Arresting Financial Crises: the Fed Versus the Classicals

Working Paper No. 751 Arresting Financial Crises: The Fed versus the Classicals by Thomas M. Humphrey* February 2013 * The author is a former senior economist and research adviser at the Federal Reserve Bank of Richmond. • The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2013 All rights reserved ISSN 1547-366X ABSTRACT Nineteenth-century British economists Henry Thornton and Walter Bagehot established the classical rules of behavior for a central bank, acting as lender of last resort, seeking to avert panics and crises: Lend freely (to temporarily illiquid but solvent borrowers only) against the security of sound collateral and at above-market, penalty interest rates. Deny aid to unsound, insolvent borrowers. Preannounce your commitment to lend freely in all future panics. Also lend for short periods only, and have a clear, simple, certain exit strategy. The purpose is to prevent bank runs and money-stock collapses—collapses that, by reducing spending and prices, will, in the face of downward inflexibility of nominal wages, produce falls in output and employment. In the financial crisis of 2008–09 the Federal Reserve adhered to some of the classical rules—albeit using a credit-easing rather than a money stock–protection rationale—while deviating from others. Consistent with the classicals, the Fed filled the market with liquidity while lending to a wide variety of borrowers on an extended array of assets. But it departed from the classical prescription in charging subsidy rather than penalty rates, in lending against tarnished collateral and/or purchasing assets of questionable value, in bailing out insolvent borrowers, in extending its lending deadlines beyond intervals approved by classicals, and in failing both to precommit to avert all future crises and to articulate an unambiguous exit strategy. Given that classicals demonstrated that satiating panic-induced demands for cash are sufficient to end crises, the Fed might think of abandoning its costly and arguably inessential deviations from the classical model and, instead, return to it. Keywords: Lender of Last Resort; Financial Crises; Bank Panics; Bank Runs; Bailouts; Penalty Rates; Collateral; High-powered Monetary Base; Broad Money Stock; Multiplier; Federal Reserve Policy; Liquidity; Insolvency; Emergency Lending; Credit Risk Spreads; Systemic Risks; Classical Economists JEL Classifications: E44, E51, E58 1 The financial crisis of 2008–09 witnessed a resurgence of interest in central banks’ time- honored role as lenders of last resort (LLR) to the financial system in times of stress. Some have deemed the Federal Reserve’s massive response to the crisis—a response in which the Fed more than doubled the size of its balance sheet—“classical” in the sense of proceeding exactly as a traditional LLR should proceed. Typical is the opinion of Hubbard, Scott, and Thornton (2009) that “over many decades and especially in this financial crisis the Fed has used its balance sheet to be a classical lender of last resort.” Others, however, have criticized the Fed as being anything but classical not only in exceeding traditional bounds in the magnitude of its balance sheet expansion, but also for rescuing unsound institutions rather than limiting its assistance to solvent but illiquid firms, for accepting worthless collateral in security for its loans, for charging subsidy rather than penalty loan interest rates, and for channeling aid to privileged borrowers rather than impartially to the market in general. Unfortunately, use of the term “classical” in the description/evaluation of the Fed’s crisis-management policy is misleading. It conflates two different versions of the LLR, namely the Fed’s version and the standard 19th century British classical variant, as if they are one and the same when they are not. The truth of the matter is that while the Fed has adhered to some provisions of the classical version, it has deviated from others. These deviations, which the Fed sees as necessitated by financial sector developments unforeseen by classical writers, nevertheless create potential problems of their own, problems the classical version was designed to avoid. The question, then, is whether the Fed might not contribute more to financial and macroeconomic stability by abandoning its departures from classical doctrine and instead return to it. In an effort to answer this question, the following paragraphs describe, analyze, and appraise the classical model and the Fed’s deviation from it. CLASSICAL THEORY OF LENDER OF LAST RESORT POLICY Classical LLR theory refers to the central bank’s duty to lend to solvent banks facing massive cash withdrawals when no other source of cash is available. Unlike today’s Fed, which sharply distinguishes monetary policy (whose task is to stabilize inflation and real activity around their target values) from LLR policy (whose purpose is averting crises), classicals viewed LLR policy 2 as part and parcel of the central bank’s broader responsibility to protect the stock of bank- created money from contraction (and to expand it to compensate for falls in its circulation velocity). The central bank fulfills its money-protection function by precommitting to expanding the money stock (that is, to inject liquidity) without limit to accommodate panic-induced increases in the demand for money. Such aggressive emergency monetary expansion is achieved either (1) through central bank discount-window lending without stint—albeit at a high interest rate so as to discourage overcautious and too frequent resort to the loan facility—to creditworthy, cash-strapped borrowers offering good collateral; or (2) through purchases of Treasury bills, bonds, and other assets either from the commercial banks themselves or on the open market. The goal is to prevent sharp, sudden falls in the money stock (and thus falls in spending and prices)—falls that, given downward inflexibility or stickiness of nominal wages, produce rises in real wages and corresponding declines in business profits, leading to falls in output and employment. Classicals noted, however, that in conducting its operations, the LLR has no business bailing out unsound, insolvent banks. Its mission is to stop liquidity crises. Nevertheless, if the LLR acts swiftly, aggressively, and with sufficient resolve, it can prevent liquidity crises from deteriorating into insolvency ones. By creating new money upon demand for sound but temporarily illiquid banks, the LLR makes it unnecessary for those banks, in desperate attempts to raise cash, to dump assets at fire-sale prices that might render the banks insolvent. The classical theory of the LLR’s responsibility can be illustrated with the aid of an expanded version of Irving Fisher’s celebrated equation of exchange Bm(c, r)V = PQ where B is the high-powered monetary base consisting of currency in circulation plus bank’s cash reserves; m(c, r) is the base multiplier, a decreasing function of both the public’s desired currency-to-deposit ratio c and bankers’ desired reserve-to-deposit ratio r; V is the circulation velocity or annual rate of turnover of the broad money stock (the latter stock consisting of the multiplicative product Bm of the base times the multiplier; P is the general price level; Q the quantity of final goods and services produced per year—that is, the real domestic product; and PQ is total dollar domestic spending or nominal domestic product (Beckworth 2011). Panics and bank runs are characterized by collapses in the base multiplier m(c, r) as the public seeks to convert checking deposits into currency—raising c—while bankers seek to hold larger reserves against their deposit liabilities—raising r. Additionally, panics induce sharp falls 3 in velocity V as the public, in a flight to safety, endeavors to augment its holdings of money balances, seen as the safest liquid asset. In the absence of LLR assistance, the resulting falls in the multiplier m and velocity V will produce corresponding equivalent falls in total nominal spending PQ, which given nominal wage stickiness, translates largely into contractions in real output and employment. To prevent this sequence from occurring, the classical LLR must, either through discount window lending or open market purchases, expand the monetary base B sufficient to offset plunges in the multiplier and velocity. In so doing, it keeps both sides of the equation unchanged at their pre-panic magnitudes and so maintains the level of total spending on its full- employment path. HISTORY OF THE CLASSICAL CONCEPT: THE THORNTON-BAGEHOT MODEL Sir Francis Baring, in his 1797 Observations on the Establishment of the Bank of England, was the first to use the term “lender of last resort” when he referred to the Bank as “the dernier resort” from which all commercial banks could obtain liquidity in times of stress. However, it was (1) the British banker, member of parliament, evangelical reformer, antislavery activist, and all-time great monetary theorist, Henry Thornton (1760–1815), and (2) the economic historian, financial writer, and long-time editor of the Economist magazine, Walter Bagehot (1826–77) who established ten bedrock principles or building blocks that together constitute the benchmark classical LLR model that continues to inform central bankers today—the former in his speeches on the Bullion Report, his parliamentary testimony, and his An Inquiry Into the Nature and Effects of the Paper Credit of Great Britain (1802) and the latter in his Lombard Street: A Description of the Money Market (1873).

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