Arnold Kling  

Bagehot vs. Bernanke/Paulson

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David Warsh links to an interesting letter sent by the British Academy Forum on why economists did not predict the financial crisis. They write,

A generation of bankers and financiers deceived themselves and those who thought that they were the pace-making engineers of advanced economies.

Read the whole thing.

Warsh himself writes,

To halt a "run," explained [Walter] Bagehot, whether on a bank, a stock market or, for that matter, on paper claims to wheat, coal, land or any other set of illiquid assets, all that was necessary was that, in moments of acute distress, the government should ease up on its monetary policy and indicate its willingness to lend money to those who wanted cash. Not just anybody, of course; sound collateral would be required. Not too easily available, either; the government would want to charge something more than was taken to be the going rate. Above all, not too frequently; a market that expects to be bailed out by a lender of last resort may take unwarranted risks.

"Lend freely but at a penalty" became the mantra

Re-read the phrases "sound collateral" and "penalty." Bernanke and Paulson forgot about those.

In fact, I would suggest that in our current financial crisis, there were plenty of institutions willing to lend to banks at a penalty rate on the basis of sound collateral. In that sense, we did not need the Fed and the Treasury to be lenders of last resort.

The problem was that banks were so highly leveraged and had charged such small risk premiums for risky assets that the only way they could survive was by having someone lend to them on the basis of unsound collateral ("toxic assets") or not charge a penalty rate, or both. In other words, to survive they needed a bailout, not a liquidity backstop. And that is what Bernanke and Paulson gave them.

Let me reiterate the profit test. If you "lend freely but at a penalty" in a liquidity crisis, then you make a profit. If you bail out leveraged firms that made bad bets, then you take a loss. If you take a loss, then what you mostly did was transfer money from ordinary taxpayers to the managers and shareholders of unsound banks.

And then you pat yourself on the back, claiming that you averted another Great Depression.

Comments and Sharing

COMMENTS (10 to date)
E. Barandiaran writes:

I agree with you but remember that to prove it you'll have to hire an accountant with experience in central banking. For example, you will have to determine the money that is being given to banks as interest on reserves with the Fed and how these interest-earning reserves are now accounted for regulatory purposes.

fundamentalist writes:

It's clear that the feds decided long ago to bail out most bankers, at least those who weren't serious competitors with Goldman-Sachs, no matter how stupid their decisions. How is that different from Soviet communism?

El Presidente writes:


If you take a loss, then what you mostly did was transfer money from ordinary taxpayers to the managers and shareholders of unsound banks.

And then you pat yourself on the back, claiming that you averted another Great Depression.

That's what happens in a liquidity trap. That's why it's necessary to make an end run around the banks and give the money directly to the consumer, something you and others would have adamantly opposed just as strongly as you insisted that we were not in a liquidity trap because of a hangup about an incomplete and arbitrary definition. Even so, the bailouts _did_ avert a catastrophe, whether or not anybody should be patting themselves on the back for having let it come down to that. "Let them fail" still doesn't sound pragmatic, no matter how many times we criticize the action we took. I would prefer not that we made them fail but that we forced them to succeed. There was a third option.

E. Barandiaran writes:

El Presidente,
Your third position reminded me of Presidente Perón. Yes, let us force others to succeed—but don’t forget “while we enrich ourselves”.
Now let me comment on your substantive point about a liquidity trap. It depends how you define it, but in the definition that I learned and taught years ago we were talking about the demand and the supply of money (the problem was and still is how you define money). What Arnold is talking about is a subsidy to someone whose business has failed--yes, you may pay the subsidy with money but it doesn't have anything to do with the demand and the supply of money as an asset.
The only sense in which the bailout of banks may have contributed to avert a catastrophe is that it avoided the typical conflicts of interests that you have in a bankruptcy. As people fight, they waste resources by stopping the production of goods and services. Indeed, when the parts to a potential conflict knows that a third party (in this case the government) may pay a lot of money to prevent the conflict, they take advantage of the third party by "hardening" their position (you may want to call it moral hazard, but from my experience I call it stupidity or venality depending on the situation).

El Presidente writes:

E. Barandiaran,

What Arnold is talking about is a subsidy to someone whose business has failed . . .

That's fine until the business is in the habit of augmenting the money supply. Then it becomes a 'bank' in at least one important respect, not just another ordinary firm. Financial firms expanded the money supply through unregulated credit. If we hadn't lost/surrendered control of the money supply in the first place we wouldn't have had this problem. Maybe another one, but not this one. Having lost control, repurchasing it at extortion prices may not have been the best move. Diluting the controlling interests may have served us much better. That's the third option.

1. Let 'em fail
2. Bail 'em out
3. Make 'em earn it

We tried #1 and didn't like it, made a poor attempt at #3, but finally drifted toward #2. It remains to be seen whether we will stiffen our spine and resume our course toward #3 or whether we'd prefer to wander around in the wilderness for a few years.

fundamentalist writes:

El Presidente: "Even so, the bailouts _did_ avert a catastrophe..."

Actually, it's impossible to know that. That's counterfactual history, which can never be proven. It's true only if you assume that Keynesian economics is true. From an Austrian perspective, the bail outs helped very little and set the stage for the next bubble. Statistically, it's impossible to separate out the correlated effects of the bail-outs and the natural ability of the economy to recover without state aid.

I read Kindleberger’s book years ago and found it very interesting. If I remember correctly, he had a chapter near the back in the edition I read in which he discussed the unifying features and causes of panics. He placed the blame on credit expansion, which he distinguished from monetary expansion. If monetary expansion doesn’t ignite booms and bubbles, then it certainly enables and advances them.

With due respect o Minsky and Kidleberger, Hayek and Mises said the same thing but much better. What Hayek and Mises contribute is the explanation of why credit expansion always results in a bust.

El Presidente writes:


It's true only if you assume that Keynesian economics is true.

It's either true or false no matter what I believe, but I believe it in part because I do find Keynesian economics persuasive with respect to our present circumstance, and in part because of the evidence that seemed to suggest collapse was an imminent possibility. I understand what you're saying about causation and regression and I agree with your point that, as a matter of fact it cannot be proven. However, as a matter of judgement I think it is clear. I should have been more careful in my statement. Thank you for setting me right.

Don the libertarian Democrat writes:

"Once a deflation has gotten under way, in a large modern economy, there is no significant limit which the decline in prices and employment cannot exceed, if the central government fails to use its fiscal powers generously and deliberately to stop the decline. Only great government deficits can check the hoarding of lawful money and the destruction of money substitutes once a general movement is under way.
While the technical limits of cumulative movements are more nearly significant in the case of upswings or booms, the proper checks in this direction also are to be found in the taxing, borrowing and spending activities of the national government."

That was Henry Simons in 1938. I hope that the quote wasn't too long. From my perspective, we faced a Debt-Deflationary Spiral, as described by Fisher and Simons, and we've avoided it by following a version of the Chicago Plan of 1933. The fact that job losses are greater than the loss in Real GDP is evidence of this.

Bernanke, being an admirer of Fisher, was a good man to have in place in this crisis. As far as I can tell, the plan is working. I consider it timid, but only in the context of a believer in a DDS. Too others, I'm sure that these moves have been not just radical, but wrong.

I don't think that this can be settled, but I try and follow Hayek's and Simon's view, evidenced in their correspondence, that disagreements can be argued with civility.

I agree that Bagehot's rules were violated. I believe that Bernanke said that Lehman had no collateral, but that AIG did. That's one of the problems with Bagehot's rules: What constitutes sound collateral.

William Gross thought that buying toxic assets would make the govt money. Maybe he will turn out to be right:

I believe that we should have intervened with Lehman. I know that it violates Bagehot's rules, but, facing a DDS, we couldn't stick to a strict interpretation of "sound".

E. Barandiaran writes:

El Presidente,
I'm sorry to reply late to your comment on my last post. Just let me say this: for 20 years I preferred to use a concept of money that in addition to currency issued by a central bank it included demand deposits, but around 1980 I abandoned the idea of including any type of deposits (including demand deposits) as money. Banks and other deposit-taking institutions may run what E. Fama once called an accounting system of payments and only in this limited sense the compete with a system of payments that relies on coins and notes issued by some institutions (today the central banks). Moreover, money and bank credit are two different concepts, so different as the difference between money and credit from any source other banks. To understand your argument, please make explicit (1) your concept of money by reference to what type of bank liabilities you consider money and (2) the mechanisms through which banks and all other deposit-taking institutions lend the funds they have mobilized as deposits.

El Presidente writes:

E. Barandiaran,

Quite alright. As you can see, sometimes I take a while too. No worries.

Money: anything that can be widely exchanged for goods (including assets) and services and to pay debts (including but not limited commodities, currency, transferable instruments, or credit)

Mechanism? Not sure what you mean by that unless you're referring to fractional reserve lending. Would you explain?

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