Free bankers like to claim Walter Bagehot, the British essayist and former (and most famous) editor-in-chief of The Economist, as one of their own. And they well ought to, for there can be no disputing the fact that Lombard Street, Bagehot’s celebrated “description of the [London] money market,” treats the concentration of cash reserves in the Bank of England as the Achilles heel of the British financial system, while in turn regarding that concentration as the unintended and “unnatural” consequence of the Old Lady’s accumulation of monopoly privileges:

I shall have failed in my purpose if I have not proved that the system of entrusting all our reserves to a single board, like that of the Bank directors, is very anomolous; that it is very dangerous; that its bad consequences though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.

But it will be said–What would be better? What other system could there be? We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system–that which would have sprung up if Government had let banking alone–is that of many banks of equal or not altogether unequal size. In all other trades competition brings traders to a rough approximate equality… There is no tendency to a monarchy in the cotton world; nor, where banking has been left free, is there any tendency to a monarchy in banking either…no single bank permanently obtains an unquestioned predominance. None of them gets so much before the others that the others voluntarily place their reserves in its keeping (pp. 66–7, my emphasis).

To be sure, Bagehot did not suggest doing away with the Bank of England, or depriving it of its special privileges, for the state of public opinion was such, he believed, that doing so would only invite “useless ridicule.” Instead, he offered his now-celebrated plea for last-resort lending: instead of merely looking after its bottom line, he argued, the Bank of England had to face up to its special obligation to safeguard the British financial system during periods of financial distress. It could best do this by lending freely, at high rates, on good securities. Bagehot’s famous argument for last resort lending, it cannot be said often enough, was a second-best way to deal with the problem of financial crises. The first-best way was free banking. That apologists for central banking are often ignorant of this aspect of Bagehot’s thought–that so many regard Bagehot’s prescription for last-resort lending as an argument, and perhaps the strongest argument, for having central banks–only makes it all the more desirable to be able to insist that Bagehot was, in fact, on our side of the free-vs.-central banking debate.

But tempting as it is to claim that Bagehot was a free banker, the truth is more complicated than that. For although in 1873 Bagehot regarded the opinion that “banking is a trade, and only a trade” to be a “sound economical doctrine” which the British government forgot “when by privileges and monopolies, it made a single bank predominant over all others, and established the one-reserve system,” some years before he’d championed the very opposite view. The occasion for this was Bagehot’s 1848 review of three works–James Wilson’s Capital, Currency, and Banking, Robert Torrens’ Principles and Practical Operation of Sir R. Peel’s Bill, and Thomas Tooke’s History of Prices–responding to the passage of the Bank Charter Act of 1844, better known today Peel’s Act. That Act had drawn a curtain across the stage upon which British monetary policy debates had played out over the course of the previous quarter century, by endorsing the views of the British Currency School, which favored a rule-bound currency monopoly, as against those of both the Banking and the Free Banking schools, with their distinct arguments to the effect that paper currency could best be left to regulate itself. Tooke and John Fullarton were the leading figures of the Banking School, while Torrens and Wilson (the founding editor of The Economist) tended to favor Free Banking.

As his review makes abundantly clear, Bagehot’s sympathies at this time lay entirely with the Currency School and Peel’s Act–a measure that was, according to him, “clearly an approach to the principle of a Government monopoly of paper money”–and against the view that “banking is a trade, and only a trade,” best regulated by competition. “A sentiment of dislike to the interference of Government,” he wrote, though “useful and healthy when confined to its legitimate function,” is also “very susceptible to hurtful exaggeration.” Those opposed to government regulation of currency were, in Bagehot’s opinion, guilty of just such hurtful exaggeration: they failed to appreciate the necessity of “confining to Government both the coining of the precious metals, and, as far as possible, the utterance of money destitute of intrinsic value” instead of leaving them subject to “the disturbing agency of individual selfishness.”

I pass over quickly Bagehot’s arguments favoring a government monopoly of coining, for they are all-too-typical of the simple-minded balderdash that takes the place of sound argument when reason becomes the slave of preconceived opinion. A specimen will suffice: allowing that “the chief utility of competition is its quality of reducing the cost of production to the minimum which Nature admits of,” thereby “supplying human wants at the least possible sacrifice of labour and capital,” Bagehot goes on to observe that “improvements in the process of coining brought about by the competition of individual coiners would have a different and less beneficial effect. What is wanted in money is fixity of value.” Bagehot imagines, in other words, that with respect to coins “cheaper” could only mean “lighter” (or more debased)–as if a private mint-master might out-compete rivals merely by seeing to it that his are the most substandard coins of all! In light of such reasoning we need not hesitate to concur with Bagehot’s opinion “that all the grounds for entrusting the Government with a monopoly of coining money hold with increased force for giving them a monopoly of the issue of paper money.” That they could not possibly hold with reduced force settles the matter.

Concerning paper money Bagehot is at least right in rejecting the Banking School’s fallacious “Law of Reflux,” according to which banks are prevented from over-issuing currency so long as they stick to making (short-term) loans, because then unwanted notes will be speedily returned to banks as loan repayments–as if banks’ were “constrained” by such repayments rather than encouraged by them to lend some more. (The Free Banking School argument, in contrast, was that under competition a bank’s excessive issues would be returned to it, not by borrowers repaying their loans, but by rival banks seeking settlement in gold, which does constrain lending.) But he spouts more nonsense in suggesting that the occasional failure of English “country” banks “reduces to a nullity the legal obligation to give coin in exchange for notes,” which obligation is admitted by proponents of free trade in banking to be essential for the safe and beneficial employment of banknotes. Surely the fact that issuing banks occasionally failed was proof, not of the “nullity” of the legal obligation in question, but of its reality: it is, on the contrary, precisely when a suspending bank is suffered to remain a going concern, instead of being wound-up, that its erstwhile obligation to secure the convertibility of its notes is rendered nugatory. In the history of English banking only one bank ever enjoyed such immunity from failure, and that bank was the Bank of England.

What, then, was the actual, eventual consequence of granting to that bank a monopoly of England’s paper currency? Was it to render the convertibility of that currency more secure than it would have been had the privilege continued to be shared among numerous banks, each of which was capable of failing? On the contrary: it was to altogether do away with even the limited degree of security that that currency once offered.

So far we have a nice distinction between the early Bagehot, champion of currency monopoly and of the “one-reserve” system that goes hand-in-hand with such monopoly, and the later Bagehot, champion of free banking and a “natural” multiple-reserve system. But the distinction isn’t quite so clear-cut as all that, for toward the end of his review Bagehot recognizes the “unnatural” character of the English banking system, with its “excessive preponderance of the Bank of England over the other establishments,” comparing it unfavorably to the Scottish system. But Bagehot’s criticism of the English system falls well short of any implied endorsement of “free trade in banking.” Instead, he merely complains that, in concentrating so much power in the hands of a single firm, legislation had rendered England’s economy excessively vulnerable to poor decisions by that firm’s directors. That misguided legislation went well beyond that–that it set the stage for crises that even the wisest Bank directors were powerless to prevent–was a conclusion he would come to only after an interval of many years.

What caused Bagehot’s thinking to change? The unworkability of Peel’s Act in practice–the Act’s provisions had to be set-aside on three occasions before 1873–undoubtedly had something to do with it. But there is another, intriguing possibility. Bagehot became personally acquainted with James Wilson, whose pro-free banking views he’d once taken to task, in 1857. The two men then became quite close: so close, in fact, that Wilson gave Bagehot his daughter’s hand in 1858, and made him the director of The Economist upon departing for India in the autumn of 1859. (Bagehot became editor-in-chief upon Wilson’s death in India the following July.) It’s tempting to assume that Wilson accomplished in person what he’d not done in print, by bringing his son-in-law and successor into the free-banking fold. The hypothesis is, I think, worthy of a fuller inquiry.*

*That Wilson did discuss the currency question with Bagehot isn’t in doubt. In his Memoir of the Right Honourable James Wilson Bagehot observed that “to those who knew Mr. Wilson well, no subject is more connected with his memory: he was so fond of expounding it, that its very technicalities are, in the minds of some, associated with his voice and image.” (Added February 10, 2012.)