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.