The Global Financial Crisis scarred global economies for a decade; COVID did not. The difference was cash, certainty, and a lender of last resort. Bagehot wrote the manual in 1873; Keynes added the addendum in 1936. Economists misplaced both. As Don Kohn said at the time, in dealing with a financial crisis: “Go fast, go hard, go soon”—and fix moral hazard later. Policy knew this once; it should again…
The Great Financial Crisis was not a destructive hurricane that laid waste to the fundamentals of wealth. It was, rather, a head injury to the economy’s coordination system. The muscles that drove the engine of wealth were still there, but useless for a long time. For when uncertainty about interbank obligations spiked, the system froze—and only a deus ex machina could restore certainty. That deus had a name—lender of last resort—but the profession second-guessed it. And still has not reinternalized it, as Dan Davies writes today:
Dan Davies: are we having fear yet? <https://backofmind.substack.com/p/are-we-having-fear-yet>: ‘The Great Financial Crisis [of 2008]…. The overall economic system… [afterwards] was no longer able to perform a vital function of balancing present consumption and investment for the future…. Economics ought to regard this as more of a puzzle than it does [that] the financial crisis, which caused practically zero physical destruction of productive capability, left scarring and after-effects for more than a decade, while the COVID-19 pandemic, which killed millions and left lots of buildings unusable, was all reversed within a couple of years, with a fairly trivial inflation by past standards as the worst economic consequence…
For, of course, he then gives the answer:
Dan Davies: are we having fear yet? <https://backofmind.substack.com/p/are-we-having-fear-yet>: ‘The actual reason… the Global[1] Financial Crisis had such bad long-term effects and the pandemic didn’t is that one… was accompanied by a deluge of public sector money and private sector loan forbearance… precisely because the previous experience had been so bad; flooding the zone with cash made sure that it wasn’t overwhelmed with the flashing red lights of “BORROWER CAN’T MEET CASH CALL”. It would be nice to know that this is now the standard operating practice for similar crises. But I don’t think we do know that, and this is worrying…
But the thing is: This was not a lesson that should have had to have been re-learned after 2008.
Why not? Because it was a lesson that had already been well-learned long before, by 1873, when Walter Bagehot published his Lombard Street. The message was settled and clear. In a financial crisis, to deal with it, you need a central back to:
So why did economics as a profession not know this 150 year-old wisdom? And why has it still not internalized it properly? That is a hard question to which I—still—do not have a very good answer. But let me endorse Dan Davies’s Call to Action. And let me set out some disorganized and largely repetitive musings.
Let me start by quoting Bagehot:
Walter Bagehot: Lombard Street <https://archive.org/details/lombardstreet00bage>; ‘These advances… should be made to obtain the object… to stay the panic…. These loans should only be made at a very high rate of interest… as a heavy fine…. [And] if it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security… the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate… and the panic will become worse and worse…
To my mind, the only significant addition to the playbook since 1873 was John Maynard Keynes’s 1936 observation that should things get really bad, perhaps—probably—more will be required than just financial-monetary policy. Bagehot had recognized the possibility:
Walter Bagehot: Lombard Street <https://archive.org/details/lombardstreet00bage>: ‘It may be said that the reserve in the Banking Department will not be enough for all such loans. If that be so, the Banking Department must fail. But lending is, nevertheless, its best expedient. This is the method of making its money go the farthest, and of enabling it to get through the panic if anything will so enable it. Making no loans, as we have seen, will ruin it ; making large loans and stopping, as we have also seen, will ruin it. The only safe plan for the Bank is the brave plan…
And Keynes provided the answer:
John Maynard Keynes: The General Theory of Employment, Interest & Money <https://archive.org/details/in.ernet.dli.2015.50092/>: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to [always] determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; ‘though this need not exclude all manner of compromises and of devices by which public authority will , co-operate with private initiative…
And without full employment, the market system cannot rebalance the economy into any tolerable approximation of a new, taught, productive configuration. Price signals are there to guide people into making decisions about what activities are truly valuable for the community. Its guidance is always very imperfect: wealth inequality and externalities are outside of its vision. But its guidance is much butter than nothing. But when unemployment is not low and aggregate demand is slack, the market flashes a big red “NOT VALUABLE!” sign in front of nearly every possible expansion of economic activity. And so the rebalancing cannot take place, and definitely will not take place rapidly.
All this has been known for a century and a half, settled doctrine for nearly a century, and brought down from the Mount Sinai of economic theory into a narrative form nearly everyone can comprehend for half a century, ever since my teacher Charlie Kindleberger published his Manias, Panics, & Crashes <https://archive.org/details/maniaspanicscras0000kind/page/n6/mode/1up>.
So why was this Bagehot playbook not SOP during and after the GFC of 2008? And why does Dan Davies feel that he has to translate the financial-crisis playbook of Walter Bagehot into a cognitive-neuroscience register of financial crisis as concussion or stroke with this?:
Dan Davies: are we having fear yet? <https://backofmind.substack.com/p/are-we-having-fear-yet>: ‘The Great Financial Crisis [of 2008]…. a cognitive shock—a kind of head injury to the overall economic system… so that it was no longer able to perform a vital function of balancing present consumption and investment for the future…. I wrote about this…. “The ‘Lehman Moment’ was entirely a control failure… the information processing system was hit with something it couldn’t handle…. Snce a lot of the economic system was built in such a way as to require the particular mix of control, information and accounting co-ordination that is provided by the financial system… the real economic damage was wildly out of proportion…. The system couldn’t handle was a very rapid increase in the uncertainty attached to the value of financial assets… [because] the system was built on the assumption that certain kinds of interbank obligations could be treated as completely risk free…. If you relaxed the assumption of zero risk even a little bit, the bandwidth needed to manage the system increased hugely. What’s needed in that sort of situation is for some deus ex machina to step in and restore certainty… [That] was very difficult, because the system wasn’t set up for this kind of centralised action…
But the system was so set up. Or, at least, with central banks set up to follow the Bagehot SOP it was.
Part of the problem is that a side-effect of restoring certainty was that as a result the wicked would flourish like the green bay tree. But as Donald Kohn said shortly afterwards:
Don Kohn: <https://elischolar.library.yale.edu/cgi/viewcontent.cgi?article=1118&context=journal-of-financial-crises>: ‘I guess it must have been at Jackson Hole 2007; the focus of the discussion was moral hazard. At that time, in retrospect, we’d hardly done anything. We’d made the discount window cheaper. We’d encouraged people to borrow. Maybe we’d eased policy a little bit. Then, there was all this discussion that, “Oh my God, you’re creating moral hazard. There’s a Bernanke put, et cetera.” Ignore that, I guess would be the advice. Just go fast. Go hard. Go soon. Correct the moral hazard issues later with regulation like in Dodd-Frank. Don’t worry about it in the middle of the crisis…
The rest of the problem was what Paul Krugman has long described as the coming of an intellectual Dark Age—one of willful obscurantism, as people who ought to have known better stopped trying to understand the economy but instead turned to solving irrelevant models with spiffy new tools they had overinvested in learning—to a large chunk of economics <https://www.princeton.edu/~pkrugman/keynes_and_the_moderns.pdf>.
Things were, perhaps, at their nadir in 2009. I remember being at an INET conference in 2011 <https://larrysummers.com/news-item/brenton-woods-speech/> at which Larry Summers was being taunted and tormented by Martin Wolf with respect to the uselessness of academic economics in dealing with the GFC:
Martin Wolf & Larry Summers: A Conversation on New Economic Thinking <https://larrysummers.com/news-item/brenton-woods-speech/>:
Martin Wolf: ‘There are some very big questions, if not some pretty obvious symptoms, of a profound failure in modern economics…. Larry… how far [do] you share that perspective[?] How far do you feel that what has happened in the last few years… just simply suggests that economists didn’t understand what was going on?
Larry Summers: ‘There are things economists didn’t know… things economists were wrong about…. things where some economists were right…. I got a lot of papers…. attempted to read all the ones that used the words ‘leverage,’ ‘liquidity,’ ‘deflation’ or ‘depression.’ And I attempted to read none of the ones that used the words ‘neoclassical,’ ‘choice theoretic,’ ‘real business cycle,’ or ‘optimizing model of.’ There were more in the second category than there were in the first. But there were a reasonable number in the first, and they told you a lot. There is a lot in Bagehot that is about the crisis we just went through. There’s more in Minksy and perhaps more still in Kindleberger. There are enormous amounts that are essentially distracting, confusing, and problem denying in the stuff that is the substance of the first year courses in most PhD programs…. Economics knows a fair amount… has forgotten a fair amount…. And it has been distracted by an enormous amount…. People who were practical understood… liquidity finding its way into… asset price inflation and being problematic…. But… those concepts… were at the very edge of, and in many cases not even at the edge, of contemporary macroeconomics to the great detriment of contemporary macroeconomics.
On the other hand… everyone who doesn’t like economics has piled on at this moment to regard this crisis as a repudiation of economics, and I don’t think that’s right. I think the wisdom that’s in the Bagehot, Minsky, Kindleberger, Eichengreen, Akerlof, Shiller…
As I noted at the time to Barry Eichengreen, Larry had just called him the wisest living economist with respect to dealing with financial crises.
This story of the great loss of public-policy and economic-theory intellectual capital was one I watched happen over the course of the first two-thirds of my career so far. But I really do not understand it, not even now.
The person who comes closest to understanding it is, I think, Paul Krugman. This is his best shot.
Paul Krugman:“Mr. Keynes & the Moderns” <https://www.princeton.edu/~pkrugman/keynes_and_the_moderns.pdf>. ‘The… moderate economic policy regime… that by and large lets markets work, but in which the government is ready both to rein in excesses and fight slumps… can last for a generation or so, but not much longer… [due to] Minsky-type financial instability… [but also] equally crucial are the regime’s intellectual and political instability.
Let me start with the intellectual instability…. Paul Samuelson back in 1948… combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasizes the way the economy can develop what Keynes called “magneto trouble”, requiring policy intervention…. It’s a deeply reasonable approach—but it’s also intellectually unstable… [because in] micro, you assume rational individuals and rapidly clearing markets… [and in] macro, frictions and ad hoc behavioral assumptions are essential. So what?… The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish….
Given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models. The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing… and, of course, went into spasms of rage when their ignorance was pointed out.
To this intellectual instability, add political instability. It’s possible to be both a conservative and a Keynesian… [look at] Keynes…. But in practice, conservatives have always tended to view the assertion that government has any useful role in the economy as the thin edge of a socialist wedge. When William Buckley wrote God & Man at Yale, one of his key complaints was that the Yale faculty taught—horrors!—Keynesian economics…. Monetarism.. [was] an attempt to assuage conservative political prejudices without denying macroeconomic realities… [with Milton] Friedman was saying was, in effect, yes, we need policy to stabilize the economy—but we can make that policy technical and largely mechanical…. When monetarism failed… it was replaced by the cult of the independent central bank…. And this worked for a while….
It worked in part because the political insulation of central banks also gave them more than a bit of intellectual insulation, too. If we’re living in a Dark Age of macroeconomics, central banks have been its monasteries, hoarding and studying the ancient texts lost to the rest of the world. Even as the real business cycle people took over the professional journals, to the point where it became very hard to publish models in which monetary policy, let alone fiscal policy, matters, the research departments of the Fed system continued to study counter-cyclical policy in a relatively realistic way. But this, too, was unstable.
For one thing, there was bound to be a shock, sooner or later, too big for the central bankers to handle without help from broader fiscal policy. Also, sooner or later the barbarians were going to go after the monasteries too; and as the… [ca. 2011] furor over quantitative easing shows, the invading hordes have arrived.
Last but not least, there is financial instability… The very success of central-bank-led stabilization, combined with financial deregulation—tself a by-product of the revival of freemarket fundamentalism—set the stage for a crisis too big for the central bankers to handle. This is Minskyism: the long period of relative stability led to greater risk-taking, greater leverage, and, finally, a huge deleveraging shock…
But I am afraid I do not find this completely satisfactory. One note: Milton Friedman did not say that government intervention to stabilize the economy can be made technical and largely mechanical: he said that whatever policy stabilizes the economy—which he long thought was a stable growth rate for the “M2” monetary aggregate—was by definition neutral and non-interventionist. A neat rhetorical trick, at the time, in allowing the maintenance of the “government failure when it intervenes in the economy is always bigger than the market failure it purports to correct” bright line for True Believers. But intellectually profoundly unhelpful.
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Bagehot, Walter. 1873. Lombard Street: A Description of the Money Market. London: Henry S. King & Co. <https://archive.org/details/lombardstreet00bage>.
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Davies, Dan. 2025. “are we having fear yet?” Back of Mind. October 30. <https://backofmind.substack.com/p/are-we-having-fear-yet>.
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Haggerty, Maryann. 2020. “Lessons Learned: Donald Kohn”. Journal of Financial Crises. 2:3. <https://elischolar.library.yale.edu/cgi/viewcontent.cgi?article=1118&context=journal-of-financial-crises>.
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Keynes, John Maynard. 1936. The General Theory of Employment, Interest, & Money. London: MacMillan. <https://archive.org/details/in.ernet.dli.2015.50092>.
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Kindleberger, Charles P. 1978. Manias, Panics, & Crashes: A History of Financial Crises. New York: Basic Books. <https://archive.org/details/maniaspanicscras0000kind/page/n6/mode/1up>
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Krugman, Paul. 2011. “Mr. Keynes & the Moderns”. Princeton. <https://www.princeton.edu/~pkrugman/keynes_and_the_moderns.pdf>.
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Summers, Lawrence & Martin Wolf. 2011. “A Conversation on New Economic Thinking”. INET. <https://larrysummers.com/news-item/brenton-woods-speech/>.
