Henry Wadsworth Longfellow probably did not have financial markets in mind when he wrote

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There was a little girl,

Who had a little curl,

Right in the middle of her forehead.

When she was good,

She was very good indeed,

But when she was bad she was horrid.

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Banking is a business of leverage. Potential return on a bank’s shareholder equity is magnified and multiplied by issuing debt (such as deposits and bonds) to multiply the amount of assets (loans to customers) that the bank can own. Leverage, however, is a “little girl” with a “little curl . . . in the middle of her forehead.” When leverage is “good,” banking is “very good indeed,” and when “she” is “bad,” banking is “horrid.”

Credit is built on trust and the legal capacity to enforce contracts of trust. Disclosed leverage (e.g., today’s central bank investments in the debt of nations) openly portrays the trust that we place in each other. It is disclosed so that the world can see whom the bank trusts and for how much. Hidden leverage is used when bank managers bully investors (in debt and equity), accountants, lawyers, and regulators to let them hide leverage (e.g., using off-balance sheet liabilities and shadow banks) without earning trust by open disclosure. When hidden leverage generates a positive return, it generates magical profits out of thin air. When it generates loss, however, the magic becomes a monster that devours shareholder value, and leads to insolvency and losses for uninsured bank depositors. When such losses are widespread, a debt-contraction crisis—a panic—soon follows.

The history of banking is dominated by great institutions that have been randomly picked off by the lunacy (or self-aggrandizing arrogance) of financial geniuses who gain control of credit decisions and undertake large investment schemes that are hidden from scrutiny and later prove fatal to the institution and its investors. The classic nineteenth century novel The Way We Live Now by Anthony Trollope is the tale of a railway bond fraud, mad speculation, and, finally, the bursting of the bubble in a crash that utterly disgraces the deluded promoters. The city of London is a place that seems to attract an inordinate share of such schemes.

By the mid-nineteenth century the thinking of Adam Smith had penetrated London’s banks. The patterns of war and speculation that plagued the United Kingdom in the eighteenth century receded after Napoleon finally was defeated at Waterloo. After a crisis in 1857 relative prosperity took hold in London, until a wholesale note discounting firm—Overend, Gurney & Company—failed. A panic began on May 11, 1866. This time, however, it ended almost immediately, because the U.K. central bank, the Bank of England, quickly acted as a lender of last resort.

Walter Bagehot was the editor (and son-in-law of the owner) of London’s Economist newspaper. As loss of confidence generated by Overend’s failure spread, banks refused to lend even to other banks with good collateral. As a result banks began to demand repayment of loans to meet the withdrawal demands of depositors. Bagehot observed as authorities stopped the panic by lending freely and openly to anyone with sound collateral.

Bagehot enumerated the terms of those loans in the form of a dictum, or principle, which began by noting:

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Walter Bagehot, Lombard Street: A Description of the Money Market, p. 199

When he talked about “a heavy fine on unreasonable timidity,” Bagehot had in mind the commodity money regime of that era in which the amount of reserves available was limited. Thus, keeping rates high was not only a penalty for the borrower, but also a way to draw liquidity, that is to say gold, back into the markets. Bagehot also understood that low interest rates fuel bad asset allocation decisions—what we call moral hazard. In the age of fiat money, however, economists have taken the opposite view, namely that an unlimited supply of reserves obviates the need to attract money back into the financial markets.

Today we see that the “heavy fine” part of the dictum was inappropriate. There is no room in Adam Smith’s great wheel of circulation for avarice or retribution. Whatever the cause, it always burdens society for the cost of finance to exceed the minimum rate required to keep the wheel circulating. We now know that the cost of the wheel rises when investors panic. Charging that raised rate only reflects the market rate. For a bank to charge even one penny more than market rate, however, signifies monopoly power that cannot be allowed if we wish ever to achieve enduring financial stability.

In 1866, the monopoly granted by Parliament to the Bank of England apparently allowed it to charge punitive rates for such loans. It would take 127 years to reach a point in the United States where corporate bond markets successfully overcame the bank monopoly imputed by the “fine” of Bagehot’s dictum. That resulted from what economists have called the democratization of credit.

The dictum that authorities should lend whatever is needed until a crisis eases, but only on good collateral, became known as the Greenspan put after the stock market crash of 1987 and the subsequent bailout of Long Term Capital Management in 1998. Mr. Greenspan made commitments that proved he would follow Bagehot’s dictum whenever a crisis loomed, namely to effect a bailout in the event of trouble, even though many believe his put exacerbated subsequent moral hazard behavior.

Kevin Villani notes that “banks began making loans in reliance on Greenspan’s commitment to flood markets with money in response to any crisis” (Villani 2013). By 2008, accumulated fraud in the system pushed the Wall Street investment banking firm, Bear, Stearns & Co., to equitable insolvency.¹ Application of the Greenspan put to resolve the Bear Stearns situation revealed flaws in the U.S. financial model that made a rescue of Lehman Brothers by the Fed impossible, precipitating the largest financial crisis ever.

After several decades, fear of fraud became the casualty of the conversion of Bagehot’s dictum into the Greenspan put. If one studies the penalties for fraud one finds that the remedies are effective, but only in falling markets. Any fraud, even an innocent misrepresentation, can be grounds for rescission of a sale of securities or other assets. Courts will not let a liar profit by forcing misrepresented assets on an innocent purchaser when the assets fall in value. In a falling market, rescission is a complete remedy for almost all fraud.

As long as the Greenspan put assured markets would not fall, fraud committed in the trading of financial assets seemed harmless. Courts don’t rescind transfers in order to give assets that rise in value back to a lying seller. As a buyer, moreover, if assets rise in value despite fraud, where’s the damage? Proving that an asset’s value would have been even higher is notably difficult.

By creating an expectation that markets will be saved in any crisis, the Greenspan put contributed to generating the enormous bubble that burst in 2007–2008. While Greenspan chaired the Fed, more and more managers came to believe that fraud was an inconsequential issue. This delusion became even worse when Greenspan’s misconception about fraud (he said it was self-correcting) helped convince regulators to waive many fraud claims during the years preceding the 2007–2009 crisis.

In view of the enormity of the $67 trillion worldwide bubble generated by these blunders, what the Federal Reserve achieved between 2008 and 2013 is even more impressive. We must, however, end fraud and unwind expectations for a continued Greenspan put to truly sustain financial stability.

With that diversion, let’s return to the United States in the late 1800s.