“And though the Bank of England certainly do make great advances in time of panic, yet as they do not do so on any distinct principle, they naturally do it hesitatingly, reluctantly, and with misgiving. In 1847, even in 1866—the latest panic, and the one in which on the whole the Bank acted the best—there was nevertheless an instant when it was believed the Bank would not advance on Consols, or at least hesitated to advance on them. The moment this was reported in the City and telegraphed to the country, it made the panic indefinitely worse. In fact, to make large advances in this faltering way is to incur the evil of making them without obtaining the advantage. What is wanted and what is necessary to stop a panic is to diffuse the impression, that though money may be dear, still money is to be had. If people could be really convinced that they could have money if they wait a day or two, and that utter ruin is not coming, most likely they would cease to run in such a mad way for money. Either shut the Bank at once, and say it will not lend more than it commonly lends, or lend freely, boldly, and so that the public may feel you mean to go on lending. To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.
In truth, the Bank do not lend from the motives which should make a bank lend. The holders of the Bank reserve ought to lend at once and most freely in an incipient panic, because they fear destruction in the panic. They ought not to do it to serve others; they ought to do it to serve themselves. They ought to know that this bold policy is the only safe one, and for that reason they ought to choose it. But the Bank directors are not afraid. Even at the last moment they say that 'whatever happens to the community, they can preserve themselves.' Both in 1847 and 1857 (I believe also in 1866, though there is no printed evidence of it) the Bank directors contended that the Banking Department was quite safe though its reserve was nearly all gone, and that it could strengthen itself by selling securities and by refusing to discount. But this is a complete dream. The Bank of England could not sell 'securities,' for in an extreme panic there is no one else to buy securities. The Bank cannot stay still and wait till its bills are paid, and so fill its coffers, for unless it discounts equivalent bills, the bills which it has already discounted will not be paid. ...
I shall have failed in my purpose if I have not proved that the system of entrusting all our reserve to a single board, like that of the Bank directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.”
Walter Bagehot, Lombard Street: A Description of the Money Market (London: Henry S. King and Co., 1873), Chapter II, paras 59-61.
Walter Bagehot (1826-1877), the great editor of the Economist magazine, wrote extensively about government and economic affairs. Lombard Street is considered a classic work on economics, finance and banking, and focuses on the management of financial crises.
A financial panic stemming the bursting of an asset bubble such as the one which we recently experienced causes the net worth of affected banks to shrink as their assets fall in value and their borrowers fail to pay on their loans. As its net worth fall, the bank’s ability to make loans is restricted and it may have to call in loans, as some banks have done in the current situation. Initially, the restrictions on credit creation reduce aggregate spending and consumption and investment expenditure falls, slowing growth in the economy, even turning it negative. As the economy deteriorates and word of the financial difficulties of some banks spreads, in a second effect, the public seeks to withdraw its funds from the banks, further reducing the liquidity of the banking system, and a full-scale financial panic ensues.
In the excerpt above, Bagehot explains what the central bank must do to prevent a panic as financial turmoil builds: “Lend freely”, as he put it, and by doing so convince the public that their funds are safe so they won’t withdraw them. But for the banks to do that, they must have the support of the central bank in providing the liquidity they need to both extend loans and meet their obligations to their depositors. Bagehot also stresses that if the monetary and budget authorities do not act boldly they will not be able to sell the bills they already own or issue new bonds. The economy will collapse.
Following Bagehot’s advice is what the Federal Reserve has been doing this past year. It has reduced interest rates, opened its discount window to investment banks, created various lending facilities, and done everything it can to expand its lending activities to the financial sector. In addition to providing liquidity, the Fed has also been very aggressive in areas beyond bank lending, arranging for support for Bear Stearns and Freddie Mac and Fannie Mae. And it can be said that, to date, the Fed has more or less succeeded, with only a few runs on banks and a financial system that seems to be wobbly but not about to fail. Most importantly, the economy has slowed but the widely expected recession as yet to make an appearance.
Economics teaches there are always tradeoffs. Yes, a full-scale financial panic has been avoided, and that was and remains the key concern of the Fed. But the very actions it has taken in response to the financial turmoil has spurred inflation, promoted moral hazard, worsened the budget deficit and deepened the national debt, and increased the trade deficit. The Fed has also increased its supervision of the financial system and significantly widened the role of the government in the economy.
As Bagehot says, “entrusting all our reserve to a single board, like that of the Bank directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.” For better or worse, we have entrusted much to the Board of Governors of the Federal Reserve System. I pray our trust is not misplaced and the problems aggravated by the strong measures taken to deal with the current financial mess do not become worse than the problem that now monopolizes our policy attention.
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