What Have We Learned Since Bagehot?

Lessons from the time before there was a Fed

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Posted in 2007-08 Financial Crisis, History of economics Tagged with: , ,

Ben Bernanke told an attentive Brookings Institution audience earlier this month, that, after he became chairman of the Federal Reserve Board, in 2006, “Literally one of the first things I did was to ask the staff to give me the handbook or what you do in the case of a financial crisis, and they provided me a little notebook, typed on a manual typewriter and mimeographed, about four pages in it, and it said, ‘Open the discount window.’ And that was about it…. Tim Geithner had a similar experience at the New York Fed, and so we went into one of the complicated and consequential crises in human history with very little in the way of playbook for thinking about how to address the crisis.”

The Brookings conference earlier this month, organized by Bernanke, former Federal Reserve Bank of New York President Geithner, and former Treasury Secretary Henry Paulson, showcased fifteen technical papers written by their lieutenants about the problems they faced and, to some degree, solved, during five desperate weeks in the autumn of 2008. Meanwhile, Bernanke, Geithner and Paulson contributed an op-ed article to The New York Times forcefully pointing out that Congress had stripped future crisis managers of several of the powers that proved crucial in the last.

A central lesson is that the next global financial crisis won’t be like the last. The reason is that financial innovation proceeds within the regulatory framework no matter what, until at some point the authorities face a landscape so different from the expected one as to be essentially unfamiliar. “Open the discount window,” the general principle that animated central banks and treasuries in the 2008 panic, is a shorthand expression of Walter Bagehot’s dictum of 1873 for the Bank of England – lend freely to troubled institutions, at a slight penalty rate, against good collateral. The authorities learned in 2008, as they struggled to make sense of sale and repurchase agreements (repo), different forms of commercial paper, derivative securities, and stock-lending practices, that there must be something more to engineering “bailouts” than that.

A perspicacious friend last week asked, as policy–makers might ask their staffs in leisured times, for the name of a book on the history of “monetary events” in the US and how they shaped the evolutions of monetary institutions and policies. She wanted to know more about such events as the 1907 panic that was mentioned here last week.

As it happens, that book appeared last Friday. Fighting Financial Crises: Learning from the Past (University of Chicago, 2018), by Gary Gorton and Ellis Tallman (University of Chicago), is a vital addition to crisis literature because it compares what happened in 2008 to the ways in which US bankers dealt with panics on their own in the years before there was a Fed.

Gorton is an economic historian who, with director Andrew Metrick, founded the Center for Financial Stability at Yale University’s School of Management, which co-sponsored the Brookings project with the Hutchins Center for Fiscal and Monetary Policy. Tallman is research director of the Federal Reserve Bank of Cleveland. Gorton and Tallman pursued their graduate studies, years apart, at the University of Rochester, whose economics department has traditionally emphasized the connection between theory and practice.

Their collaboration started as a lengthy study of the panics of the US National Banking era, 1863-1914, both their sources and the means taken to combat them. Those fifty years constitute, they write, a laboratory in which to differentiate, for example, “between arguments that government policies cause financial crises (e.g. moral hazard, ‘too-big-to-fail,’ etc.) from the underlying causes that the government policies aim to address.”   They soon realized they couldn’t demonstrate cause and effect by the high standards of present-day econometric practice. Hence the book instead of a paper, history instead of statistics.

The authors trace the development of clearing house associations, owned by member bank, from their roots in eighteenth-century England. Originally no more complicated than daily luncheon meetings at which representatives of member banks “cleared, or settled, claims made on one another by their customers and reconciled accounts. By the nineteenth century, banks were no longer paying currency and coin across the table. They had devised certificates to settle claims within the clearing house – short term IOUs.

After the Panic of 1866, the second such event to spread internationally (1857 was the first), journalist Bagehot (he was editor of The Economist) wrote Lombard Street: A Description of the Money Market to convince the Bank of England that it must take over responsibility for the suppression of panics when they occurred,  as “the lender of  last resort.” He succeeded, and the Panic of 1893 was well contained in Britain, though it produced a serious depression in the United States, where the clearing house associations had continued to do their best. Bankers learned many lessons along the way.

Twice before the US Congress had created a central bank to manage the American banking system; twice their charters had been allowed to expire amid arguments about the merits of centralization and local control. The Panic of 1907, a three-week event in which the stock market fell fifty percent, was the last straw.  This time the baffling feature was the role of the newly-invented trusts. The crisis, which began with the failure of New York’s Knickerbocker Bank, the city’s third largest, spread across the nation as depositors lined up to withdraw their funds from regional banks, and small country banks simply closed their doors. Only after J.P. Morgan organized a syndicate of his fellow bankers was the New York Association able to quell the rampant fear. The financial system became orderly.. Five years later Congress established the Fed.

Gorton and Tallman narrate all this in a dozen chapters with surprising clarity, drawing perspectives from history on the modern crisis, illuminating lessons learned after 2008 by showing how they were intuitively understood by practitioners of an earlier day.  In a concluding chapter they offer five “guiding principles” for dealing with financial crises in the future.

Find the short-term debt. Manage the information environment (that is, suppress bank-specific information). Open emergency lending facilities (that is, follow Bagehot’s rule). Prevent systemically important institutions from failing during the crisis. And consider that certain laws and regulations need not be applied during a financial crisis.

All of these were applied in 2008, though seldom masterfully.  It took more than two weeks for the Treasury Department to come up with a plan to render opaque the condition of the banking system overall – by forcing healthy banks to accept emergency TARP loans along with the weak. Secrecy had been no part of Bagehot’s playbook, perhaps because discretion was so deeply embedded in British banking traditions as to be taken for granted.  Regulators had to find a way to reinvent a practices that had been a standard part of the clearing house playbook. With illustration, analysis, and nuance on every page, Fighting Financial Crises is one hundred and fifty years better than Lombard Street.