Financial Panics and the Lender of Last Resort

Walter Bagehot was a mid-Victorian era journalist in Britain who married the eldest daughter of James Wilson, the founder of The Economist magazine. When Mr. Wilson died in 1860, Walter became the editor in chief of The Economist.  Over the next 17 years that he held that position, he transformed the journal into one of the world’s foremost business and political publications. 

Sadly, today the venerable and still respected magazine is a stalwart advocate of the philosophy of globalism, which is destructive to the interests of the common man in modern societies even while it continues to enrich the pockets of financier class, power elites of the Wall Streets of the world.

Bagehot’s seminal financial opus is titled Lombard Street. That street is the central street in the London financial district and the street on which the Bank of England is located. Walter’s book began life as a series of articles in The Economist beginning in 1858. It was not compiled into his influential book and published until 1873.

Great Seal of the Bank of England

In Lombard Street, Bagehot describes in detail the wise origins and workings of England’s central bank.  He explains how and why those actions had maintained the financial stability of the entire national banking and finance industry of England since the bank’s founding in 1694.  That one bank thereby supported the growth of the commerce of that nation and became an indispensable to it. On the shoulders of the stability of the English banking system stood the all the outcomes and human progress of the First Industrial Revolution in England.

The key (but not the only) goal of central banking is to avert banking panics, that is, a run on any of the banks in that nation. A bank run is caused by a sudden loss of confidence in the bank’s solvency by its depositors. That panic on the part of the depositors then causes many of the bank’s depositors to demand the cash they have previously deposited in the bank.

Banks don’t keep their deposits in the form of cash, because capital not invested does not produce a return on the investment. Unemployed capital would not be productive.

A run on one bank can spread rapidly to become a run on the entire banking system.  Panic is remarkably contagious, and widening panic can destroy an entire nation’s economy in a single day or several days at the most.

The key stabilizing element in a banking system is for that system to have a lender of last resort.  That lender of last resort is a financial institution who does keep a large amount of cash on hand and can rapidly loan that cash to a distressed bank thereby stopping a panic and assuaging the fears of the bank’s depositors. In England the lender of last resort was and is the semi-private Bank of England (BoE).

The national treasury needs an institution to distribute newly printed and minted money and to remove old and worn money from circulation.  The central bank also performs that job for the nation. In that role having large amounts of unemployed capital makes sense, hence the semi-private nature of most central banks.

The rest of a nation’s banks are private banks are private, for profit businesses. If they need to make an emergency draw on the largess of their central bank, the rapid loan which is provided to them should be provided at a relatively high interest rate, of say at 2 or 3 times the prime lending rate. So, if the prime rate of the day was 5%, then the responsible central bank emergency loan would be made at 10 or even 15%. The high cost of the “bailout” should be born by the bank’s private shareholders who are then highly motivated to repay the emergency loan as soon as possible to get out from under the high cost of the interest payments.

It should also be noted that Bagehot states that the wise central bank would routinely review the books of the nation’s private banks, so it will be aware just how sound a given bank is during an emergency.  If the endangered bank was not sound over-all, the central bank is duty-bound to allow the bank to fail or it would allow the bank’s affairs to be “wound up” in an orderly fashion. The lender of last resort does not exist to keep mismanaged banks alive!

Bankruptcy is the fertilizer of a healthy economy. In due course the employees of the failed institution will be working elsewhere and the physical assets of the unsound business will have been purchased by those who can make better use of them. The badly managed institution is gone, but none of its productive assets are lost or wasted.

It is, of course, also important both for the stability of the banking system and for the good of the depositors that common people who are depositors do not lose the money they had deposited in a failed bank.  In modern times in the United States, the depositors at an unsound bank are insured to a limited degree against the loss of their deposits by the Federal Deposit Insurance Corporation (FDIC). 

Since the start of the US Federal Reserve System (the FED), in 1913, the soundness of Bagehot’s “lender of last resort” system has been foolishly distorted by the actions of the FED by it’s inherent bad monetary choices and its similarly inherent (and illegal) practice of bailing out the unsound and speculative financial institutions which, in part, caused each of the respective crashes in the first place.

In the post World War II, and the post Bretton Woods era, the FED routinely and repeatedly acts as a faucet out of which flow tax payer dollars from Main Street (via the US Treasury) to Wall Street’s private-for-profit speculator shareholders. This action on the part of the FED is undertaken in the guise of “handling” one financial crisis after another.

The knavish, risky behaviors of the Wall Street investment banks are generally a major factor involved in the crises in the first place. These foolishly risky actors are then rewarded for their bad behaviors by the agency-captured FED who routinely hands the wealthy Wall Street shareholder’s money from the pockets of modest working class Americans who can’t personally afford the extra financial burden and will never be repaid.

This unwise FED practice is nothing like Bagehot’s responsible lender of last resort program described above.  This unstable and destructive system has two particularly bad aspects:

1. The private-for-profit corporate speculator whose risky (speculative) investment decisions which have caused the problem in the first place, bears no risk or consequence for their reckless behavior. In fact they often profit from the crash they have caused.

2. The anticipated “free” bailout from Mail Street acts as a moral hazard and encourages the repetition of the foolishly risky speculative investment practices that caused the crash in the first place. This bad cycle will not only repeat, but the subsequent crash will be financially larger, and the time between crashes will get shorter and shorter, which is exactly what we have seen globally since the end of World War II.

3. The additional sad irony is that during normal financial times it is the agency-captured FED which makes the dangerous financial bubble grow with its easy money policies which support prime interest rates which are too low. The optimum interest rate to support financial stability is never between zero and two percent.

However, that same unstable and destructive system is, of course favored by the already wealthy financier power elite classes for two reasons:

1. Those wealthy financial power-elites speculators are the benefactors. They get free money put into their pockets from the financially strapped pockets of Main Street.

2. Though it is often ignored, the political influences of the wealthy financier types support their crony power-elite politicians, legally (though political donations), quasi-legally (through enormous election law loopholes), and illegally with brides (directly or indirectly with de facto brides given to the politician’s spouses, family members or close associates).

The politicians in Congress provide a wink and a nod to it all and authorize the FED’s bailout expenditures. Thus the crony capitalist system of emergency payoffs (bailouts) to Wall Street has become so common, that Main Street no longer screams objections when the financial institutions are given enormous amounts of “free” money from the American taxpayers. This recurrent quasi-legal looting of Main Street by politicians and government “regulators” is a glaring example of the agency-capture problem endemic in the nominally independent Congressional regulatory agencies in the US government.

The best (though by no means the only) documentation of these shady, but all too common practices in American politics is available from the many exposes written by Peter Schweitzer and his investigative journalism team (including Miranda Devine) at the Government Accountability Institute, whose exposes date back to 1993, and include over 19 full-length books documenting the rampant corruption present in both political parties.

The first detailed and well documented account of the phenomenon of agency-capture, which all the so-called independent congressional regulatory agencies are subject to, was written by Samuel Huntington in 1949 as his Harvard PhD dissertation on the Interstate Commerce Commission’s agency-capture which began in 1885.