Academic journal article The Cato Journal

L Street: Bagehotian Prescriptions for a 21st Century Money Market

Academic journal article The Cato Journal

L Street: Bagehotian Prescriptions for a 21st Century Money Market

Article excerpt

In Lombard Street, Walter Bagehot (1873) offered his famous advice for reforming the Bank of England's lending policy. The financial crisis of 1866, and other factors, had convinced Bagehot that instead of curtailing credit to conserve the Bank's own liquidity in the face of an "internal drain" of specie, and thereby confronting the English economy as a whole with a liquidity shortage, the Bank ought to "lend freely at high rates on good collateral." Bagehot's now-famous advice has come to be known as the "classical" prescription for last-resort lending.

Largely forgotten, however, is Bagehot's belief that his prescription was but a second-best remedy for financial crises, far removed from the first-best remedy, namely, the substitution of a decentralized banking system--such as Scotland's famously stable free banking system for England's centralized arrangement. Bagehot's excuse for proffering such a remedy was simply that he did not think anyone was prepared to administer the first-best alternative: "I propose to maintain this system," he wrote, "because I am quite sure it is of no manner of use proposing to alter it.... You might as well, or better, try to alter the English monarchy and substitute a republic" (Bagehot 1873: 329-30).

Like Bagehot, I offer here some second-best suggestions, informed by recent experience, for improving existing arrangements for dealing with financial crises. Unlike Bagehot, who merely recommended changes in the Bank of England's conduct, I propose changes to the Federal Reserve's operating framework. And although, like Bagehot, I consider my proposals mere "palliatives," I do not assume that we cannot ultimately do better: on the contrary, I doubt that any amount of mere tinkering with our existing, discretionary central banking system will suffice to protect us against future financial crises. To truly reduce the risk of such crises, we must seriously consider more radical reforms (see, e.g., Selgin, Lastrapes, and White 2010).

A Top-Heavy Operating System

Both the financial crisis and the ways in which the Fed felt compelled to respond to it point to shortcomings of the Fed's traditional operating framework a framework that relies heavily on a small number of systematically important financial firms known as "primary dealers," as well as on JPMorgan and Bank of New York Mellon in their capacity as "clearing banks" for the Fed's temporary open market transactions.

In theory these private institutions serve as efficient monetary policy agents--that is, as private middlemen or conduits through which liquidity is supplied by the Fed to the rest of the financial system. The theory breaks down, however, if the agents themselves become illiquid or insolvent, or if some agents fear being damaged by the liquidity or insolvency of others. In that case, the agents may cease to be effective monetary policy conduits. Instead, their involvement can undermine the implementation of ordinary monetary policy, denying solvent firms access to liquid assets. The Fed may for these reasons alone--and setting aside others that contribute to the agents' "systematic significance"--be compelled to bail out a monetary policy agent, further interfering with efficient credit allocation. The expectation that it will do so in turn enhances agents' "too big to fail" status, encouraging them to take excessive risks, and increasing the likelihood of future crises.

In what follows I explore the drawbacks of the Fed's top heavy operating framework, especially as revealed by the recent financial crisis. I then offer suggestions for making that framework both less top-heavy and more flexible. The suggested reforms should serve to reduce both the extent of the Fed's interference with an efficient allocation of credit and the extent of implicit guarantees in the financial system, while making it easier for the Fed to adhere to the spirit of Bagehot's classical rules for last-resort lending. …

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