Arresting Financial Crises: The Fed Versus the Classicals

Levy Economics Institute, Working Papers Series

19 Pages Posted: 6 Feb 2013

See all articles by Thomas M. Humphrey

Thomas M. Humphrey

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: February 5, 2013

Abstract

Nineteenth-century British economists Henry Thornton and Walter Bagehot established the classical rules of behavior for a central bank, acting as lender of last resort, seeking to avert panics and crises: Lend freely (to temporarily illiquid but solvent borrowers only) against the security of sound collateral and at above-market, penalty interest rates. Deny aid to unsound, insolvent borrowers. Preannounce your commitment to lend freely in all future panics. Also lend for short periods only, and have a clear, simple, certain exit strategy. The purpose is to prevent bank runs and money-stock collapses — collapses that, by reducing spending and prices, will, in the face of downward inflexibility of nominal wages, produce falls in output and employment. In the financial crisis of 2008-09 the Federal Reserve adhered to some of the classical rules — albeit using a credit-easing rather than a money stock–protection rationale — while deviating from others. Consistent with the classicals, the Fed filled the market with liquidity while lending to a wide variety of borrowers on an extended array of assets. But it departed from the classical prescription in charging subsidy rather than penalty rates, in lending against tarnished collateral and/or purchasing assets of questionable value, in bailing out insolvent borrowers, in extending its lending deadlines beyond intervals approved by classicals, and in failing both to precommit to avert all future crises and to articulate an unambiguous exit strategy. Given that classicals demonstrated that satiating panic-induced demands for cash are sufficient to end crises, the Fed might think of abandoning its costly and arguably inessential deviations from the classical model and, instead, return to it.

Keywords: Lender of Last Resort, Financial Crises, Bank Panics, Bank Runs, Bailouts, Penalty Rates, Collateral, High-Powered Monetary Base, Broad Money Stock, Multiplier, Federal Reserve Policy, Liquidity, Insolvency, Emergency Lending, Credit Risk Spreads, Systemic Risks, Classical Economists

JEL Classification: E44, E51, E58

Suggested Citation

Humphrey, Thomas M., Arresting Financial Crises: The Fed Versus the Classicals (February 5, 2013). Levy Economics Institute, Working Papers Series, Available at SSRN: https://ssrn.com/abstract=2212175 or http://dx.doi.org/10.2139/ssrn.2212175

Thomas M. Humphrey (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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