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Robust Political Economy and the Lender of Last Resort

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Abstract

Of the leading versions of lender of last resort policy, which is to be preferred in a world of realistic incentive and information imperfections? The three most prominent versions of lender of last resort policy are: the Classical system of central bank lending on good collateral at a penalty rate, the Richmond Federal Reserve system of open market operations to prevent liquidity drains, and the New York Federal Reserve system of commitment to taking any and all action necessary to prevent the spread of financial contagion. We compare these policies to the mechanisms that developed in free banking systems. Free banking systems had no formal lender of last resort, but instead developed institutions that lessened the possibility of systemic panic in the first place. We find that free banking weakly dominates the Classical system. Free banking also outperforms the New York Fed and Richmond Fed systems on the incentive margin, but is weaker on the information margin. In addition, the paper discusses how the New York Fed doctrine is the only stable activist policy, since the limited responses necessitated by the Classical and Richmond Fed policies are not credible.

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Notes

  1. See for example Ahrend (2010); Beckworth (2012); Benes and Kumhof (2012); Boettke and Smith (2013a, b, c); Diamond and Rajan (2009); Dowd and Hutchinson (2010); Espinosa (2012); Hetzel (2012); Horwitz and Luther (2010); Jarocinski and Smets (2008); Leamer (2007); Mehrling (2010); O’Driscoll (2012); Kling (2010); Kotlikoff (2010); Roberts (2010); Selgin et al. (2012); Sumner (2011, 2012); Taylor (2007, 2009); White (2008, 2009, 2012); Woodford (2012); Woolsey (2012).

  2. This is not the only explanation of the financial crisis put forth. For a sample of opinions on the causes of the financial crisis see Critical Review Vol. 21, No. 2–3.

  3. The former explanation draws on the Austrian theory of the trade cycle (Garrison 2000; Horwitz 2000) whereas draws on the Monetarist story of Friedman and Schwartz (1963). These theories are not irreconcilable, and may in fact be complementary (Boettke and Luther 2009).

  4. Moral hazard explanations also feature prominently in these works. See especially Espinosa (2012), Roberts (2010), and White (2012a, b).

  5. The lender of last resort in these models is assumed to be an actor of a different kind from the profit-seeking bankers.

  6. An approach similar to the one advocated here can be found in Calomiris (2013). While concerned with banking panics rather than last-resort lending per se, Calomiris considers similar historical cases and reaches similar conclusions to those to be discussed later in the paper.

  7. While the range of human behavior is perhaps better captured by a continuum rather than the discrete categories presented above, these categories highlight the essential feature of robust political economy: comparing best-case to worst-case scenarios. Robust political economy is fundamentally a search for those institutions that function well even in these worst-case scenarios. As Boettke and Leeson (2004: 100) recognize, “Many systems can stand up tothe test of the easy case, but very few remain standing when confronted with the hard case.”

  8. In a slightly different vein, Anna Schwartz (1987) examined the efficacy of the lender of last resort under different economic and regulatory conditions. This can be considered a proto-exercise in robust political economy analysis of monetary institutions.

  9. Stability is important for robustness because ambiguity with respect to the lender of last resort arrangement the monetary authority uses is costly. In particular, market actors will be forced to invest greater resources in understanding the “true” last-resort lending rule, will err in decisions predicated on a given last-resort lending rule when another is effect, or some combination of both. Recent research (e.g. Baker et al. 2013) has highlighted how uncertainty can negatively impact economic outcomes; uncertainty with respect to the underlying monetary rule during times of financial turbulence raises similar problems, and ought be avoided wherever possible.

  10. More specifically, this means preventing the spread of contagion by ensuring the continued viability of illiquid, but still solvent, organizations.

  11. Of course, the different versions of last resort lending doctrine will propose different means by which the end of financial stability is best achieved.

  12. The following is a condensed summary of the process described by white (1999: chapter 1), which the interested reader should consult for a more in-depth discussion.

  13. Clearinghouses in the U.S. during the National Banking Era provided a unique way to ameliorate a crisis. Member banks of a single clearinghouse would suspend individual operation, suppress information concerning the solvency of individual banks, and issue certificates redeemable by the clearinghouse as a whole. This was an important source of emergency liquidity in a system constrained by regulations that prohibited branch banking and, due to collateral requirements, rendered the conversion of currency to deposits artificially inelastic (Smith 1990). This had the benefit of substituting the solvency of the system as a whole for the solvency of individual member banks during a panic. However, the uniqueness of the U.S. case makes it inappropriate for drawing general inferences, so it will not be treated in detail here. Interested readers should consult Gorton (1985, 2010), Gorton and Mullineaux (1987), and Timberlake (1984).

  14. Because the inside money-outside money distinction is intrinsic to the operation of all free banking systems, it is impractical to discuss any specific historical case in this subsection as is done in others. Readers interested in specific historical details should consult the free banking literature cited above.

  15. Evidence of this stability can be seen by comparing Canada’s laissez-faire approach with that of the U.S. during the National Banking Era. While in the U.S. there were little seasonal variations in note circulation and large fluctuations in interest rates come the harvest season, in Canada note circulation was around 20 % higher in the autumn relative to its own mid-winter seasonal lows and there were no noticeable seasonal interest rate fluctuations (Schuler 1992: 88; Selgin and White 1994b).

  16. In Upper Canada, the governor threatened to shut down banks that suspended payments. As a result banks suffered reserve drains and were forced to contract their loans more than banks in other provinces. The crisis in Upper Canada was said to be worse “than anywhere else in North America” (Schuler 1992: 83).

  17. This historical example suggests clearinghouses also had a way of dealing with problem posed by Diamond and Dybvig (1983). This suggests that under panic condition the suspension of payments, contrary to Diamond and Dybvig, was welfare-enhancing (Selgin 1993).

  18. Interestingly, Bagehot himself preferred free banking, what he called “the natural system—that which would have sprung up if Government had let banking alone” (Bagehot 1896[1873]), to central banking. He advocated his now-orthodox rules for last-resort lending because he believed the political constraints prevented a transition to the kind of banking system that existed in Scotland.

  19. The exception is the United States, which will be discussed further below.

  20. Goodfriend (2012) argues that the Bank of England’s adherence to Bagehot’s rules was due to the incentives provided by shareholder residual claimancy.

  21. The response of the Federal Reserve to the recent crisis will be explored more fully in the section covering the development of the New York Fed doctrine.

  22. It is also important to note that Bagehot’s recommendations do not specify any punishment mechanism for central bankers who overstep their bounds, and none of the historical cases where Bagehot’s rules were expected to be followed exhibited institutional fixes to rectify this oversight.

  23. Obviously, the penalty rate also must be below whatever rate prevails on the market during times of trouble, or else nobody would borrow using the discount window. This has not been a concern historically since during panics liquidity dries up, and banks can hardly afford to be making loans when they need liquidity to solidify their own short-term position. This makes loans between banks an exceedingly risky proposition even at high interest rates.

  24. Congdon (2009), along these lines, argues the Bank of England should be privatized so that it will lend more freely during times of turbulence.

  25. This is, of course, conditional upon market agents perceiving the limited response as credible, which we have seen is not the case. Nevertheless, exploring the information issues is important for the purposes of theoretical exposition.

  26. The interaction between incentive and information effects yields insight as to why banks load up on exotic, high-risk, high-return assets: The informational point is moot, since the lender of last resort will likely bail them out in the event of trouble anyway.

  27. Bordo (1986, 1990) provides evidence, in the form of the number of panics, that European central banks acting as Bagehotian lender of last resorts outperformed contemporaneous U.S. system. Also, Bordo (1990: 24) compares further the unique U.S. system to the Bank of England. In each of the crisis years common to both countries, the negative deviation from trend real output was greater in the U.S. than in Britain, and in three out of six cases from 1873 to 1932 the crisis evolved into a full panic in the U.S., whereas none of the crises evolved into panics in Britain.

  28. Again, this is due in part to the differing monetary-institutional environment between the modern Fed and European central banks in the late 19th century. Residual claimancy is especially important (Goodfriend 2012).

  29. This view is endorsed also by Friedman (1960), Kaufman (1991), and Schwartz (1992).

  30. Supply-side factors will be an important part of the New York Fed doctrine, which will be explored in the next subsection. Remember also the private clearinghouse response in the U.S. avoided potential supply-side problems by grouping under a single organization for the duration of the crisis; Bagehot’s rules avoided them by committing to intervene on a bank-by-bank basis.

  31. Why wouldn’t these supply-side factors also be a problem for adherents to Bagehot’s rules? After all, the end result—illiquid banks stay open at a cost, insolvent banks close—is the same. The answer lies in the monetary authority’s lack of a hard budget constraint. This frees the monetary authority from the worries that private agents must confront in times of trouble, such as evaluating the soundness of other agents’ underwriting standards (Flannery 1996).

  32. Remember Bernanke’s (1983) theoretical explanation for why a banking panic may occur even without a collapse in the monetary aggregates, although we have yet to observe such an event.

  33. Though rarely discussed, the legality of these actions is somewhat ambiguous. See Todd (2002) for a lawyer’s perspective on the legality of lender of last resort activities.

  34. The list of current primary dealers can be found at http://www.newyorkfed.org/markets/pridealers_current.html

  35. The Fed relies on repo contracts mainly as a way to conduct temporary monetary policy, e.g. meeting seasonal demands for currency during the holidays. See Selgin (2012: 303–308) for an overview and Tuckman (2010) for a detailed explanation in the context of the financial crisis.

  36. For example, JPMorgan Chase refused to process Lehman’s payments, freezing $17 billion of its assets on the eve of its collapse (Duffie 2009: 39).

  37. The PDCF was basically a “new and improved” discount window for primary dealers. By the time the Fed closed the PDCF in February 2010, total accumulated lending through the program was approximately $9 trillion; Merrill Lynch, Citigroup, and Morgan Stanly each received approximately $2 trillion (Sheridan 2011: 14).

  38. These are not the only steps the Fed took to prevent the spread of financial contagion; we limit the discussion to the mechanisms above because they are the most relevant to this paper. For a more detailed account see Hummel (2012) and Stewart (2009).

  39. While quantitative easing is usually considered a tool of monetary policy (albeit an unconventional one) rather than a lender of last resort activity, the Fed’s targeting of MBS points to systemic concerns as well.

  40. This process is described in detail by Gorton (2010). The only “anomaly” with the above story is the failure of Lehman Brothers, which was on the list of primary dealers in 2007. Hummel (2012: 189–190) suggest the limited initial response of the Fed can be explained by worries over inflation, since commodity (and especially oil) prices were rising in 2007–08, just as the crisis was unfolding.

  41. Although the passage of Dodd-Frank does seem to ratify TBTF in the U.S. See e.g. Wilmarth (2011).

  42. See Sumner (2011, 2012) for the theory behind a nominal income target, especially in the context of the financial crisis.

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  1. Berry College, 2277 Martha Berry Highway NW, Mount Berry, GA, 30149, USA

    Alexander William Salter

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  1. Alexander William Salter
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Correspondence to Alexander William Salter.

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Alexander William Salter is an Assistant Professor of Economics at Berry College.

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Salter, A.W. Robust Political Economy and the Lender of Last Resort. J Financ Serv Res 50, 1–27 (2016). https://doi.org/10.1007/s10693-015-0219-9

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