When and how much?

‘Too little, and too late’ is one of the saddest phrases in the lexicon not
only of central banking but of all activity. But how much is enough?
When is the right time?
Bagehot’s rule is to lend freely at a penalty rate. ‘Freely’ means only
to solvent borrowers and with good collateral, subject to the inevitable
exceptions. It means rejecting the expedients that various central banks
are tempted to indulge in crises. Early in 1772 the Bank of England tried
to apply the brakes to overtrading by selective limitation of discounts
and was criticized.71 In 1797 the Bank began to prorate discounts, and
Foxwell thought that might have been undertaken again in 1809.72 An-
other technique when a central bank feels it is getting overcommitted
is to tighten up on eligibility requirements for collateral, changing the
maturity of eligible bills from 95 or 90 to 65 or 60 days, or adding to
the number of names required. In May 1783 the Bank of England had
discounted so heavily for its own clients that it departed from its regular
practice and refused to make advances on subscriptions to government
bonds issued that year. Clapham commented that fortunately no public
or private catastrophe of the sort that starts a panic occurred that sum-
mer since the Bank had limited its capacity to meet one.73 In this case
the Bank was behaving like a private bank worried about its own safety
rather than a public institution with the responsibility to provide for the
safety and stability of the system.
The lender of last resort might supply funds to the system through
open market purchases rather than through the discount mechanism.
How much should the central bank expand the money supply? Were the
$160 million in October 1929 and the additional $210 million through
November 1929 adequate? In the view of the Federal Reserve Bank of
New York they were not. The New York Fed was operating under a di-
rective from the Board of Governors in Washington that permitted it
to buy $25 million of government bonds a week. It violated this rule in
October by buying $160 million, and on November 12 recommended

to the Board that the limit of $25 million a week be removed and that

the Open Market Investment Committee be authorized to buy $200 mil-

lion of bonds for the system. After considerable negotiation, the Board

reluctantly approved this request on November 27, and $155 million

was purchased between November 27 and January 1, 1930. By this time,

discounts were running off rapidly, interest rates had fallen sharply, and

the need for a lender of last resort—to accommodate the liquidation of

call loans in the market—was over.74

Some monetarists seem ambivalent on the role of the lender of last

resort. Friedman and Schwartz quoted Bagehot approvingly on not starv-

ing a panic.75 They asserted that the action taken by the Federal Reserve

Bank of New York in buying $160 million in October 1929 was ‘timely

and effective’ although they were gently skeptical about Harrison’s claim

that the open market purchases kept the stock exchange open.76 Fried-

man was opposed to all discounting and believed the stock market crash

was not a major factor in producing or deepening the depression.77 An

ultra-monetarist view maintains that the open market operations of the

period constituted a renewal of the credit inflation of the 1920s.78 But

most monetarists believe that there is no need to have a lender of last

resort so long as the money supply increases at a constant rate. In retro-

spect the open market operations were woefully inadequate in the weeks

from mid-October to the end of November 1929. They enabled the New

York banking system to take over the call loans of out-of-town banks but

at the cost of reducing the amount of credit available for purchases of

stocks, commodities, and real estate, which led to declines in their prices

and unleashed the depression.79

The timing of the Federal Reserve Board under the chairmanship of

Alan Greenspan in the Black Monday crash of October 1987 was impec-

cable, as also was the help for the U.S. capital market when the collapse

of Long-Term Capital Management was avoided in September 1998.

Timing presents a special problem. As the boom mounts to a

crescendo, it must be slowed without precipitating a panic. After a crash

has occurred, it is important to wait long enough for the insolvent firms

to fail, but not so long as to let the crisis spread to the solvent firms

that need liquidity—‘delaying the death of the strong swimmers,’ as

Clapham put it.80 In a speech during the debate on the indemnity bill

on December 4, 1857, Disraeli quoted the leader of an unnamed ‘great-

est discount house in Lombard Street’ who said that ‘had it not been

for some private information which reached him, to the effect that in

case of extreme pressure there would be an interference on the part of

the Government, he should at that moment have given up the idea of

struggling any further, and [that] it was only on that tacit understanding

that he went on with his business.’81 Questions could be raised about

the equity of private information and of tacit understandings for insiders

but not outsiders. Still, the remark underlines the importance of timing.

Whether too soon and too much is worse than too little and too late is

difficult to specify.

In 1857 the U.S. Treasury came to the rescue of the market too early

and helped it inflate still further. In 1873 the response was too slow, no

steps were taken during the first part of the year.82 Sprague refers to ‘the

unfortunate delay of the Clearing House,’ that is, the slowness of any

authority to respond to the 1907 crisis, in which as in no other crisis

since the Civil War, things were allowed to drag on too long.83

If the need for a lender of last resort is accepted after a speculative

boom and it is believed that restrictive measures are not likely to slow the

boom at the optimal rate without precipitating a collapse, the lender of

last resort faces dilemmas of amount and timing. The dilemmas are more

serious with open market operations than with a system of discounts. In

the latter case, Bagehot specified the right amount: all the market will

take—through solvent houses offering sound collateral—at a penalty

rate. With open market operations the decision for the authorities is

more difficult, but Bagehot was right not to starve the market. Given a

seizure of credit in the system, more is safer than less since the excess

can be mopped up later.

Timing is an art. That says nothing—and everything.

To whom on what?

The rule laid down by Bagehot was that loans should be granted to all
comers on the basis of sound collateral ‘as largely as the public asks for
them.’46 But in his testimony before the 1875 inquiry, two years after the
publication of Lombard Street, Bagehot resisted the suggestion that last-
resort lending be turned over to a body of commissioners appointed by
the government on the grounds that they might make loans to ‘improper
persons.’ They would be subject to political pressure while the Bank of
England is ‘a body withdrawn from the political world and not subject
to political pressures.’47
Bagehot’s suggestion that central banks are immune from political
pressure seems naive. The dilemma about collateral is that its soundness
depends on when and whether the panic is stopped; the longer the panic
continued, the sharper the decline in the prices of securities and bills of
exchange and commodities and hence the less sound the collateral. In
this case, it becomes necessary to look at the character of the borrower,
something that J.P. Morgan was reported to consider exclusively. Here
the dilemma relates to the wry comment that bankers lend money only
to those that do not need it.
Central banks typically have rules.48 When the rules cannot be easily
broken—as in the Federal Reserve Act of 1913, which permitted only gold
and negotiable bills of exchange but not government securities to be held
as reserve against Federal Reserve notes and demand deposits—there is
frequently trouble. There is also trouble when rules are too readily bro-
ken. The beauty of the Chancellor of the Exchequer’s letter of indem-
nity was that it preserved the rule while violating it and did not create a
precedent, at least not for a time. The Bank of France and the Reichsbank
occasionally discounted only three-name paper. But discretion to reject
paper because it was ‘unsound’ or the borrower because of his character
gave the lender of last resort a life-or-death power that might not always
be used with complete objectivity. The literature is filled with accusa-
tions of venality on the part of the directors of central banks. Protestant
and Jewish directors of the Bank of France were alleged to have punished
the Catholic (and worse-off) supporters of the Union G ́ n ́ rale in 1882,
e e
while saving the insider Comptoir d’Escompte in 1888.49 In the crisis
of 1772, the Bank of England’s issuance of new regulations about dis-
counting and refusal to discount doubtful paper were interpreted as an
attempt to break the Jewish houses in Amsterdam that had been most in-
volved in the speculation. Then there was the Bank’s decision to refuse

the bills of Scottish banks, and finally to stop discounting altogether,

which was probably ‘a step taken quite deliberately to break up a group

of Dutch speculators.’50 Outsiders particularly suffered. The Bank of the

United States was allowed to fail in New York in December 1930 by a

syndicate of banks amid accusations that the Bank was being punished

for its pushy ways.51

The rule of discounting for everyone with good paper evolved slowly

in Great Britain. For a time ‘the invariable practice’ was respectable Lon-

don names on paper with no more than two months to run; but this

description of 1793 is accompanied by a statement that while a request

from Manchester had been turned down (along with one from Chi-

chester, where refusal helped to bring a bank down), £40,000 had been

advanced to Liverpool banks. Only in July 1816 did the Bank, break-

ing a rigid precedent, agree to accept ‘country securities of undoubted

respectability if the firm cannot get enough London names.’52

The fact is that the Bank of England made advance on a wide range of

different types of assets much beyond two-name paper. In 1816 the Bank

broke its rule against lending on mortgages, undertaking a ‘Transaction

quite out of the ordinary course of Business’ to relieve the distress of

poor people in the Black Country. The Bank resolved to lend only in

the old way ‘on notes of respectable parties’ but a few years later the

Bank began a regular mortgage business on the ground that the volume

of discounts and especially the income from discounts had collapsed—a

private rather than a public purpose.53 At one stage the Bank even made

loans on the security of a mortgage on a plantation in the West Indies

(ultimately the Bank foreclosed on this loan54 ) and on unimproved land

in England. The land was unencumbered by mortgage but belonged to

a duke, an indication that collateral and the character (or status) of the

borrower were not unrelated. Loans were not made on land in Scotland

or in Ireland.55

With the growth of railroads, Bank of England loans were made on the

collateral of railroad debentures. In 1842, as the second railway mania

got under way, the Bank voted to make an occasional loan to firms in

difficulty and to well-tried firms for development.56 The Bank of France

began lending to a railroad syndicate in 1852; in fact, it was accused

of supporting, if not starting, the feverish speculation in railroads.57

Walter Bagehot thought the Bank of England mistaken for not lending

on railroad debentures when it did so on consols and Indian securities;

Bagehot stated that a railway was less liable to unforeseen accidents

than the Empire of India.58 But Indian securities were guaranteed by the

Colonial Office and in effect were British government obligations.

Exchequer bills were issued on the collateral of goods, as were Ad-

miralty bills in Hamburg. Clapham observed that many of the Bank’s

advances in 1825 were not actually on goods but rather on personal

security;59 the Bank loaned freely and was not ‘over-nice.’60 In a few

weeks in 1847 the Bank advanced £2.25 million in both usual and un-

usual ways, including the securities of the Company of Copper Miners,

through which it involuntarily acquired a copper works.61

The rule is that there is no rule. One does not lend to insolvent banks,

except to avoid the mischief that would occur if the Lord Mayor of Lon-

don were to go bankrupt (1793),62 or to maintain for a time a payroll in

Newcastle, a town used to banking disasters.63 The Bank of France had

never discounted as much as 4 million francs for anyone but Jacques

Laffitte when Samuel Welles, an American banker, applied in 1837; he

proved to be an exception.64 (The Laffitte transaction had also been ex-

ceptional, with a political motivation.) The Conseil General could not

abandon such an important bank, so it received a line of credit of 15 mil-

lion francs.65 In the crisis of 1830 the Bank of France discounted royal

and municipal bonds, customs receipts, woodcutting receipts, obliga-

tions of the city of Paris, and canal bonds repayable by lottery.66

Some of the decisions that the lender of last resort must make are

easy, such as whether to discount Treasury bills. Some are difficult, such

as whether to take shaky collateral from shaky banks. The record is full

of firms that were refused help, failed, and paid off 20 shillings to the

pound, and of banks that were helped in one crisis but went down in the

next. The 241-page appendix to Evans’s book on the commercial crisis

of 1857 was devoted to court records of bankruptcies in Britain between

1849 and 1858. The reading is doleful. G.T. Braine, who was refused

accommodation by the Bank of England in 1848, paid 20 shillings to

the pound and ended up with a surplus double that originally estimated.

One also finds petitions in bankruptcy brought by the Bank, as against

Cruikshank, Melville and Co., for the unpaid residue of a bill it drew on

another bankrupt firm that had paid only 12s. 6d. to the pound.67

Even the judgment of history is not always helpful. The Bank of En-

gland first refused to help the three American ‘W banks’ (Wiggins,

Wilsons and Wildes) in the fall of 1836 and then relented and advanced

them credit in March 1837. Andr ́ ad` s noted that the Bank took a bold

e e

step and had no occasion to regret its courage.68 Clapham held on the

contrary that the Bank lent most reluctantly and was not surprised when

Wilsons and Wiggins failed at the end of May and Wildes thereafter and

the consequence was ‘a long, dreary tale of debt lasting 14 years.’69 To

Matthews, the Bank of England’s aid to the three banks ‘in the vain hope

of avoiding their suspending was a matter of faulty judgment but the

principle on which they operated was a sound one.’70

Who is the lender of last resort?

The lack of clear agreement in Great Britain about whether the Treasury
should relieve panics through the issue of Exchequer bills or whether
instead the Bank of England should discount freely at a penalty rate, even
if it is necessary to suspend the limits imposed by the Bank Act of 1844
has already been noted. Uncertainty about the answers to these questions
may be optimal, along with the question of whether the governmental
authorities will come to the rescue and whether they will arrive in time if
they decide to come. Thus there was no explicit provision for a lender of
last resort in Great Britain and no fixed rule as to which agency should fill
this role. In 1825 the Exchequer was not the selected agency. The task was
given resolutely to the Bank of England whose reluctant acceptance was
‘the sulky answer of driven men.’21 In 1890 guarantees were used rather
than the Bank or the Exchequer. Gradually the responsibility devolved
on the Bank, which led Alfred Marshall to write that ‘its directorate came
to be regarded at home and abroad as a committee of safety of English
business generally.’22
The Bank of France had agreed by the 1830s that it had responsibilities
in a crisis but it thought it had other responsibilities as well, such as
to ensure monopoly of the bank note circulation which permitted it
to let the regional banks fail in 1848 and then to convert them into
subsidiaries (comptoirs). The provinces had been fearful of Paris; they
wanted the privilege of note issue for their own regional banks because
of the concern that in a crisis Paris would take care of its own needs

at the expense of the regions. But after Le Havre acquired a bank, the

mistake was making too many illiquid industrial loans, including those

to shipyards and to importers of cotton when its price was falling. In

February 1848 the Banque du Havre made a trip to Paris. ‘The return was

not glorious. The Bank of France had been impitiable.’23 It refused to

lend on mortgages, saying, ‘The statutes forbid it, and you have refused

to accept a comptoir.’ 24

The Bank of France wavered over this question even as it wanted to

destroy the regional banks. From America, Chevalier observed that the

Bank of France had discounted freely in 1810, 1818, and 1826—with

Jacques Laffitte as governor for the first two years—making great efforts

to sustain commerce; but it lacked the same courage in the crisis of

1831–1832.25 In 1830, after the revolution, the task was left to local

authorities. A regional bank, conducted with honesty but not prudence,

threatened a provincial crisis. The local receiver general undertook to

discount its doubtful paper, apparently after consulting Paris, where,

Thiers testified, after ‘mature reflection the public interest was put above

that of the Finance Minister, M. Louis,’ ‘with happy results,’ that is, the

avoidance of the collapse of the bank and a resultant disturbance.26

After it achieved its monopoly of the note issue and the conversion of

the banks in the regions into branches of the Bank of France, the Bank

began to act as a lender of last resort. Its statutes required it to discount

only three-name paper; the task became one of producing acceptable

names. Sixty comptoirs d’escompte were established throughout France,

as well as a number of sous-comptoirs organized by various branches of

trade to hold stocks of goods and issue paper against them. With the

names of the merchant, the sous-comptoir, and a comptoir, the Bank of

France could discount the paper and relieve the liquidity crisis. Louis

Raphael Bischoffsheim of Bischoffsheim & Goldschmidt mocked the re-

quirement of three names: ‘The number is not important. With bad

signatures one can collect 10 instead of three. I prefer one good to 20

bad.’27 After the crisis was over, a number of the comptoirs were taken

over by bankers, merchants, and industrialists and became regular banks.

The most famous of this group the Comptoir d’Escompte de Paris took

its place among the leading banks in the country.28

The Cr ́ dit Mobilier of the Pereire brothers was not saved in 1868: on

e

this occasion, the Bank of France refused to discount its paper, which

might be interpreted as the revenge of the establishment on an outsider,

the Rothschilds against the Pereires who had once worked for them;29 as

punishment for not conceding the Banque de Savoie note issue to the

Bank of France when the Pereires took over the Savoy bank after the re-

gion had been ceded to France by Italy in 1860; or as the entirely normal

refusal of a lender of last resort to bail out an insolvent institution.30

Cameron accuses the Bank of France of conducting guerrilla warfare

against the Pereire brothers in the interest of a Rothschild-Pereire quar-

rel that went back to the 1830s.31

The Bank of France and Paris bankers again did not come to the res-

cue of the Union G ́ n ́ rale in 1882 but seven years later they rescued

e e

the Comptoir d’Escompte de Paris. Critics of the Bank of France ascribe

the difference in outcomes to venality. A less emotional position asserts

that a second large bank failure in seven years might have completely

destroyed the French banking system and that on this account Rou-

vier, the minister of finance, took the necessary measures to have the

Bank of France and the Paris banks advance 140 million to the Comp-

toir d’Escompte.32 In the Union G ́ n ́ rale operation, as was noted in an

e e

earlier chapter, the Paris banks withdrew from the speculative activity

when it began to peak in August 1881 and advanced 18.1 million francs

to the Union G ́ n ́ rale after the crash the following January to permit its

e e

more orderly liquidation rather than to save the bank.33 Led by the Roth-

schilds and Hottinguer, and including the Comptoir d’Escompte and the

Soci ́ t ́ G ́ n ́ rale (but not the Lyons rival of Bontoux, the Cr ́ dit Lyon-

ee e e

e

nais), the consortium represented the establishment, in which it was

not really necessary to distinguish the Bank of France from the leading

private banks (hautes banques) and deposit banks.

In Prussia the king was the lender of last resort in 1763. In 1848 various

state agencies, including the Prussian Bank, the Seehandlung, and the

Prussian lottery vainly tried to help the Cologne bank, A. Schaaffhausen,

before it was allowed to reorganize as a joint-stock bank. In the absence

of a central bank in 1763, 1799, and 1857 the Hamburg city government,

the chamber of commerce, and the banks—any and all leading agencies

took part in the rescue operation.

The experience of the United States is especially pertinent to the ques-

tion of the identity of the lender of last resort. There was some ambiguity

as to whether the First Bank of the United States and then the Second

Bank of the United States were lenders of last resort despite the des-

ignation of the Bank in each case as a chosen instrument. On various

occasions, the U.S. Treasury came to the aid of the banks by accept-

ing customs receipts in post-dated thirty-day notes (1792), by making

special deposits of government funds in the banks that were in trouble

(1801,1818, and 1819), and by relaxing the requirement that a com-

mercial bank pay the Bank of the United States in specie (1801).34 After

the failure to renew the charter of the Second Bank of the United States

in 1833, the U.S. Treasury was even busier, both before and after pas-

sage of the 1845 law that required the Treasury to keep its funds out

of the banks. In times of crisis and in periods of stringency caused by

crop movements, the U.S. Treasury would pay interest and/or principal

on its debt in advance, make deposits in banks despite the law, offer

to accept securities other than government bonds as collateral for de-

posits of government funds, or buy and sell gold and silver. Banks began

to look to the Secretary of the Treasury for help in an emergency and

to relieve seasonal tightness. In the fall of 1872, Secretary of the Trea-

sury George S. Boutwell served as a lender of last resort by reissuing

retired greenbacks—which may have been illegal. His successor, William

A. Richardson, did the same thing a year later.35

The U.S. Treasury could absorb money in deposits and pay out cash

surpluses it had acquired in previous periods but apart from the green-

back period it could not create money. For this reason, the Treasury

was unsatisfactory as a lender of last resort, unless it had previously had

budget surpluses and built up its holdings of cash. In 1907, when its

cash holdings were low, the Treasury issued new bonds—$50 million of

Panama Canal bonds, which were eligible for collateral for national bank

notes, and $100 million of 3 percent certificates of indebtedness—that

it hoped would entice existing cash and specie from hoards. In the end,

the crisis was averted by a capital inflow from Great Britain of more than

$100 million.36 Moreover, the devices used to cope with a crisis were

ad hoc. An analysis of the crisis of 1857 suggested that the Federal gov-

ernment was incapable of intervening effectively and that the public,

including the banks, was left without guidance to stem the crisis.37 In

fact intervention proved to be too much and too early.

The complex record of interference by the U.S. Treasury raises the

question of whether the market should not have regulated itself and, if

so, how. O.M.W. Sprague, the historian of the crises under the National

Banking System for the 1910 Aldrich Commission, believed that the

banks should have taken responsibility to ensure that they had enough

reserves to meet all needs.38 But Sprague was vague on which banks

should take this responsibility or why the duty fell on them in the ab-

sence of responsibility embodied in legislation. Noblesse oblige? Duty?

Several statements by Sprague indicate why a limited number of New

Bank regulation and supervision

Can financial crisis be forestalled by strict regulation and supervision?
Some observers advocate such an approach. Others recommend deregu-
lation. Most of the rules for sound banking are already incorporated in
the regulations or are implicit in banking tradition. Many of the rules
are ignored by banks and regulators alike. Banks are supposed to ‘mark
to market,’ that is, value their loans and investments each day (or week
or month) at the price that would be realized if they were sold in the
market rather than at their historic cost. Reserves should be established
against ‘problem loans’ and write-offs against ‘doubtful’ ones. As a bank’s
capital declines as its loan losses increase, the bank might be required to
raise more capital or be closed under the traditional rules. As an illustra-
tion of the unusual character of banks following these rules, the press
was full of the news in the spring of 1987 when Citicorp wrote down
the value of its Third World debt and the FSLIC allowed 500 insolvent
banks to remain open in the hope that they would become sufficiently
profitable to rebuild their capital. As part of the regulation process, the

Federal Reserve Board began to collaborate with other central banks in

the Group of Ten to strengthen bank structures worldwide by gradually

approaching uniform capital requirements and then risk-based capital

requirements.

Emphasis on capital requirements as a percentage of assets or other

liabilities has led some banks to switch to ‘off-balance sheet’ operations.

These transactions generate fees or commissions for the banks, but the

asset or liability is contingent or committed so that it is not shown on

the balance sheet except as a footnote. These off-balance sheet transac-

tions include interest rate and currency swaps, futures contracts, options,

underwriting risks, ‘repos’ (sales of securities with a guarantee to repur-

chase them at a later date), and note-issuing facilities. Each of these can

perhaps be valued as an option or warrant and included among assets or

liabilities when calculating the appropriate amount of required capital,65

but significant financial sophistication is required.

A strong case can be made for stricter regulations and supervision of

banks to forestall lending in euphoric periods that may end in finan-

cial crisis. Historical fact suggests that such a case rests on a counsel of

perfection. The bank examining system in the United States divides re-

sponsibility among the Comptroller of the Currency, the Federal Reserve

Banks, and the state banking commissioners. In one view there is compe-

tition not in deregulation but in reregulation.66 ‘Divided responsibility,’

said a famous German banker-politician, ‘is no responsibility.’67 The as-

tute personnel needed in time of emergency are unwilling to submit to

the boredom of long periods of calm. The mismanagement of banks is

hard to detect before a crisis. In boom, entropy in regulation and su-

pervision builds up danger spots that burst into view when the boom

subsides. The question then is whether to liquidate, stall, guarantee, bail

out, take over, or rely on other means of last-resort lending.

Lady Luck once worked effectively to assist a bank in distress. Wirth

wrote that the Brothers Kauffmann in Hamburg were failing during the

crisis of 1799 when one of the brothers sent his bride a Hamburg city lot-

tery ticket, which carried a first prize of 100,000 marks banco. She bought

the same number in another lottery in the Duchy of Mecklenburg, the

prize for which was an estate worth 50,000 Prussian thalers, then equal

to 100,000 marks banco. She won both, and the Brothers Kauffmann

were fully rehabilitated.68 The odds at Las Vegas may be higher for the

solution to a global crisis.

The hallmark in the development of ‘the Art of Central Banking’ over the

last two hundred years has been the evolution of the concept of a lender

of last resort. The expression comes from the French dernier ressort, and

centers on the last legal jurisdiction to which a petitioner can take an

appeal. The term now has become thoroughly anglicized, and in central-

banking English places the emphasis on the responsibilities of the lender

rather than the rights of the borrower or petitioner.

The lender of last resort stands ready to halt a run out of real assets and

illiquid financial assets into money by supplying as much money as may

be necessary to forestall the run; the concept is of an ‘elastic supply of

money’ that expands to meet the demand in panics. How much money?

To whom? On what terms? When?

These questions are those faced by the lender of last resort and follow

from the dilemma that if investors believe that banks and perhaps other

selected borrowers will be supported in moments of distress by a lender

of last resort, they will be less cautious in the extension of loans during

the next boom. The public good of the lender of last resort weakens the

responsibility of private lenders to ensure that they make ‘sound’ loans.

If, however, in a panic the rush from the sales of securities and com-

modities into money cannot be halted, the fallacy of composition takes

center stage. The sale of these assets by investors in the effort to min-

imize losses leads to declines in the asset prices, with the consequence

that a large number of otherwise previously solvent and well-capitalized

firms may become bankrupt.

The development of the lender of last resort evolved from the practice

of the market rather than from the minds of economists. Ashton asserted

that the Bank of England was already the lender of last resort in the eigh-

teenth century,5 although this pronouncement does not entirely square

with his statement that ‘long before the rules for the treatment of crises

were laid down by economists, it was recognized that the remedy [for

a financial crisis] was for the monetary authority (the Bank of England

or the government itself) to make an emergency issue of some kind of

paper which bankers, merchants and the general public would accept.

When this was done the panic was allayed.’6

The indecision as to whether the central bank or the government was

the final monetary authority remains to this day and qualifies the state-

ment that the Bank of England emerged as the lender of last resort in the

1700s. E.V. Morgan maintained that the Bank of England’s realization

of its responsibility was delayed by the government’s action in issuing

Exchequer bills in 1793, 1799, and 1811, and that the Bank assumed

the role as lender of last resort only gradually during the first half of the

nineteenth century ‘in spite of the opposition of theorists.’7 The same

evolutionary process can be seen in the Bank of France. In 1833 the ma-

jority of the Conseil General overrode Hottinguer’s idea for a policy on

the English model as well as Odier’s plea for an entirely new policy and

concluded that the major function of the Bank of France was to defend

the French franc. Capital outflows were not to be feared. Interest rates

should not be held artificially low or speculation will be encouraged

and crises intensified. When a crisis occurred, however, the Bank should

provide abundant and cheap discounts to moderate the intensity of the

crisis and shorten its duration.8

The role of the lender of last resort was not respectable among theo-

rists until Bagehot’s Lombard Street appeared in 1873, although Sir Francis

Baring called attention to the idea at the end of the eighteenth century 9

and Thornton’s classic, Paper Credit, developed both the doctrine and the

counter-arguments in his discussion of the financial problems of the En-

glish country banks.10 Bagehot traced the origin of the doctrine to David

Ricardo rather than to Baring and Thornton in his statement before the

Parliamentary Select Committee on Banks of Issue in 1875: ‘The ortho-

dox doctrine laid down by Ricardo is that there is a period in a panic

at which restrictions upon the issue of legal tender must be removed.’11

Bagehot himself had articulated the doctrine in his first published arti-

cle, written in 1848, when he commented upon the suspension of the

1844 Bank Act in the panic of 1847:

It is a great defect of a purely metallic circulation that the quantity

of it cannot be readily suited to any sudden demand . . . Now as paper

money can be supplied in unlimited quantities, however sudden the

demand may be, it does not appear to us that there is any objection on

principle to sudden issues of paper money to meet sudden and large

extensions of demand . . . This power of issuing notes is one exces-

sively liable to abuse . . . It should only be used in rare and exceptional

cases.12

Exchequer bills

One ancient device short of lending money to a firm in trouble was
to issue marketable securities to the firm against appropriate collateral.
(Of course, as the first part of this chapter indicated, when markets break
down, even the most liquid securities may not be sold readily.) The secu-
rities have been private and public; both types were part of the complex

package put together by Hamburg in 1857. In 1763 and 1799, in an

equally complex and jerry-built system of support, admiralty bills were

an integral feature.60 The widest development, however, concerned the

Exchequer bills issued in Britain in 1793, 1799, and (without enthusi-

asm) 1811, but sternly rejected in 1825.

The Exchequer bill was widely thought to have been the idea of Sir

John Sinclair, although it may have originated with the Bank of England.

On April 22, 1793, City leaders met with the Prime Minister, William

Pitt, to devise means to combat the crisis that arose from the failure of

100 of the 300 country banks and the calamitous decline in commodity

prices. The next day, eleven of their number met at the Mansion House

to formulate a scheme for state assistance. According to Clapham, there

was no clear guide to what ought to be done. In due course, the idea

emerged of having the government issue £3 million in Exchequer bills,

a total that was later raised by parliament to £5 million, to be issued to

merchants on the collateral of goods that they would deposit in the cus-

toms houses. An additional feature of the plan was to issue £5 notes—the

previous minimum was £10—to economize on the use of gold and silver

coin. The Exchequer bills were issued by special commissioners rather

than the Bank of England. Some £70,000 worth of these bills was imme-

diately sent to Manchester and an equal amount to Glasgow. The device

worked like a charm, according to MacPherson. Three hundred thirty-

eight firms applied for only £3 million of the total amount. A total of

£2.2 million was granted to 228 firms, only two of which subsequently

went bankrupt. Applications for more than £1.2 million were withdrawn

after the panic abated.61

In 1799 the panic in Hamburg had an echo in Liverpool, and Exche-

quer bills again were used. Parliament provided £500,000 in Exchequer

bills, used solely in Liverpool, against £2 million of goods stored in

warehouses.62

In 1811 the question arose again. A Select Committee on the State

of Commercial Credit was appointed. Among its members were Henry

Thornton, Sir John Sinclair, Sir Thomas Baring, and Alexander Baring.

The committee’s report, completed in a week, recorded the distress of

exporters to and importers from the West Indies and South America,

as well as the piles of goods bound for the Baltic that had been cut off

and stored in London warehouses, and recommended a new issue of

£6 million of Exchequer bills. Support was moderate in the House of

Commons because of the overtrading in Latin America; the opposition,

while sympathetic to the distress, doubted the wisdom of bailing out the

speculators. Huskisson, who later made his mark as the president of the

Board of Trade, claimed that the evil came from too easy credit:

Did gentlemen not see that the race of old English merchants, who

never could persuade themselves to go beyond their capital, was super-

seded by a set of mad and extravagant speculators, who never stopped

so long as they could get credit, and that persons of notoriously small

capital had now eclipsed those of the greatest consequence; so that

speculations now took place even in the lowest articles of commerce

. . . If the relief given was used for further speculation, it would only

aggravate the evil—and he feared that this might be done—in which

case the present measure would go only to add six million to the

circulation and to raise the prices of all our commodities.63

Smart gave the fullest account of the debate and noted that many criti-

cized the measure, though few were bold enough to deny it. In the end

the proposal passed, but few applications were made and only £2 million

was advanced. ‘Not many of those who were in embarrassed circum-

stances were able to furnish the desired security, and it is difficult to see

what remedy there was in being enabled, by advances, to produce more

goods when the radical evil was that there was no market for them.’64

Deposit insurance

Since 1934, federal deposit insurance in the United States has prevented
bank runs by providing an ex ante guarantee of deposits, limited orig-
inally to $10,000 but gradually increased to $100,000. The increase in
the upper limit on the amount of insurance on each deposit was said
by a knowledgeable bureaucrat to have been reached as a compromise
between a proposal in the U.S. House of Representatives to increase the
upper limit from $40,000 to $50,000 and a proposal in the U.S. Senate
for an increase from $40,000 to $60,000. When large banks, including
the Continental Illinois Bank in 1984 and the First Republic of Dallas
in 1988, got into trouble, the FDIC deliberately removed all limits on
the amounts of deposits covered by the guarantees to halt imminent
runs and so in practice it established that banks with significant deposits
over $100,000 were ‘too big to fail’ (although the shareholders of these

banks would probably lose all of their investments in the bank’s shares;

similarly the owners of the subordinated debt of these banks might lose

their investments). The deposits of the foreign branches of these banks

had implicitly become insured even though the banks had paid deposit

insurance premiums only against their domestic deposits. Although de-

posit insurance was designed to prevent bank runs by taking care of the

‘little man,’ with a deposit initially less than $10,000, this ceiling had in

practice been raised to the sky.56

The formal $100,000 maximum on the amount of a deposit that would

be insured gave rise to ‘deposit brokers’ who would arrange for the place-

ment of larger amounts of money into deposits of $100,000 or less, en-

suring that the depositor would be fully insured. John Doe could have

an insured deposit of $100,000, his wife Mary could also have an in-

sured deposit of $100,000, and together John and Mary could have a

third insured deposit of $100,000. And the Does could follow the same

strategy with the bank across the street. The effect of this innovation

was that it provided a guarantee to wealthy individuals and hence cir-

cumvented one purpose of the ceiling. Moreover it encouraged banks to

make riskier loans since they were confident that they were protected

against runs—if these riskier loans proved profitable, the owners of the

banks would benefit and if the loans went into default, the owners would

not have to worry about bank runs (although the market value of their

own shares might decline and even become worthless).

The implosion of the bubble in Japan in the 1990s caused the value of

the loans of the banks headquartered in Tokyo and Osaka and various

regional centers to decline sharply below the value of their liabilities.

Nevertheless, there were no bank runs, the depositors were confident

that they would be made whole by the government if any of the banks

were closed.

Deposit insurance has limited both bank runs and contagion in the

runs from one troubled bank to other banks in a neighborhood. What

accounts for the reluctance to provide insurance at an earlier date?

In the long tradition of the United States, free banking, even wildcat

banking, was the rule. Anyone could start a bank, and many did. Risks

were large, banker turnover rapid. A guarantee of bankers’ deposits would

have constituted a license to speculate, if not embezzle, and would have

removed the threat of withdrawal of deposits, which was the major check

on the irresponsibility of bankers. Deposit guarantees were rejected as

conducive to bad banking as late as March 2, 1933, when the Board of

Governors of the Federal Reserve was not prepared to recommend such

a guarantee, or any other measures, on the eve of the national bank

holiday.57

The Federal Deposit Insurance Corporation had an excellent financial

record until the 1970s; the deposit insurance premiums that it collected

were much higher than the amount it paid out on bank failures. From

the beginning in 1934 through 1970, only one bank with deposits of

more than $50 million had failed, and most failures were of banks with

deposits of less than $5 million. The FDIC had in most cases arranged

for takeovers of the failed banks so that the few depositors with deposits

above the maximum insured amounts did not incur losses.

Beginning in the late 1970s the problems of the FDIC and those of

the Federal Savings and Loan Insurance Corporation (FSLIC) mounted

sharply. The FDIC rescued a considerable number of banks including

two giants, the Continental Illinois of Chicago and the First Republic

Bank of Dallas; honoring the deposit insurance guarantee cost these

agencies billions of dollars. The usual operating procedure was to close

the bank or the thrift institution when its capital had been depleted,

and then to carve a ‘good bank’ from the rescued institution while the

remaining assets of the failed institution would be retained for eventual

sale by another newly-created government agency, the Resolution Trust

Corporation (RTC). Both the insurance agencies incurred large losses in

honoring their guarantees; eventually they would obtain the funds to

pay for these losses by borrowing from the U.S. Treasury. In the early

1990s, the estimates were that the total losses to the U.S. taxpayers would

amount to $150 billion but the pick up in the growth rate of the U.S.

economy meant that the RTC received more money than anticipated

from the sale of collateral and bad loans so the losses totaled about $100

billion.58 There was some question whether a portion of this cost to the

taxpayers could be reduced by increasing the insurance premiums on

bank deposits—a suggestion resoundingly opposed by sound banks.59

The Hamburg crisis of 1857

The background of the crisis of 1857 in Hamburg was that trade had
expanded, particularly because the Crimean War had led to an expansion
of credit. Hamburg was the ‘all-English’ city of Germany, but had close
relations with the United States in sugar, tobacco, coffee, and cotton,
and with Scandinavia. When the deflationary tidal wave swept across the
Atlantic, Hamburg was inundated. The panic touched off by the failure of
Ohio Life on August 24 arrived in Hamburg three months later (following
price declines of 30 percent) with the suspension of Winterhoff and
Piper, a firm that was engaged in the American trade.45 Daily dispatches
from the British consulate in Hamburg by date tell the story:
November 21: Some of the leading merchant houses and two banks
plan for relief.
November 23: Two major houses engaged in the London trade fail,
and the Discount Guarantee Association grows more cautious in en-
dorsing Hamburg bills.46 On one authority the Discount Guarantee
Association is exhausted in three days.47

November 24: A Discount Guarantee Association (Garantie-

Diskontverein) is formed, initially with a capital of 10 million marks

banco, later raised to 13 million (about £1 million), of which the

sum of 1 million marks is to be paid in immediately.

November 28: The chamber of commerce and leading merchants

induce the senate to call parliament (B ̈ rgerschaft) to arrange to

u

issue government bonds in order to lend 50 to 662/3 percent of the

value of hypothecated goods, bonds, and shares to merchants in

distress.

December 1: With the suspension of Ullberg and Cremer, ten to

twelve houses in the Swedish trade have gone down. The Discount

Guarantee Association will not issue any more guarantees. Business

is at a standstill.

December 2: A suggestion is made to change the laws of bankruptcy

to enable creditors to share in attachment of goods.

December 7: A proposal is made to establish a state bank for dis-

counting good bills to the amount of 30 million marks banco (about

2

£2.4 million). The bank would advance government bills bearing 6 3

percent interest on mercantile bills of exchange. Parliament rejects

this, wanting instead to issue 30 million marks banco of paper cur-

rency as legal tender. The senate rejects this, insisting on clinging

to the silver standard.

In the end, a compromise was reached for a State Loan Institute fund

of 15 million marks that included 5 million marks banco of Hamburg

government bonds and 10 million in silver to be borrowed abroad.48

The story of the silver train (Silberzug) is recounted in Chapter 12 as an

example of an international lender of last resort.

One observer totaled the sums available for rescue operations to 35

million marks banco, which included 15 million in the Discount Guar-

antee Association, 15 million in the State Loan Institute, and 5 million

from the chamber of commerce. He compared this amount with 100

million marks banco of protested bills and noted that if merchants spec-

ulated with capital equal only to one-sixth the value of their goods, a 17

percent decline in prices of these goods would be sufficient to wipe out

their capital position. To the suggestion that the senate was 300 years

behind the times, he reported with approval the senate’s answer: The

merchants have been 300 years ahead of the times in issuing debt. State

help in these cases, he insisted, merely means assistance for speculation

and perpetuation of higher prices at the cost of the consumer.49

The most famous guarantee of liabilities was that worked out by William

Lidderdale when he was Governor of the Bank of England during the

Baring crisis of 1890. Similar guarantees had occurred earlier in Great

Britain. In December 1836 the private bank Esdailes, Grenfell, Thomas

and Company, which served as London agents for seventy-two country

banks, was in financial difficulties. The view was that this firm could not

be allowed to fail because of its relationships with the country banks;

moreover, its paper included all the best names in the City. The assets

of the bank far exceeded its liabilities, and the London bankers offered

guarantees. The Bank of England led the list with £150,000. Esdailes

survived, but only for two years.50

The guarantee was worked out as an alternative to a letter of indemnity

that permitted suspension of the Bank Act of 1844. The letter was offered

by the Chancellor of the Exchequer, Lord Goschen, to Lidderdale, who

refused on the ground that ‘reliance on such letters was the cause of a

great deal of bad banking in England.’

If Lidderdale refused to quiet the market by the usual means that

had been employed in 1847, 1857, and 1866, he was not one to let the

market take its medicine. In August 1890 he warned Baring Brothers that

the firm would have to moderate its acceptances for its Argentine agent,

S.B. Hales. Baring Brothers revealed its acute distress to Lidderdale on

Saturday, November 8. Fearful of a panic when Barings’ condition was

made public, the Bank of England met with the Exchequer on Monday,

November 10, turned down the letter of indemnity, prepared for the

problem by seeking assistance from foreign countries (a subject for

Chapter 12), and formed a committee headed by Lord Rothschild to

address the question of the large overhang of Argentinean securities in

the market.

Clearinghouse certificates

The major device used in the United States to cope with bank runs prior
to the creation of the Federal Reserve System was the clearinghouse cer-
tificate, which is a near-money substitute that was the liability of a group
of large local banks. A bank subject to a run could pay the departing de-
positors with these clearinghouse certificates rather than with coin. The
New York clearinghouse was established in 1853 and the one in Philadel-
phia in 1858 after the panic of 1857. During the panic of 1857, New York
banks failed to cooperate to halt the run. The Mercantile Agency of New
York took the position that if four or five of the strongest banks had
come to the assistance of the Ohio Life and Trust Company, enabling
it to meet its obligations, the business and credit of the country would
have been preserved.36 By 1873 the New York banks were ready to accept
payment on cleared checks in clearinghouse certificates rather than in
currency or bank notes. The advantage of the use of these certificates was
that the incentive for any bank to bid deposits away from its competitors
was reduced. Sprague insisted that this system had to be accompanied
by an agreement to pool bank reserves; otherwise, a bank that was not
subject to a net drain might be forced to suspend payments after it paid
cash to its own depositors if it had not received cash in settlements from
other banks.37 In 1873 reserves were pooled.
One serious drawback of clearinghouse certificates was that they were
acceptable only in the local area—New York, Philadelphia, Baltimore.
Thus these certificates helped maintain domestic payments such as pay-
rolls and retail sales within a city but they dampened the effective flow of

payments between cities. In the 1907 panic, 60 of the 160 clearinghouses

in the United States adopted clearinghouse certificates to facilitate local

payments. Nevertheless Sprague claimed that the dislocations of the

domestic exchanges were no less complete and disturbing than on pre-

vious occasions. The prices of New York funds in Boston, Philadelphia,

Chicago, St. Louis, Cincinnati, Kansas City, and New Orleans between

October 26 and December 15, 1907 varied from a discount of 1.25 per-

cent in Chicago on November 2 to a 7 percent premium in St. Louis on

November 26, an increase from 1.5 percent the previous week.38 In De-

cember 1907 Jacob H. Schiff wrote: ‘The one lesson we should learn from

recent experience is that the issuing of clearinghouse certificates in the

different bank centers has also worked considerable harm. It has broken

down domestic exchange and paralyzed to a large extent the business of

the country.’39

Other devices of the same general character were clearinghouse checks

and certified checks that were both close substitutes for money and

increased the means of payment in circulation.

Nonbank groups can also organize to mitigate a panic. Consider, for

example, the stock market consortium. On October 24, 1907, a bankers’

pool, headed by J.P. Morgan, loaned $25 million at 10 percent in call

money in an attempt to stem the collapse of the stock market.40 Twenty-

two years to the day later, on Black Thursday in 1929, Richard Whitney

went from post to post on the floor of the New York Stock Exchange and

placed bids to buy stocks on behalf of a syndicate headed once again by

J.P. Morgan and Company.41

Banks have also collaborated through rescue committees (as in Vienna

in May 1873 and earlier), loan funds, funds for guarantees of liabilities,

arranged mergers of weak banks and firms, and other devices whereby

the strong banks support the weak and failing banks.42 Three examples

include the role of the Paris banks in the 1828 crisis in Alsace, various

devices employed by Hamburg in meeting the difficulties of 1857, and

the Baring Brothers loan guarantee of 1890.

Three firms in textiles failed in December 1827 at Mulhouse. The Paris

banks then refused to accept any Alsatian paper, and the Bank of France

set a limit of 6 million francs on the amount it would support, a figure

‘scarcely the fortune of two Alsatian houses.’ The Bank of France then

decided against accepting any paper with Mulhouse or Basel endorse-

ments and that decision precipitated a panic. On January 19 two more

Mulhouse merchants failed. On January 22 in Paris there were rumors

of the failure of two Schlumberger firms. The Paris banks sent Jacques

Laffitte as an emissary to Mulhouse; he arrived on January 26 and offered

to lend 1 million francs on the consignment of merchandise. Before he

came, however, two textile merchants, Nicholas Koechlin and Jean Doll-

fuss, had left Mulhouse for Paris. To raise cash, these merchants had been

selling inventories on the market at discounts of 30 to 40 percent from

the traditional market prices for these goods. Nine houses failed from

January 26 to February 15. L ́ vy-Leboyer wrote that it could have been

e

worse. At the last minute a syndicate of twenty-six Paris banks, presided

over by J.-C. Davillier, extended a credit of 5 million francs to Koechlin

and Dollfuss, who returned to Alsace on February 3 and distributed 1 mil-

lion francs to those of their colleagues who offered guarantees and kept

4 million for themselves. These measures restored confidence.43 Those

who qualified for neither the Koechlin-Dollfuss fund nor Basel money

failed.44

Moral suasion and other exhortatory devices

The dominant argument against the a priori view that panics can be
cured by being left alone is that they almost never are left alone. The
authorities feel compelled to intervene. In panic after panic, crash after
crash, crisis after crisis, the authorities or some ‘responsible citizens’ try
to halt the panic by one device or another. The authorities may be un-
duly alarmed and the position might correct itself without serious harm.
The authorities may be stupid and unable to learn. (The Chicago School
assumes that the market participants are always more intelligent than the
authorities, in large part because the authorities are motivated by short-
term political objectives.) The uneven distribution of intelligence cannot
be tested against crisis management because authorities and leading fig-
ures in the marketplace both exert themselves in the same direction to
halt the spread of falling prices, bankruptcy, and bank failures. If there
is a learning process at work—and the assumption of rationality requires
one—the lesson has been that a lender of last resort is more desirable
and less costly than relying exclusively on the competitive forces of the
market.
One insight from the historical record is that there are many examples
when the authorities initially were resolved not to intervene but eventu-
ally reluctantly did so. Lord Liverpool threatened to resign as Chancellor

of the Exchequer in December 1825 if an issue of Exchequer bills was

provided to rescue the market after he had warned against excessive spec-

ulation six months earlier.22 William Lidderdale, Governor of the Bank

of England at the time of the Baring crisis, refused categorically to accept

a ‘letter of indemnity’ to permit the Bank to exceed its lending limit.23

On both occasions face was saved by finding some other approach to

avert the panic. The initial strong moral stand not to intervene was re-

versed on many other occasions as the panic escalated. These included

the intervention of Frederick II in the Berlin crisis of 1763,24 the Bank of

England’s refusal to discount for the ‘W banks’25 and the U.S. Treasury’s

decision in 1869.26

In a run, each depositor rushes to get his or her money from the bank

before the bank is forced to close because its money holdings have been

exhausted. Banks are often reluctant to pay the depositors because their

money holdings are always much smaller than their short-term deposit

liabilities. During the Great Depression, banks took their time to pay

off depositors, hoping, like Micawber, for something to turn up. The

technique goes back to the eighteenth century.

Mcleod’s Theory and Practice of Banking describes how the Bank of

England defended itself in September 1720 against a run brought on by

its reversal of a promise to absorb the bonds of the South Sea Company

at £400. The Bank organized its friends in the front of the line and paid

them off slowly in sixpence coins. These friends brought the cash back to

the Bank through another door. The money was deposited, again slowly

counted, and then again paid out. The run was staved off until the feast

of Michaelmas (September 29). When the holidays were over, so was the

run, and the Bank remained open.27

A second story, which may well have the same origin and is likely

to be more accurate, is that the Sword Blade Bank, a supporter of the

South Sea Company, resisted attempts to redeem its paper with silver

coins. When the run started on September 19, the bank brought up

wagonloads of silver that it paid out ‘slowly in small change.’ One de-

positor is reported to have received £8,000 in shillings and sixpences

before the bank closed its doors on Saturday September 24.28 The cir-

cumstances suggest one story; the dates, two. Since the Sword Blade

Bank and the Bank of England were mortal enemies, it is unlikely they

cooperated.

The lessons of 1720 were not lost on the Bank of England a quarter cen-

tury later. The Young Pretender (Charles Edward, grandson of James II)

landed in Scotland in July 1745, unfurled his banner in September,

invaded England in November, arrived in Carlisle on November 15,

and reached Derby on December 4. Panic broke out on Black Friday,

December 5, 1745. British consols fell to 45, the lowest price on record,

and a run began on the Bank of England. The Bank resisted, partly by

paying off its notes in sixpence coins. The time gained was used to in-

duce London merchants to proclaim their loyalty and readiness to accept

Bank of England notes. The second half of the prescription, collecting

pledges of faith in notes, was used again in similar circumstances when

the French landed at Fishguard in 1797. On that occasion, 1,140 signa-

tures of merchants and investors in government stock were collected in

a single day.29 The time gained in 1745 by both the slow payout and the

petition of support enabled the government to organize the army that

defeated the Young Pretender at Culloden in April 1746.

One way to stop a panic is to stop trading by closing the market. Trading

on the New York Stock Exchange was halted in 1873, and in London

and many other cities at the outbreak of war in 1914. In both cases the

motivation was to stop a run by providing the market participants with

more time to think through whether it was necessary or desirable to sell

at what were almost certainly depressed prices.

However, shutdowns may drive the trading underground and intensify

the panic. Moreover, short-run and long-run goals are in conflict. Closing

the stock market during one panic may exacerbate the next, as investors

sell their stocks or withdraw their money from the call money market

because they are fearful that trading will be halted. The New York Stock

Exchange was closed in a panic in September 1873, but a financial editor

suggested that fear that trading on the exchange might be halted in

October 1929 was a factor in hastening the withdrawal of call money by

out-of-town banks and other market participants.30 The closing of local

stock exchanges in Pittsburgh and New Orleans for two months in 1873

had fewer serious consequences, since they traded only the securities of

the local firms that had brought on their difficulties.31

The New York Stock Exchange and the other stock exchanges in the

United States were closed for a week after the bombing of the World

Trade Center towers on September 11, 2001 because the communications

and the technical support systems were inoperative. Many of the same

securities could have been traded on the regional stock exchanges in the

United States but these exchanges would have been overwhelmed.

The declaration of a legal holiday by the government is another tech-

nique for closing the market, which was used during the panic of 1907 in

Oklahoma, Nevada, Washington, Oregon, and California.32 The device

was the forerunner of the bank holidays that started at the local level in

the fall of 1932 and were generalized throughout the country on March

3, 1933, the day that Franklin D. Roosevelt was inaugurated as president.

(A bank holiday closes only the banks, while a legal holiday shuts down

all business.)

Another device is to suspend the publication of bank statements, as

in 1873, in the hope that ‘what you don’t know won’t hurt you.’ The

technique was designed to hide the large losses of reserves of a few banks

since the fear was that accurate news would further reduce depositor

confidence.33

Some commodity and financial markets set daily limits on the maxi-

mum change in prices; when the limit is reached, trading is suspended

for the rest of the day. Specialists in individual stocks have often taken

a ‘time out’ whenever the imbalance between the buy orders and the

sell orders has been exceptionally large. This ‘circuit breaker’ was rec-

ommended for U.S. stock markets after the meltdown of Black Monday,

October 19, 1987. The proposal for the New York Stock Exchange was

to postpone trading for a stated interval—such as twenty minutes—in

those stocks whose prices increased above or declined below the limit.

Time has been gained by moratoriums on payment of all debts or on

particular types of obligations, such as bills of exchange that have less

than two weeks to run. The most ubiquitous measure of this sort is that

the bank examiners ignore bad loans in the portfolios of banks as long as

they can, an implicit moratorium on marking the loans to their market

value. Regulatory forbearance was used in the U.S. savings and loan

debacle in the 1980s. The International Monetary Fund and the World

Bank continued to allow the indebtedness of many of the poor African

countries to increase by the amount of the interest that was due; if these

institutions had declared the loans in default, they would have had to

recognize the losses on the loans. The banks that were the lenders to the

Real Estate Investment Trusts (REITs), landlords of mortgaged shopping

centers and the owners of mothballed Boeing 747s allowed the interest

due on their bank loans to compound because they wanted to delay the

recognition of the losses on these loans to a more propitious moment

when their own capital would be larger. But the lenders need forbearance

from the bank examiners.

Official moratoriums may be less effective than informal ones, how-

ever. A moratorium on the settlement of differences in payments due on

the 1873 Vienna Stock Exchange lasted a week, from the stock market

collapse to May 15. A guarantee fund of 20 million guilden was put to-

gether by the Austrian National Bank and the solid commercial banks;

these imitations of earlier measures were of little assistance.34 Another

moratorium was noted in Paris after the July Monarchy when the mu-

nicipal council decreed that all bills payable in Paris between July 25

and August 15 should be extended by ten days. This moratorium ster-

ilized the commercial paper in banking portfolios and did nothing to

discourage a run by holders of notes, who demanded coin.35

Letting It Burn Out, and Other Devices

If many financial crises have a stylized form, should there be a stan-
dard policy response? Assume plethora, speculation, panic; what then?
Should the governmental authorities intervene to cope with a crisis and
if so at what stage? Should they seek to forestall increases in real estate
prices and stock prices as the bubble expands so the subsequent crash
will be less severe? Should they prick the bubble once it is evident that
asset prices are so high that it is extremely unlikely that increases in
rents and in corporate earnings will be sufficiently rapid and large so as
to ‘ratify’ these lofty prices? When asset prices begin to fall, should the
authorities adopt any measures to dampen the decline and ameliorate
the consequences?
Virtually every country has established a central bank to prevent or
minimize shortages of liquidity, especially during a financial crisis. Many
countries have some type of deposit insurance arrangement to reduce
the likelihood that there might be a run on their domestic banks, and to
forestall what otherwise could be a self-fulfilling prophecy that a shortage
of liquidity would trigger a solvency crisis. Even when there is no formal
insurance for bank deposits, the citizens of many countries believe that
their governments have become committed to ensuring that they will
not incur losses if the banks should fail.
This chapter and the next two center on the management of financial
crises. This chapter initially considers the view that the best remedy
for panic is to ‘leave it alone’—to let it run its course, and to allow the
economy to adjust to the decrease in household wealth that follows from
the declines in prices of real estate, stocks, and commodities.
The primary rationale for noninterference is the moral hazard that
the more interventionist the authorities are with respect to the current

crisis, the more intense the next bubble will be, because many of the

market participants will believe that their possible losses will be limited

by government measures. The moral hazard argument is that interven-

tion skews the risk and reward trade-off in the minds of many investors

by reducing both the likelihood and the scope of future losses.

A variety of policy measures that have been used to minimize the

impacts of the decline in asset prices are considered, followed by a dis-

cussion of the measures that might be adopted to forestall the panic by

dampening the development of the mania. The next chapter focuses on

the lender of last resort in a domestic context and the following one on

the lender of last resort in an international context.

Many economists take the view that the panic will work its own cure, and

that ‘the fire can be left to burn itself out.’1 ‘Cool if not very imaginative

heads in the Bank [of England] parlour thought it in the nature of panics

to exhaust themselves.’2 Lord Overstone maintained that support of the

financial system in crisis is not really necessary because the resources of

the system are so great that even in times of the utmost stringency those

that offer a sufficiently high rate of interest could borrow a large amount

of money.3 In 1847 an increase in the private rate of discount to 10 and

12 percent in London stopped the flow of gold to the United States; a

small sloop was sent to overtake a ship that had already sailed for New

York and got it to turn around and unload £100,000 in gold.4 Testify-

ing before the 1865 French Enquˆte (inquiry) into monetary circulation,

e

Baron James de Rothschild stated that increases in interest rates could

be relied upon to reduce speculation in commodities and securities. He

added: ‘If speculators could find unlimited credit, one can’t tell what

crises would ensue.’5

The moral hazard problem is that policy measures undertaken to pro-

vide stability to the system may encourage speculation by those who

seek exceptionally high returns and who have become somewhat con-

vinced that there is a strong likelihood that government measures will

be adopted to prevent the economy from imploding—and so their

losses on the downside will be limited. A ‘free lunch’ for the spec-

ulators today means that they are likely to be less prudent in the

future. Hence the next several financial crises could be more severe.

The moral hazard problem is a strong argument for nonintervention as

a financial crisis develops, to reduce the likelihood and severity of crises

in the future. Will the policymakers be able to devise approaches that

penalize individual speculators while minimizing the adverse impacts of

their imprudent behavior on the other 99 percent of the country? Even

then the cost-benefit question is whether the benefit to the economy

from not allowing the panic to run its course is worthwhile in terms of

the undeserved reward to the speculators.

The view that a panic should be allowed to pursue its course has two el-

ements. One element takes pleasure, or schadenfreude, in the troubles that

the investors or speculators encounter as retribution for their excesses;

this somewhat puritanical view welcomes hellfire as the just deserts for

the excessively greedy. The other sees panic as a thunderstorm ‘in a

mephitic and unhealthy tropical atmosphere’ that clears the air. ‘It puri-

fied the commercial and financial elements, and tended to restore vitality

and health, alike conducive to regular trade, sound progress and perma-

nent prosperity.’6 One powerful statement of this position was made

by Herbert Hoover as he characterized—without approval—the view of

Andrew Mellon:

The ‘leave-it-alone liquidationists’ headed by Secretary of the Trea-

sury Mellon felt that government must keep its hands off and let the

slump liquidate itself. Mr. Mellon had only one formula: ‘Liquidate

labor, liquidate stocks, liquidate the farmers, liquidate real estate.’ He

insisted that when the people get an inflationary brainstorm, the only

way to get it out of their blood is to let it collapse. He held that even

panic was not altogether a bad thing. He said: ‘It will purge the rot-

tenness out of the system. High costs of living and high living will

come down. People will work harder, live a moral life. Values will

be adjusted, and enterprising people will pickup the wrecks from less

competent people.’7

The neo-Austrian economic historian Murray Rothbard added: ‘While

phrased somewhat luridly, this was the sound and proper course for

the administration to follow.’8 The conservative historian Paul Johnson

commented: ‘It was the only sensible advice Hoover received during his

presidency.’9

The opposing view conceded that while it is desirable to purge the

system of bubbles and manic investments there is the risk that a de-

flationary panic would spread and wipe out sound investments by the

nonspeculators who would not be able to obtain the credit they need to

survive.