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Walter Bagehot’s Theory: The Essential Guide to Central Banking
The great number of modern theories explaining the role of central bank in each country were established based on British journalist’s Walter Bagehot’s paper (1873), where he explains the workings of banking system of his time. In first chapter of the book writer points out the seriousness of the danger of possibly bank runs, when commercial banks has insufficient equity and can not predict or control sudden money withdrawals admitting that central bank can avoid liquidity problems if only it were managed more professionally. He calls this problem as lack of leadership in the banking system identifying that managers merchants, who author names ‘amateurs’ care about their own-interest rather than the bank’s. This concepts shows relevance for business and economy students of nowadays, because only by clearly understanding the role of central banking, its management and money market graduates can fight “amateurs” and take leadership in improving bank system. However, I think that today’s financial industry has not came up with the solutions that Bagehot has described. As identified in the ‘Economist’ article (2007) bank is solvent it its assets are worth more that the money it owes to its depositors and creditors and as long as they believe that their money is safe, they will keep their money in a bank. But if customers start feeling that others are going to withdraw their money everyone will start taking their cash money out of the bank, and will cause a bank run. The aim of this essay is to consider, whether theories of Walter Bagehot is still relevant in today’s financial industry and what solutions of management can still be applicable.
Bagehot starts his chapter by identifying the dilemma of every banker which is about bankers lacking knowledge about where and when to invest money also, how much to keep as reserve and how much to invest. The banker and the manager has different interests. Managers usually serve their own needs while not caring much about keeping bank alive. However, bankers are liable to lose money if the bank fails, so they are doing their best to keep it working. Moreover, Bagehot identifies that banks should keep reserve to protect bank from sudden panics or in terms to financial drains, giving an example of two drains: foreign, when countries can deposite money and then take them anytime and a domestic drain, when suddenly everyone withdraws their money causing a bank run. Bagehot also states that bank should raise the interest level when there is large demand for money, because higher interest rates encourage people to deposite more money in a bank, also, it attracts investments from foreign countries making an increase in value of local currency. However, despite that Bagehot’s article was written in 1873, his explanations are still relevant for today’s financial industry. He identifies that during money drains bank should lend money freely at higher interest rates against good security, because that can help to prevent people from feeling insecure while keeping their money in a bank. On the other hand, by lending freely central bank can not be guaranteed that there still be a demand for it’s money, or as seen in the example of 2008 crisis, when United States of America lent too much money to people that they were not able to pay their debts and caused an economic downturn.
Bagehot was one of the first writers that had not only explained the role of central banking, but also identified main managing issues and made a suggestion for improvement. His ideas formed the perception that irresponsible management and decisions made by focusing on one’s own needs can lead to bank runs or even the financial downturns, crises. Bagehot identifies that solution to keep bank alive is to lend freely at higher rates during financial drains by not showing the signs of unsecurity. However, this can lead to negative consequences by lowering the value of circulating money. To conclude with, Bagehot’s theories have their own advantages and disadvantages, but this short essay has shown that the main ideas of Bagehot can still be used to explain the role of central banking system.
References
- Walter Bagehot, Lombard Street: A description of the Money Market (London: Henry S. King, 1873). Third Edition
- What would Bagehot do? (n.d.). Retrieved from https://amp.economist.com/finance-and-economics/2007/08/16/what-would-bagehot-do.
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