How to save the financial system the old fashioned way: lessons from Walter Bagehot
If you do a search for Walter Bagehot on the web-sites of major newspapers around the country you’ll probably find numerous articles written during the past six months citing his book Lombard Street: A Description of the Money Market and praising the Federal Reserve for following his advice of “lending freely” and averting financial meltdowns in March (Bear Stearns) and again in July (Fannie Mae and Freddie Mac).[1]
I read Lombard Street recently and found Bagehot’s wisdom especially relevant given our current financial crises.
Bagehot was a 19th century British essayist and an early editor of The Economist.[2] In Lombard Street Bagehot offers the following advice to monetary policy makers for stopping a financial panic, ruinous for the 19th century British system of fractional reserve banking[3] (and our banking system today), dead in its tracks:
“A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.”[4]
And from this comes the famous saying that in a crises the holders of a nation’s cash reserve should “lend freely” to stop the panic.
The “cash reserve” is the “safety fund” of unencumbered cash which the lender of last resort, the Bank of England in Bagehot’s time, the Federal Reserve for us, keeps on hand “to meet extraordinary and unfrequent demands” for immediate cash in times of alarm and panic.[5]
According to Bagehot, an “alarm” is “an opinion that the money of certain persons will not pay their creditors when those creditors want to be paid.”[6]
What stops an alarm?
Lending money on good security so those “certain persons” are able to pay their creditors.
What happens if the “certain persons” can’t get the money they need?
A panic starts.
The fear then becomes that not just “some persons” but very many, if not all, persons won’t be able to pay their creditors when those creditors want to be paid.
When this happens, everyone tries to accumulate as much cash as they can and consequently create a severe strain on bank liquidity.
Since no bank in a fractional reserve system can make all their deposits available at once, if the panic is not stopped every bank, even the lender of last resort, will eventually go under.[7]
Serious stuff.
The way to stop the panic, according to Bagehot, is for the holders’ of the cash reserve to lend it freely and make money plentiful:
“The ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for certain essential purposes, and one of those purposes is the meeting a demand for cash caused by an alarm within the country. It is not unreasonable that our ultimate treasure in particular cases should be lent; on the contrary, we keep that treasure for the very reason that in particular cases it should be lent.”
If the central bank can’t stop the panic then no one can: “The bank or banks which hold the reserve may last a little longer than the others; but if apprehension pass a certain bound, they must perish too.”[8]
As recent events have shown, Mr. Bernanke and Mr. Paulson know their Bagehot: they have created and implemented programs that offer banks (Term Auction Facility), investment banks (Primary Dealer Credit Facility), and Fannie Mae and Freddie Mac (the recent bailout) unprecedented access to hundreds of billions of dollars from the Federal Reserve just when they’ve needed it the most.[9]
Mr. Bernanke and Mr. Paulson deserve some credit.
They have lent America’s reserve (even though it’s not a real cash reserve but just a promise on future savings because of our deficit spending ways) very freely and have prevented the widespread panic that can literally cause the whole financial system to collapse if allowed to spread.
Good job.
But it’s important to note that Bernanke and Paulson have only implemented part of Bagehot’s plan.
Bagehot placed three conditions on his policy of lending freely during a financial crisis:
1. Money needs to be lent freely but at a “very high rate of interest” to ensure people think twice before going to the lender of last resort for help. “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.”
2. Money should only be lent on “good security” or securities which during normal times are safe and easily used as collateral for cash. “No advances indeed need be made by which the Bank will ultimately lose.”
3. The interest rate needs to be raised to attract more capital to the country: “We must look first to the foreign drain, and raise the rate of interest as high as may be necessary, Unless you can stop the foreign export, you cannot allay the domestic alarm.”[10]
So while it’s great the Fed is lending freely, we should all pause to ponder these facts and their long-term effects on our financial system:
1. No one is paying a high price for having to run to the taxpayer for help.
2. Mortgage backed securities are being used to get cash.
3. The interest rate is being held very low and capital is flowing out of the country.
As you’ll see in the links below, to take the Primary Dealer Credit Facility as an example, mortgage backed securities (MBS) are allowed as collateral and the Fed is only charging 25 basis points above the target federal funds rate (2.00%) for investment banks to borrow your money.
True, the MBS have to be “investment grade” to count as collateral for the facility but remember, many of the mortgage backed securities banks and investment banks have written down to less than $.50 on the dollar during the past year were once rated “AAA” by the credit rating agencies.[11]
Moreover, if taxpayers can’t get a loan for 2.25% why should private banks and investment banks who took wild risks get one?
Where is the penalty part of Bagehot’s plan?
http://www.newyorkfed.org/markets/pdcf_faq.html
http://www.frbdiscountwindow.org/currentdiscountrates.cfm?hdrID=20&dtlID=51
This doesn’t even begin to address the inflationary impact of maintaining a 2.00% interest rate (I bought a gallon of milk for $5.49 this weekend).
So what’s the path forward?
Well it’s painful in the short-term but doing all of what Bagehot recommends in Lombard Street will bring long-term strength and stability to our financial system.
The Fed and the US Treasury need to:
1. Charge a much higher rate of interest to banks and investment banks that use the Term Auction Facility, Discount Window, or Primary Dealer Credit Facility: provide liquidity but make them pay for it.
2. Reject junk securities if offered as collateral: private individuals took the risks; they, not taxpayers, should have to pay the price.
3. Raise interest rates to increase capital inflows and curb inflation.
If they don’t we run the risk of “lending freely for free” and setting poor precedents that will only provide fleeting relief to a financial system that requires a more robust remedy to return to health.
[1]Walter Bagehot. Lombard Street: A Description of the Money Market. Foreword by Peter L. Bernstein. (New York: John Wiley & Sons, Wiley Investment Classics, 1999).
[2]http://en.wikipedia.org/wiki/Walter_Bagehot
[3]http://en.wikipedia.org/wiki/Fractional-reserve_banking
[4]Bagehot, 51
[5] Ibid, 25-26.
[6] Ibid, 53
[7] Ibid, 55.
[8] Ibid, 53-55. For the whole discussion see pp. 21-74.
[9] http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
[10]Bagehot, p.56 & 197.
[11] See http://en.wikipedia.org/wiki/Subprime_mortgage_crisis “Role of credit rating agencies.”
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