Abstract

"Bagehot's Giant Bubble Failure"

Andrew Odlyzko, University of Minnesota (odlyzko@umn.edu)

Walter Bagehot is remembered today primarily for his 1873 book "Lombard
Street," cited frequently for its advocacy of the doctrine of lender
of last resort, in which central banks pump money into the economy to
ameliorate the damage from a financial crisis. As is widely known,
his recommendations basically articulated and justified what the Bank
of England had done during the Overend, Gurney crisis of 1866.

There is an immense literature on the lender of last resort, and extensive
coverage of the Overend, Gurney crisis and of Bagehot's career. However,
there is curiously little available about the investment mania that
led to that crisis, and of Bagehot's understanding of it. It turns
out that Bagehot was seriously concerned by various anomalies in the
British financial markets of the 1860s. However, he did not succeed in
penetrating the depths of "financial engineering" that concealed what
was happening, and managed to come up with innocent explanations for
the interest rate aberrations that bothered him and other observers.
Since none of the other prominent observers of the time appear to have
done better, this may not have been a giant failure, but it was a failure
to identify a giant bubble.

The British mania of the 1860s bears remarkably many resemblances
to the real estate bubble that led to the Global Financial Crisis of
2008. It also provides an interesting modification to Kindleberger's
characterization of manias, in that the initial displacement was provided
not by real profits, but by illusory ones arising from "creative finance."

At time of submission of this abstract, a preliminary version of the
paper is available at https://ssrn.com/abstract=3445450. It will be
extensively revised by the time of the conference, largely in order to
provide more background on the British investment mania of the 1860s,
and the "creative finance" that was involved in it.