To avert a financial panic, central banks should lend early and freely to solvent banks against good collateral but at penal rates

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business…

The great majority, the majority to be protected, are the ‘sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

Walter Bagehot Lombard Street: A Description of the Money Market (1873).

The classical theory of the lender of last resort stressed

(1) protecting the aggregate money stock, not individual institutions,

(2) letting insolvent institutions fail,

(3) accommodating sound but temporarily illiquid institutions only,

(4) charging penalty rates,

(5) requiring good collateral, and

(6) preannouncing these conditions in advance of crises so as to remove uncertainty.

Did anyone follow these rules in the global financial crisis? The Fed violated the classical model in at least seven ways:

  1. Emphasis on Credit (Loans) as Opposed to Money
  2. Taking Junk Collateral
  3. Charging Subsidy Rates
  4. Rescuing Insolvent Firms Too Big and Interconnected to Fail
  5. Extension of Loan Repayment Deadlines
  6. No Pre-announced Commitment
  7. No Clear Exit Strategy

…{the Fed’s} policies are hardly benign, and that extension of central bank assistance to insolvent too-big-to-fail firms at below-market rates on junk-bond collateral may, besides the uncertainty, inefficiency, and moral hazard it generates, bring losses to the Fed and the taxpayer, all without compensating benefits. Worse still, it is a probable prelude to a severe inflation and to future crises dwarfing the current one.

Thomas Humphrey (2010)

Old macroeconomic fallacies never die, they just wait for the next recession

Thomas Kuhn’s Structure of Scientific Revolutions showed that sciences do not march onwards and upwards towards the light. Kuhn found that once a central paradigm is selected, there is no testing or sifting, and tests of basic assumptions only take place after accumulated failures and anomalies in the ruling paradigm plunge the science into a crisis.

Scientists do not give up the failing paradigm until a new paradigm arrives, which resolves the failures and anomalies that caused the crisis. It takes a theory to beat a theory.

Murray Rothbard, when discussing Kuhn, pointed to economics is an example of a science which moves in a zigzag fashion, with old fallacies sometimes elbowing aside earlier but sounder paradigms.

Thomas Humphrey wrote an excellent 250-year long literature surveys of both the rules versus discretion debate and the cost-push theories of inflation in the 1998 and 1999 Richmond Fed Quarterly.

Humphrey wrote the reviews to see if economics was a progressive science in the sense that superior new ideas relentlessly supplant inferior old ones.

Humphrey showed that policy rules were popular in good times to contain inflation, and when unemployment was rising, discretionary policies returned to vogue. The policy debate keeps recycling because

  1. people forget the lessons of the past; and
  2. For better or worse, politicians and the public have tended to believe that central banks, the focus of his studies, have the power to boost output, employment, and growth permanently.

Mercantilists, with their fears of hoarding and scarcity of money together with their prescription of cheap (low interest rates) and plentiful cash as a stimulus to real activity, tend to gain the upper hand when unemployment is the dominant problem.

Classicals, chanting their mantra that inflation is always and everywhere a monetary phenomenon, tend to prevail when price stability is the chief policy concern.

Cost-push fallacies about inflation were even more resilient against repeated refutations.

There is nothing new under the sun in macroeconomics. The same issues that divided twentieth-century monetarists and non-monetarists as well as current macroeconomists were discussed by everyone from David Hume (1752) to Knut Wicksell (1898) and in the Bullionist-Anti-Bullionist and the Currency School-Banking School controversies:

  • rules v. discretion,
  • inflation as a monetary v. real cost push phenomenon,
  • direct v. inverse money-to-price causality,
  • central bank-determined v. market demand-determined money stocks,
  • exogenous v. endogenous money, and
  • backing v. supply-and-demand theories of money’s value

Current macroeconomists and monetary economists often unaware of the eighteenth and nineteenth-century origins of the ideas they employ.

Barro (1989) “New Classicals and New Keynesians, or the Good Guys and the Bad Guys”, made the point that Keynesian macroeconomics does not seek out new theoretical results for testing; rather the aim is to provide respectability for the basic viewpoints and policy stances of the old Keynesian models.

Bellante (1992) likewise, noted that the search in Keynesian economics for microeconomic foundations is to blunt criticism, rather than because it is otherwise useful. The analytical apparatus may change, but the policy conclusions remain the same.

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