Lombard Street: Lend Freely in a Panic

In his second chapter, Bagehot describes how a banking panic grows and how it can be stopped.

“Credit is a set of promises to pay; the only question is whether those promises will be kept.At first a panic is just vague conversation: ‘Is A. B. as good as he used to be? Has not C. D. lost money?’Then a thousand people begin to think, ‘Am I talked about? Is my credit as good as it used to be?’Every merchant tries to borrow while borrowing is still possible, and the small money dealers run to the great banks for help.

A panic is a kind of nerve pain, and according to the rules of science you must not starve it.The holders of the cash reserve must lend most freely to merchants and smaller bankers, whenever the security is good.In wild periods of alarm, one failure makes many, so the best way to prevent the later failures is to stop the first one.

In 1825 the Bank of England said, ‘We lent it by every possible means,’ and after a day or two the whole panic died down.Very large loans at very high rates are the best remedy, because any idea that money cannot be had raises alarm to panic, and panic to madness.”

Central bankers today call this ‘Bagehot’s rule’: lend freely, at a high rate, against good security.