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Bagehot on Government, the banking system, and moral hazard (1873)

The British economic journalist Walter Bagehot (1826-1877) wrote in 1873 a perceptive analysis of the dangers of government meddling in the money market in general and in banking in particular. Without using the exact term he came up with the idea that a “moral hazard” would occur if the government propped up a failing bank leading other banks to assume that the same would happen to them if they were reckless in their handling of money:

Still less should it [the government] give peculiar favour to any one [bank], and by entrusting it with the Government account secure to it a mischievous supremacy above all other banks. The skill of a financier in such an age is to equalise the receipt of taxation, and the outgoing of expenditure; it should be a principal care with him to make sure that more should not be locked up at a particular moment in the Government coffers than is usually locked up there. If the amount of dead capital so buried in the Treasury does not at any time much exceed the common average, the evil so caused is inconsiderable: it is only the loss of interest on a certain sum of money, which would not be much of a burden on the whole nation; the additional taxation it would cause would be inconsiderable. Such an evil is nothing in comparison with that of losing the money necessary for inevitable expense by entrusting it to a bad bank, or that of recovering this money by identifying the national credit with the bad bank and so propping it up and perpetuating it. So long as the security of the Money Market is not entirely to be relied on, the Government of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank.

Nothing can be truer in theory than the economical principle that banking is a trade and only a trade, and nothing can be more surely established by a larger experience than that a Government which interferes with any trade injures that trade. The best thing undeniably that a Government can do with the Money Market is to let it take care of itself.

But a Government can only carry out this principle universally if it observe one condition: it must keep its own money. The Government is necessarily at times possessed of large sums in cash. It is by far the richest corporation in the country; its annual revenue payable in money far surpasses that of any other body or person. And if it begins to deposit this immense income as it accrues at any bank, at once it becomes interested in the welfare of that bank. It cannot pay the interest on its debt if that bank cannot produce the public deposits when that interest becomes due; it cannot pay its salaries, and defray its miscellaneous expenses, if that bank fail at any time. A modern Government is like a very rich man with very great debts which he cannot well pay; its credit is necessary to its prosperity, almost to its existence, and if its banker fail when one of its debts becomes due its difficulty is intense.

Another banker, it will be said, may take up the Government account. He may advance, as is so often done in other bank failures, what the Government needs for the moment in order to secure the Government account in future. But the imperfection of this remedy is that it fails in the very worst case. In a panic, and at a general collapse of credit, no such banker will probably be found. The old banker who possesses the Government deposit cannot repay it, and no banker not having that deposit will, at a bad crisis, be able to find the £5,000,000 or £6,000,000 which the quarter day of a Goverment such as ours requires. If a Finance Minister, having entrusted his money to a bank, begins to act strictly, and say he will in all cases let the Money Market take care of itself, the reply is that in one case the Money Market, will take care of him too, and he will be insolvent. 

In the infancy of banking it is probably much better that a Government should as a rule keep its own money. If there are not banks in which it can place secure reliance, it should not seem to rely upon them. Still less should it give peculiar favour to any one, and by entrusting it with the Government account secure to it a mischievous supremacy above all other banks. The skill of a financier in such an age is to equalise the receipt of taxation, and the outgoing of expenditure; it should be a principal care with him to make sure that more should not be locked up at a particular moment in the Government coffers than is usually locked up there. If the amount of dead capital so buried in the Treasury does not at any time much exceed the common average, the evil so caused is inconsiderable: it is only the loss of interest on a certain sum of money, which would not be much of a burden on the whole nation; the additional taxation it would cause would be inconsiderable. Such an evil is nothing in comparison with that of losing the money necessary for inevitable expense by entrusting it to a bad bank, or that of recovering this money by identifying the national credit with the bad bank and so propping it up and perpetuating it. So long as the security of the Money Market is not entirely to be relied on, the Government of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank.

About this Quotation:

Walter Bagehot came to the firm conclusion that banking was a trade like any other, that all government interference in a trade causes injury to that trade, and that therefore the best policy for a government to follow was that of laisser-faire [“let it take care of itself”]. If a government did step in to save a failing bank (in this case by depositing government funds in the bank to prop it up) then the rescued bank enjoyed what he called “a mischievous supremacy” over the other banks which were not so favored by the government. The net result was that a bad bank was allowed to continue to function, thus creating what we now call a “moral hazard”. Bagehot called his conclusion on this matter “the cardinal maxim”, namely “that any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank.”

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