Averting Financial Crises: Advice from Classical Economists (Thornton and Bagehot)

Superb article on financial history by Thomas Humphrey of Richmond Fed.

He reviews the basic ideas of Thornton and Bagehot on lender of last resort (LOLR) and then sees how Fed policy fits within those ideas:

What would the classicals have thought about the Fed’s handling of the crisis? Certainly they would have applauded the Fed’s filling the market with liquidity. Likewise, they would have approved of the Fed’s expansion of its balance sheet and of the monetary base. These things were precisely what the classical prescription called for — expanding the monetary base to match corresponding increases in the public’s and bankers’ demand for money.

At the same time, classicals might have noted that the Fed’s expansion of the monetary base, while sufficient to offset the panic-induced fall in the multiplier relationship between base and bank money in a fractional reserve system, was insufficient to counter falls in velocity caused by the public’s flight to money as the safest liquid asset. The result of this increased money demand (or fall in velocity) was a shortfall of the supply of broad money below the demand for it, leading to a prolonged fall of spending, output, and employment below their pre-crisis paths. [Editor’s Note: For elaboration on this view and those that follow, see Readings.]

Likewise, the classicals would have approved of the Fed’s Bagehot-like actions to lend to a wide variety of borrowers on a wide array of assets. But they would have looked askance at the Fed’s acceptance of opaque, dubious, hard-to-value collateral that arguably would have been deemed questionable even in normal times. The same holds for the Fed’s direct purchase of tainted assets.

Most important, Thornton and Bagehot would have condemned both the Fed’s bailout of arguably insolvent, too-big-to-fail firms such as American International Group Inc. and Citigroup and its charging of subsidy rather than penalty rates for its assistance.

And they would have scolded the Fed for extending its loan deadlines beyond very short-term (week- or at most month-long) intervals, for its failure to precommit to ending all future crises, and for not spelling out the conditions and indicators that would trigger its actions in future crises.

Thornton, who sharply distinguished between the monetary and credit rationales of LLR policy, would have disagreed with the Fed’s credit-market rationale. To Thornton, the LLR’s purpose was to protect the money stock from contraction and to expand it to offset falls in velocity. This was in sharp contrast to the Fed’s stated LLR rationale, which was to free up credit markets, shrink panic-widened yield spreads, and get banks lending again. Thornton would have shunned the Fed’s credit-market rationale even though it achieved much the same result as his monetary one.

Finally, classicals might have opposed the Fed’s payment of positive interest on excess reserves. The Fed implemented this measure in 2008 to prevent its credit interventions from resulting in monetary expansion. And it retained the interest-on-excess-reserves measure even when it later shifted to a policy of monetary expansion. Such payments, which boost demand for idle reserves and keep them immobilized in reserve accounts rather than getting them lent out into active circulation in the form of bank deposit money, would be inconsistent with the classicals’ goal of expanding or maintaining the stock of broad money as required to keep economic activity at its pre-panic level. Bankers’ demands for reserves already are extraordinarily elevated during crises. Paying interest on excess reserves only raises those demands further.

Despite claims to the contrary, the Fed never acted as an unmitigated classical LLR in the recent financial crisis. Instead, it adhered to parts of the classical prescription while deviating from others. So when you hear the Fed described, often by Fed policymakers themselves, as a classical LLR, be skeptical.

Actually one should be skeptical of whatever central banks say. They have distorted markets for many years and will continue to do so in future. The template by Bagehot and Thornton will never really strictly apply in real time when one needs to take a quick decision to revive sentiments. At that point of time one does not think about Bagehot or Thornton. These exercises are all afterthought to justify/criticise one’s actions. At the time of crisis, it is really difficult to distinguish between solvency and liquidity leading to all kinds of policy questions.

We can keep looking for that perfect central bank intervention. But in reality there is not any. Like all economic actions, there are trade-offs here as well..


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