Mismanaged Financial Panics

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 folly of globalism, which is destructive to the interests of the common people in modern societies even while it continues to enrich the pockets of financier class, of the power-elites on the Wall Streets of the world.  One aspect of the morally criminal “Wall Street over Main Street” crony capitalism practices of modern societies.

Bagehot’s seminal financial opus is titled Lombard Street. That street is the center in London’s financial district and it is 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. Those articles were not compiled into his influential book and published until 1873.

England’s Banking System was the Foundation of the First Industrial Revolution

In Lombard Street, Bagehot describes in detail the wise origins and workings of England’s central bank. He describes how England’s private-for-profit banking industry began to concentrate the deposits of the common people into large sums of capital which could be lent to entrepreneurs to enable the commercial developments which became the world’s First Industrial Revolution.

He also explains, in detail, how and why the wise and safe actions of Bank of England 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 indispensable to it. On the shoulders of the stability of the English banking system stood all of the outcomes and human progress of that First Industrial Revolution in England.

Wise Management of Financial Panics

One of the key goals of central banking is to avert banking panics. A panic is “a run on the bank.” If the depositors of a bank suddenly think the bank has run out of money, then they naturally race to the bank, en mass, to withdraw their money.  The rumor of a bank being insolvent spreads like a wild fire.

“Bad new goes around the world while good news is putting it shoes on.”

If the bank doesn’t have enough cash on hand to payout to this surge of demands then the panic worsens quickly.  A run on one bank can quickly provoke a run on all the banks in a given city or a given country.

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 some of the banks depositors then causes many of the bank’s other depositors to demand their cash deposits back as well.

Bank Don’t Routinely Keep Large Amounts of Cash on Hand

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.

Banking Systems Must Have A Lender-of-Last-Resort

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.

The Treasury of England uses The Bank of England to Manage the Nation’s Currency

In England His Majesty’s Treasury uses the Bank of England as the institution which distributes newly printed and minted money and which removes old and worn money from circulation.  Central Banks routinely perform that role in most countries.  In that role having large amounts of unemployed capital makes sense, hence the semi-private nature of most central banks.

Wise Banking Practice Uses High Cost Emergency Loans, Not “Bailouts” to Manage Financial Panics

The rest of a nation’s banks are private banks are private-for-profit shareholder owned businesses. If a developing bank run causes a private bank to 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 loan” 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.  This high cost practice also encourages future banking prudence, so the bank can avoid the high cost of an emergency loan.

It should also be noted that Bagehot states that the wise central bank would routinely review and examine the books of the nation’s private banks.  The Central Bank should be aware just how sound a given bank is.

Mismanaged Banks Must Be Allowed to Fail

During a banking emergency a financially unsound bank which is endangered, by a financial panic must be allowed to fail. The central bank is duty-bound to the public interest to allow unsound banks to fail.  The general good of the overall banking system is dependent the wise closure of badly managed banks.  

Of course the central bank must also oversee the process by which the mismanaged bank’s affairs are “wound up,” so it happens in an orderly fashion. The wise 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. The influential Austrian-American economist Joseph Schumpeter call this process creative destruction.  Peter Drucker referred to it as active abandonment. It is the fertilizer of a sound economy. 

The Banking System Must Also Provide Some Protection for Depositors

It is, of course, also important both for the stability of the banking system and more importantly for the good of the depositors that common people who are depositors do not lose the money they deposited in banks that fail.  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.

The Chronic Folly of the FED

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 the shareholders of Wall Street’s private-for-profit financial corporations. 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 financial crises in the first place. These greedy and foolishly risky actors are then rewarded for their bad behaviors by the agency-captured FED.  The FED 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.

The Facts Don’t Support the FED’s Choice of Actions

This unwise FED practice is nothing like Bagehot’s morally sound, and wisely responsible lender of last resort program described above.  This unstable and destructive system has three 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 crashes 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 crashes will be financially larger, and the time between such 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 larger and fast with its low interest rate “easy money” policies which support prime interest rates which are clearly too low. The optimum interest rate to support financial stability is never between zero and two percent.

The Broken System Favors the Wealthy Financial Power-Elites, not the Common Man

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 of the FED’s corrupt system. The Wall Street financiers 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 Information is Out There, You Just Have to Let It In

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.

Conclusions

The FED is a “captured agency.”  Like all of the many Hegelian “independent” regulatory agencies established by the US Congress, the industry the FED was supposedly established to regulate, became the industry the FED actively protects and causes to flourish.  The FED never acts for the actual good of the people or for the good of critical national interests.

The FED’s congressional mandate obliges it to halt the devaluation of the national currency (prevent inflation) and to support maximum employment.

The FED accomplishes neither goal.  Its official target inflation rate is two percent.  The legal mandate is for zero percent.  The real unemployment rate is much higher than the government’s official statistics show, and even those numbers are much higher than they need to be.

What the FED does do quite well is to make sure that the power-elite financier’s on Wall Street stay profitable.  That goal is accomplished by repeatedly extracting funds from the people on Main Street and directing them the pockets of those on Wall Street.

Wise management using the principles of Walter Bagehot, described above, would not cause any problem for the nation or the common working men and women of America.  It would greatly diminish the unstable roller-coaster ride of the national economy’s many financial crashes and panics.

This complex system is not that complicated. The “its-complicated” myth is not a reason the acquiesce and fail to fix it. Facts and moral integrity need to be restored to the system. The myth of “too-big-to-fail” must be ended.  The lender-of-last-resort, needs to be a LENDER of last resort.  Crony capitalism is NOT good for America!