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8 MIN READ - From the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff
In the Economics Correspondent’s previous series on banking instability in England we learned that the first two centuries of the Bank of England's establishment and a slew of destructive banking regulations imposed by British Parliament led England to weather no fewer than seventeen financial crises.
Ultimately a proposal for stability was penned by banker and The Economist editor Walter Bagehot (pronounced “badge-it”) in his famous 1873 book “Lombard Street.”
Bagehot blamed the Bank of England itself, its centralization of gold reserves, and the banknote monopoly bestowed upon it by Parliament for repeated systemic financial crises. Further he recommended throwing out the central bank and emulating the decentralized, deregulated, and nearly laissez-faire Scottish private banking system of 1716-1845 that had produced not a single crisis during its 129 years.
However Bagehot knew that it was politically impossible to dismantle the Bank of England since it had become so ingrained in the British psyche. Therefore his next best solution, assuming the central bank was to be upheld, was that it clean up its own mess, acting in a lender of last resort (LOLR) capacity: lending freely and early to solvent but illiquid banks at high interest rates during times of crisis.
Since then central bankers the world over have lauded Bagehot as a visionary, pioneer, and champion of central banking, and they’ve cited Bagehot’s Rule repeatedly as justification for their aggressive bailouts of troubled institutions.
In his book “The Courage to Act,” former Federal Reserve Chairman Ben Bernanke recounts the 2008 financial crisis and cites Bagehot more than any other nonliving economist (including Milton Friedman), justifying the Fed’s aggressive emergency lending programs by invoking Bagehot’s name over and over.
Bernanke even goes so far as to suggest that if Bagehot were alive today he would wholeheartedly approve of such massive bailout programs. After detailing not only emergency lending and asset purchases for banks, but also TALF program lending on millions of auto loans, student loans, small business loans, and credit card loans he writes “Walter Bagehot would have been pleased.” (p. 469)
There’s no shortage of other central bankers asserting they were only following Bagehot’s antidotes and that Bagehot himself would have approved.
It may be no surprise to CO Nation that the Economics Correspondent disagrees.
BAGEHOT’S RULE ITSELF
We don’t have to look far to see what’s wrong with Bernanke’s characterization of archangelic Bagehot smiling down upon the 2008 Fed with patrimonial approval. We only need look closer for a moment at Bagehot’s Rule itself.
The Federal Reserve’s website defines Bagehot’s Rule as:
“[T]o avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at 'high rates.”
This is an accurate summation, and even Bernanke himself states:
“To calm panic, Bagehot advised central bankers to lend freely at a high interest rate, against good collateral, a principle now known as Bagehot’s dictum.” (p. 45)
Why did Bagehot recommend that central bankers “lend freely (without limit),” to “solvent firms,” “against good collateral,” and “at high rates?”
-“Lending freely” is obvious. If many banks fail simultaneously due to illiquidity then panic and widespread depositor withdrawals could spread. Thus Bagehot argued the central bank should not skimp on short term lending assistance to bolster liquidity.
-As for “solvent firms” and “against good collateral,” that’s not too hard to understand either.
Bagehot didn’t want the central bank pouring good money after bad into banks with negative equity. If banks were well managed but failing due to a simple liquidity run in times of panic, then the central bank would help savable institutions with its loans secured on good collateral. But for the minority of banks that were just badly managed and effectively bankrupt, they should be allowed to fail and not take central bank money down with them in the process.
-And “high rates” (sometimes referred to as “punitive rates”) were to ensure that illiquid banks regretted having managed their reserves so poorly. If they remembered paying so high a price for liquidity loans they were less likely to repeat their mistakes in the future (ie. moral hazard).
Also a punitive rate of interest ensured only truly needy banks would take central bank loans. If the interest rate was too low, healthy liquid banks would take advantage of the crisis to grab cheap funding and impose unnecessary leverage upon the central bank’s balance sheet.
As Bagehot himself wrote, a punitive rate of interest “will prevent the greatest number of applications by persons who do not require it… …that the [central] Banking reserve be protected as far as possible.” (p. 97)
-Finally it’s important to know Bagehot defined “solvent firms” as commercial banks only. (White, 2014)
BREAKING THE RULES
So just how faithfully did Bernanke, the Fed, and the world’s central bankers adhere to Bagehot’s Rule in 2008?
1) “Lend freely (without limit).”
There’s no question they adopted this policy and took it to new heights. Not only did the Fed lend trillions of dollars to troubled banks, it gladly allowed investment banks, insurance companies, and other nonbanking firms to change to commercial bank status overnight and secure bailout lending. General Electric comes to mind, having hurriedly bought a tiny Connecticut community bank in the depths of the crisis and then receiving a $16 billion Fed loan that dwarfed its newly acquired bank’s entire balance sheet.
Major insurers also changed their status such as The Hartford, Lincoln Financial, Genworth, and most famously AIG. And as Bernanke points out in his book, the lending extended to hundreds of billions of dollars for auto loans, student loans, small business loans, and credit card loans.
2) “Lend… …to solvent firms.”
Not only were the largest, most troubled institutions in 2008 illiquid, many were also insolvent. Loaded up to the hilt with nonperforming mortgages and bad securitized loans, firms like Citigroup, Merrill Lynch, countless regional and superregional banks, and nonbank institutions all received huge discount loans from the Fed despite their solvency coming into question or simply being bankrupt.
As evidence the Fed advanced credit to several commercial and investment banks that ultimately failed anyway or had to be saved through acquisition such as Washington Mutual (failed) and Wachovia (failed) or Bear Stearns, Merrill Lynch, and National City (all acquired).
But if the Fed loaned to many firms that were insolvent and never acquired, why are some of them still with us today? Because the Fed not only granted emergency liquidity loans, it also purchased their lousy mortgage securities in open market operations, the first time in its century-long history that the central bank bought mortgage paper instead of traditional, safer U.S. Treasuries.
Buying assets directly from banks, particularly lousy assets, was never on Bagehot’s list of remedies either.
Finally extending massive loans to non-commercial banking institutions, even solvent ones, violates another tenet of Bagehot’s Rule.
3) “Lend… on good collateral.”
Obviously lending to banks that are offering failing subprime and Alt-A mortgages as collateral directly violates Bagehot’s Rule also.
4) “Lend… …at high rates [of interest].”
As everyone already knows, the Fed loaned hundreds of billions of dollars through its discount window at nearly zero percent.
One can hardly call zero or even 0.5% interest a high or punitive rate, and in fact securing so much money so cheaply would have been impossible during the preceding boom years.
And with Fed lending rates so low, countless healthy and liquid banks lined up for cheap credit, something Bagehot specifically wished to avoid. Even banks that didn’t want rescue money were coerced into taking it, most famously Wells Fargo whose CEO was threatened with punitive government action if his bank didn’t accept a $25 billion TARP injection that the bank ultimately repaid with interest.
So if Bagehot were alive today, he’d perceive the world’s central bankers fulfilling only one of the four commandments of his doctrine while brazenly contravening the other three—all in his name.
MORE BAGEHOT DISAPPROVAL
Furthermore, if we look closer into Bagehot’s book we find he was a staunch hard-money gold standard advocate who hated any suggestion of unbacked or overissued paper money. Bagehot went out of his way to criticize central banker John Law’s 1719 Mississippi Company paper money scheme that inflated world history’s first stock market bubble in Paris which burst and threw France into a protracted depression.
He also sneered at the unbacked paper "greenbacks" circulating in America during and following the Civil War, although Congress began redeeming greenbacks for gold two years after Bagehot's death (1879).
And as we’ve already mentioned, Bagehot wanted to get rid of the Bank of England completely, but reluctantly accepted that doing so was politically impossible. His argument in “Lombard Street” is rather lengthy but here are key corroborating passages:
“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 [of England] 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.”
“But it will be said ‘What would be better? What other system could there be?’ We are so accustomed to a system of banking, dependent for its cardinal function on a single bank [the Bank of England], that we can hardly conceive of any other. But the natural system that which would have sprung up if Government had let banking alone is that of many banks of equal or not altogether unequal size. In all other trades competition brings the traders to a rough approximate equality…”
“I shall be at once asked ‘Do you propose a revolution? Do you propose to abandon the one-reserve System and create anew a many-reserve system [private competitive Scottish system of 1716-1845]?’ My plain answer is that I do not propose it. I know it would be childish. Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible…”
“…Just so, an immense system of credit, founded on the Bank of England as its pivot and its basis, now exists. The English people, and foreigners too, trust it implicitly... …Nothing would persuade the English people to abolish the Bank of England; and if some calamity swept it away, generations must elapse before at all the same trust would be placed in any other equivalent. A many-reserve system, if some miracle should put it down in Lombard Street, would seem monstrous there. Nobody would understand it, or confide in it…”
“…On this account, I do not suggest that we should return to a natural or many-reserve system of banking. I should only incur useless ridicule if I did suggest it.”
-Lombard Street, pp.32-34.
So in conclusion, whatever one thinks of the emergency measures employed in 2008, the claims by Bernanke and modern central bankers that they were only doing Bagehot’s bidding fall flat in light of even a cursory glance at the evidence.
They only followed one of the four conditions of Bagehot’s Rule while blatantly breaking the other three.
And while the gold standard or animus towards monopoly central banks is not addressed directly in Bagehot’s Rule, his unwavering support of the gold standard is present throughout his writings, and his calls for abolishment of the Bank of England in favor of a private, decentralized, competitive banking system appear within “Lombard Street” itself.
Bagehot would have expressed outrage and indignation at the Fed and particularly the Bank of England issuing unbacked fiat paper monies and computerized reserves without gold backing, blowing up the very asset bubbles he had blamed the monopoly central bank for inflating in his own time.
So after scrutinizing Bernanke’s claims of devotion to Bagehot’s Rule a bit more closely, we can safely conclude that “No Mister Chairman, Walter Bagehot would not have been pleased. He would have been very, very displeased by the conduct of central banks not only in 2008, but for many decades prior.”