Saturday, May 10, 2014

An awkward wrinkle in Bagehot's dictum (or Circeronian public policy)

Bagehot’s Dictum (aka Bagehot's Rule)—that [in a financial crisis] the central bank provide money at higher interest rates to illiquid financial institutions if they are solvent (their assets are greater than their liabilities) but lets insolvent financial institutions (their liabilities are greater than their assets) fold—has, as it is usually summarised, an awkward wrinkle. Tight monetary policy can make financial institutions insolvent by increasing their liabilities and destroying their assets. As a commenter on Scott Sumner's blog nicely put it, the US GFC bailouts were as if the Fed punched financial institutions in the eye and then offered them a steak until the swelling went down.

As this post points out (citing an excellent paper [pdf] by Brad DeLong), Bagehot’s own formulation does not have that problem, since he argued for lending against what would be good collateral in normal times.

Sir Robert Peel (1788-1850)
I can very much recommend DeLong's paper to anyone interested in these issues. Having read it, I believe I was a little harsh in a preceding post on Sir Robert Peel and his Bank Charter Act (1844). Sir Robert seems to have known exactly what he was doing, insisting on 100% cover ratio for Bank of England banknotes (i.e. all its banknotes being entirely backed by gold) with the presumption that the law would simply be overridden in emergencies, thus creating a lender of last resort which was completely credible but could act as required in financial crises. Which is what happened. During actual or potential financial crises, Chancellor's of the Exchequer would issue suspension letters, suspending that part of the Act.  

Now, there is no basis in English law for suspending a statute--in whole or in part--simply as an executive act but, as DeLong says, it was apparently taken as a case of Salus populi suprema lex esto ("the needs of the people are the supreme law") and everyone just let it go through to the keeper. 

I stand by my comment that the banking school was more correct than the currency school on the basis of price level shifts with specie-convertible currency but that was not the point of what Peel was trying to do, though he no doubt found the support of the currency school helpful.

[Cross-posted at Skepticlawyer.]

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