Commentary by Mark Gilbert

Walter Bagehot, an economist and author writing in the 19th century, had the answers to the current credit crunch.

In 1866, the UK money markets were in turmoil. The collapse of a private bank called Overend & Co. threatened to destroy the fragile trust underpinning the credit system.

The parallels with today are powerful, as ripples from the crash in the US subprime mortgage market threaten to swamp parts of the financial markets. Central banks are losing control of monetary policy, as short-term money-market rates jump and long-term bond yields develop immunity to policy changes. Their sovereignty is under fire, as the crisis forces them to be reactive rather than proactive.

So what would Bagehot, who edited the Economist newspaper from 1861 until 1877, make of the current crisis?

The following question-and-answer dialogue combines current questions with comments culled from his book "Lombard Street," published in 1873: I reckon we have a lot to learn from a guy who died 130 years ago.

1) Was the Bank of England too slow in providing emergency finance to the banking community? Did its reticence exacerbate the problem by making commercial banks wary of lending to each other?

"The best way for the bank or banks who have the custody of the bank reserve to deal with a drain arising from internal discredit is to lend freely. The holders of the cash reserve must be ready not to keep it for their own liabilities, but to advance it most freely for the liabilities of others."

"The first instinct of everyone is to the contrary. There being a large demand on a fund which you want to preserve, the most obvious way to preserve it is to hoard it — to get in as much as you can, and to let nothing go out which you can help."

"The plain problem before the great dealers comes to be `how shall we best protect ourselves? No doubt the immediate advance to these second-class dealers is annoying, but may not the refusal of it be even more dangerous? A panic grows by what it feeds on; if it devours the second-class men, shall we, the first class, be safe?"

2) It looks very much like the UK government stepped in and overruled the central bank, guaranteeing deposits and perhaps forcing the bank to start auctioning three-month money just days after Bank of England Governor Mervyn King had said such actions risk sowing "the seeds of a future financial crisis." Is that wise?

"Banking is a trade. Nothing can be more surely established by a larger experience than that a government which interferes with any trade injuries that trade. The best thing undeniably that a government can do with the money market is to let it take care of itself."

3) Should the government bail out mortgage companies with unsustainable business models that rely too much on the money markets for the finance to fund the home loans they make? Should they let such institutions fail?

"If the banks are bad, they will certainly continue bad and will probably become worse if the government sustains and encourages them. The cardinal maxim is, that any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank."

4) Would that really be possible, given the television pictures of people lining up to withdraw their savings from Northern Rock Plc? Could the government and the Bank of England really stand by and watch and do nothing?

"It might give its aid, lend Exchequer bills, or otherwise pledge its credit for the moment, but when the exigency was passed it might let the offending banks suffer. There would be a penalty for their misconduct. New and better banks, who might take warning from that misconduct, would arise."

5) How can the central bank pump cash into the market without risking moral hazard by rescuing lenders from their bad decisions?

"The end is to stay the panic. 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."

6) Do we overestimate the power of central banks?

"The value of money is settled like that of all other commodities — by supply and demand. Many persons believe the Bank of England has some peculiar power of fixing the value of money. It can affect the rate of discount at any particular moment, but it cannot effect the average rate."

7) Will the economy suffer as the credit bubble bursts?

"In so far as the apparent prosperity is caused by an unusual plentifulness of loanable capital and a consequent rise in prices, that prosperity is not only liable to reaction, but certain to be exposed to reaction."

"The mercantile community will have been unusually fortunate if during the period of rising prices it has not made great mistakes. Every great crisis reveals the excessive speculations of many houses which no one before suspected. The good times too of high price almost always engender much fraud. There is a happy opportunity for ingenious mendacity."

(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)