This Time It Is Not Different: Walter Bagehot and the Persistent Concerns of Financial Macroeconomics: Origins of Central Banking: The Market Failure
Thus by late 1825 in Britain the revaluation of assets that was the collapse of the canal boom had created a situation in which “money” was “in request”: safe, liquid stores of value were scarce relative to demand both because the financial crisis had led banks and businesses to seek to hold a greater share of their wealth in safe, liquid form and because the financial crisis meant a substantial proportion of safe and liquid “inside” assets—the debts of bankers, merchants, and industrialists presumed to be well-capitalized—were not so.
Note that the assets households and businesses scramble for in and in the aftermath of a financial crisis do not have to be, exclusively, means of payment themselves: assets that are still trusted will do as well, or almost as well. In the fall and winter of 1825-6, all across the British economy, economic agents were attempting to build up their stocks of safe, liquid financial assets out of a fear that they might need them because their creditors, who were also trying to build up their stocks of safe, liquid financial assets, might not roll over their loans. All across the British economy economic agents were trying to cut their flow of spending below their expected flow of income—and finding themselves unable to do so, as one agent’s income comes from another agent’s spending. The consequence was that currently-produced goods and services became “in comparative disrepute”: as spending fell, production and employment fell.
What, then, was it appropriate for the government to do?
Neither Say (1803) nor Say (1829) not Mill (1844) connected the dots and drew out the implications. But they are clear. In normal times, banks exist to undertake and make their profits by undertaking liquidity and safety transformations: turning illiquid and risky claims on the capital stock of the economy and on its income into the safe, liquid claims that businesses and households demand and that are used for transactions purposes. They thus create “inside money”. They do this by bearing risks, by figuring out which risks to bear, and by convincing their creditors that they know their business so that their liabilities are safe assets—and thus become liquid means of payment.
But what if the private financial sector is at the moment unable to perform these safety and liquidity transformations at the scale needed to satisfy demand? What if merchants and bankers are not able to create inside-money substitutes for the product serving as the medium of exchange? What if the private market fails?
