May 4, 2015
Sovereign Valley Farm, Chile
It was another time. Another era. Another superpower.
Great Britain’s was the largest economy in the world in 1873. And it showed.
The British pound dominated world trade and was the most widely used reserve currency on the planet.
And London was the undisputed epicenter of global finance.
There was more money in London, in fact, than in just about every other major financial center in the world combined.
Britain was clearly at the top of the world.
But in 1873, a financial reporter named Walter Bagehot published a book that shined a huge spotlight on some of this phony prosperity.
Bagehot was Editor-in-Chief of The Economist at the time. He was a brilliant finanical thinker, and the book, Lombard Street: A Description of the Money Market, was his masterpiece.
For example, the book describes how, even though the British banking system was the most widely used and powerful in the world, it was dangerously overleveraged:
“There was never so much borrowed money collected in the world as is now collected in London,” writes Bagehot.
He further shines a huge spotlight on the risks of illiquidity, describing how Britain’s largest banks only held a very small percentage of their customer’s funds in cash:
“[T]here is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England.”
“[T]he amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.”
In Bagehot’s day, banks invested or loaned out the vast majority their customers’ savings, only holding around 10% to 15% of deposits in reserve. Bagehot found this abysmally low.
Yet today some of the largest banks in the world hold as little as 3%. And debt levels have hit records never before seen in the history of the world.
Our system is even more leveraged and more indebted.
But the similarities don’t stop there.
Bagehot reminds readers of the spectacular collapse of banking house Overend, Gurney, and Co… sort of the Lehman Brothers of its day.
Overend had engaged in pitifully stupid behavior, run itself into insolvency, and was not bailed out by the government.
Overend failed in 1866, and it nearly dragged down the entire financial system with it.
It had been only seven years since that crisis when he wrote Lombard Street. But the major banks were right back to their same old reckless, irresponsible behavior. He writes:
“Even the great collapse of Overends, though it caused a panic, is beginning to be forgotten.”
Bagehot also blasts the central banking system (dominated by the Bank of England) which had effective control over the economy:
“All banks depend on the Bank of England, and all merchants depend on some bank.”
Of course, no one truly understood how that system worked. Everyone just had confidence that the central bankers were smart guys and absolutely would not fail:
“[F]ortunately or unfortunately, no one has any fear about the Bank of England. The English world at least believes that it will not, almost that it cannot, fail.”
“[N]o one in London ever dreams of questioning the credit of the Bank, and the Bank never dreams that its own credit is in danger.”
But as Bagehot points out, the data showed otherwise:
“Three times since 1844 [the Bank of England] has received assistance, and would have failed without it. In 1825, the entire concern almost suspended payment; in 1797, it actually did so.”
Clearly these central bankers weren’t particularly good at their jobs. Bagehot sums it up like this:
“[W]e have placed the exclusive custody of our entire banking reserve in the hands of a single board of directors not particularly trained for the duty—who might be called ‘amateurs’. . .”
“But still there is a faith in the Bank, contrary to experience, and despising evidence.”
This is miraculously dim-witted– to assume the men behind the curtain are going to get it right, and to willfully ignore the objective evidence which shows:
- there is an unsustainble amount of debt in the system
- the banking system is dangerously illiquid and overleveraged
- banks are still engaged in the same risky behavior, 7 years after a major crisis
- the central bank has far too much control over the economy
- yet is run by amateurs
- and is itself is at risk of failing
Of course, it wasn’t too long after this that Britain was overtaken as the world’s #1 economy, military power, and reserve currency.
Whew. Sounds crazy. Good thing we learned those important lessons, and that our modern system is so much better.