So why isn’t there more demand for the common-sense solutions he put forward...

...Bagehot’s Lombard Street is an insider’s look at the Bank of England, and at the principles on which political and fi nancial leaders act when advanced economies come under pressure...

...The business of banking ought to be simple,” he wrote...

...It is a rather terrifying thought...

...His name rhymes with gadget...

...Because common sense is not much use in a fi nancial panic...

...and if, like the old trader, he make ?5,000 a year, he will still, after paying his interest, obtain ?3,000 a year, or 30 per cent, on his own ?10,000...

...But while the boom was going on there was all sorts of rationalizing about why it was okay that the social hierarchy should be reordered through stock and housing speculation...

...But in the name of justice we ought to recall that there was one candidate who did foresee our predicament with considerable accuracy when it still lay far in the future...

...It will discourage people from paying more than is reasonable for assets on the belief that they come equipped with an insurance policy (the promise of a central bank rescue) that has been underwritten by taxpayers...

...If it is hard, the banker is either delegating poorly or has entangled his institution in complex transactions where it has no business...

...diligence produces wealth...

...A final problem is that there are limits to how accountable a central bank can be...

...If the bank ever acknowledged a duty to rescue banks by generous extensions of credit, it would create a form of moral hazard...

...But the modern economic system interacts with the modern political system—democracy—in a rather uncomfortable way...

...Credit is close to a synonym for the mood of the ruling class...

...But a dirty secret of regulation is that it frequently infl uences conduct most effectively when it is capricious and opaque...

...Treasury terrifi ed the fi nancial world by not coming to the rescue of Lehman Brothers...

...His Refl ections on the Revolution in Europe: Immigration, Islam, and the West will be published by Doubleday in July...

...But modern banking is precarious by design...

...Avaricious people get hurt, but it is in the nature of crashes that they are not the ones who get hurt most...

...If the rate at which he borrows be 5 per cent, he will have to pay ?2,000 a year...

...Chagrin at seeing one’s neighbors get richer faster may be a sign of bad character, but do not for a minute assume there is nothing to feel chagrin about...

...And in the same way, nothing but experience can tell us what amount of “reserve” will create a diffused confi dence...

...We should be moral in the way we think about money, but a credit system tends to make a mess of moral accounting...

...As most merchants are content with much less than 30 per cent, he will be able, if he wishes, to forego some of that profi t, lower the price of the commodity, and drive the old-fashioned trader—the man who trades on his own capital— out of the market...

...The Unwisdom of Crowds Financial panics still require what Walter Bagehot prescribed— that practical men violate their own principles BY CHRISTOPHER CALDWELL Neither Barack Obama nor John McCain had much of value to say about the fi nancial crisis as it raged through the headlines this fall...

...But a central bank must do the opposite...

...Bagehot thought the bank should come clean about what it really was: There should be a clear understanding between the Bank and the public that, since the Bank hold our ultimate banking reserve, they will recognise and act on the obligations which this implies—that they will replenish [the reserve] in time of foreign demand as fully, and lend it in times of internal panic as freely and readily, as plain principles of banking require...

...But in a serious banking crisis, doing the commonsensical thing—hunkering down and counting your pennies—has proved to be not practical at all...

...A tragic fi gure present in almost every historic account of speculation and collapse in history is the person who believed, year after year, that the boom was an illusion, and held himself aloof until, at the very last minute, whether out of self-doubt or deference to the opinions of his fellow man, he entered the fray and was (having bought at the top, rather than the bottom, of the market) wiped out...

...If it is hard it is wrong...

...People in a democracy are most comfortable when their institutions do the same things that they would do as individuals...

...that holds farmers to be better people than fi nanciers...

...From a central-banking perspective, the cultural contradictions are not results of capitalism but elements of it...

...Antidepressants work only until the mind (or is it the brain...

...Those who kept their money in savings banks in the 1990s lost out to those who did things we are supposed to disapprove of, like “spending money they didn’t have,” borrowing profl igately to invest in stocks and even bonds, which appreciated at an average of 15 percent a year over the decade...

...Of course it’s not...

...It certainly was in September when the U.S...

...Participation in this system is not exactly required, but it is not exactly optional, either...

...But, once a banking system intervenes, they are both gambling and they are both saving...

...According to Bagehot, “Adventure is the life of commerce, but caution, I had almost said timidity, is the life of banking...

...These caps were hewed to when the economy was running smoothly...

...There is a hint of both Andrew Jackson and Thomas Aquinas in the way he referred to central banking as an “unnatural” thing in its very conception...

...Many ordinary retailers could not pay their suppliers until they got the money for the things they sold...

...The situation today requires the same mix...

...That is why objections to central banking, although they can come from the right (Ron Paul, Jim Bunning) or the left (Barney Frank, William Greider), tend to be populist...

...But there was a reason for the central bankers’ dissembling...

...Yet at the time Bagehot was writing, a quarter century later, the law had already been suspended three times...

...There is no permanent right match of medication for a depressive...

...That is why, in the so-called Anglo-Saxon world, Bagehot’s book still provides the bedrock of policy thinking during fi nancial emergencies, including our present one...

...No similar occasion has ever yet occurred,” Bagehot wrote, “in which it has not been suspended...

...Many Americans who have wound up underwater on their houses and maxed out on their credit cards are greedy, climbing, brand-intoxicated, materialistic shopaholics who thought the world owed them a living...

...It’s easy to see now...

...It included stringent caps on the ratio of notes issued to reserves held...

...fi nds a way around them, at which point a new, unfamiliar drug must be substituted...

...and idleness undermines capitalism...

...It did so by injecting credit into the economy, by bailing people out...

...Those principles are depressing in the extreme for anyone with an uncomplicated idea of how a democracy works...