This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Origins of Central Banking: "Inside Money" and "Outside Money"
The natural way to repair this market failure is for the government to temporarily supplement the “inside money” that the financial system can no longer create with its own “outside money”. It is then the task of the government to create the safe and liquid financial assets that the private market desires. The central bank should then act as the financial system’s lender-of-last-resort.
It can do so through any of a number of channels:
It can buy relatively risky and illiquid bonds in exchange for its own safe and liquid liabilities: that is called expansionary monetary policy.
It can take risk onto its balance sheet by guaranteeing the liabilities of private banks: that is called expansionary banking policy.
It can make investments in bridges, in the human capital of twelve-year-olds, and in social welfare and pay for them by issuing its own relatively safe and liquid debt: that is called expansionary fiscal policy.
All of these were attempts to resolve the problem noted by John Stuart Mill and Jean-Baptiste Say in 1829: an excess demand for safe and liquid financial assets, an excess demand that by Walras’s Law is matched by an excess supply of currently-produced goods and services.
Economic theory was not to get to this destination in a clear and coherent fashion until Bagehot (1873). But economic practice and policy ran ahead of theory, getting there at the end of 1825. Such an attempt to compensate for the failure of the market to create sufficient “outside money” to cure a financial crisis and the resulting downturn in real activity—to create the safe, liquid financial assets to match market demand—was undertaken by the Bank of England at the end of 1825. And this first such attempt is the origin of what we today would see as modern central banking.
