>Ben’s Bastardization of Bagehot


“[T]o avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates.'”

These are the words of Walter Bagehot, a Brit famous for his work and writings about economics and specifically about “Lenders of last resort” or Central Banks.

Bagehot has five basic dictums to avert a panic:

Lend Early
Lend Freely (without limit)
Lend to Solvent Firms
Lend against Good Collateral
Lend at High Rates

Bagehot is often referred to by central bankers when bailing out financial institutions and he has been quoted by Bernanke in the past, it is clear that Bernanke (Federal Reserve Chairman) has been influenced by Bagehot.

The question really becomes, is Ben Bernanke following the Bagehot dictums or bastardizing them?

I vote for the latter, though my vote doesn’t matter, the evidence is clear the latter is the course taken.

Did the Fed lend early?

No, in fact it didn’t understand the true nature of what was happening on Wall Street (though keep in mind the Fed was set up to work with banks, not necessarily investment banks – but that line was crossed when Glass-Steagall was repealed and the Fed should have been prepared)

Did the Fed Lend Freely?

Not really, not until it was too late (they helped Bear, but not Lehman). This one they get a free pass as they should not have lent to Bear or Lehman give the next few dictums

Lend to Solvent Firms?

Now this is the funny thing, it seems the Federal Reserve and Treasury are doing the exact opposite of the Bagehot Dictums, they are lending the most to the most insolvent firms (Citi, Bear, AIG, Fannie, Freddie). This is the key to all the other dictums, my belief is that Bagehot felt that insolvent firms should be allowed to fail, allowing them to continue created moral hazard and rewarded the profligate at the expense of the parsimonious (a bit strong, but both P words!). The big mistake made was the free lending of funds to firms that are now and will be in the future insolvent.

Lend against Good Collateral?

I think the evidence shows that the collateral lent against was not good, in fact our own government called it Toxic.

Lend at high rates?

There is some disagreement about why Bagehot created this dictum – was it to avoid moral hazard or to simply keep the solvent, liquid firms from borrowing needlessly. Regardless, it works both ways and avoids moral hazard while keeping solvent firms with cash away from borrowing. The Fed and Treasury fail on this point. Warren Buffet lent at much better terms to Goldman Sachs than did the Treasury. Banks can now borrow from the Fed at effectively a zero percent rate – which they do and then engage in a carry trade.

Ben Bernanke’s Fed and Paulson/Geithner’s Treasury have used Bagehot’s dictums as an excuse for their bailout’s, but in doing so have bastardized them.

Effectively the Fed’s action have turned what would have been a Great Recession into a Depression and potentially into another Great Depression, far from avoiding a Depression, Bernanke, Geithner and Paulson have served one up for us.

Don’t mistake me to be saying that the markets are going to crash, though that possibility exists. My point is that while a recovery could be underway and may in fact happen (perhaps even greater than we all think), it will in fact be another in a long series of faux rallies, perhaps the third in a trilogy that began with the Tech bubble and crash, then continued with the Housing bubble and crash. What will this third (and hopefully last) bubble bring? When will it end? What will be its affects? These are all questions without good answers (though many are trying).

It feels ironic to me that Paul Volcker is once again the voice of reason and sanity and yet he seems to be ignored in favor of Bernanke, Geithner, Dodd and Frank. Will it be the irony of ironies that the window dressing (Volcker) is in fact the one person in this administration that people should be listening too? I’m not saying we should rename Volcker to the Fed, but certainly getting rid of Geithner and replacing Bernanke would be wise moves.

Scott Dauenhauer CFP, MSFP, AIF


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