Thursday, December 13, 2012

Fed Describes it's Responses to 100 Years of Financial Crises

commentary by Roger Erickson

[ps: has Congress published a working paper on 236 years of policy crises?]

Working Paper 2012-056A by Mark A. Carlson and David C. Wheelock

“It is the duty of the United States to provide a means by which the periodic panics which shake the American Republic and do it enormous injury shall be stopped.” −Robert L. Owen

We review the responses of the Federal Reserve to financial crises over the past 100 years. The authors of the Federal Reserve Act in 1913 created an institution that they hoped would prevent banking panics from occurring. When this original framework did not prevent the banking panics of the 1930s, Congress amended the Act and gave the Federal Reserve considerably greater powers to respond to financial crises. Over the subsequent decades, the Federal Reserve responded more aggressively when it perceived that there were threats to financial stability and ultimately to economic activity. We review some notable episodes and show how they anticipated in several respects the Federal Reserve’s responses to the financial crisis in 2007-2009. We also discuss some of the lessons that can be learned from these responses and some of the challenges that face a lender of last resort.

The founding of the Federal Reserve System in 1914 established the first official U.S. lender of last resort. Recurrent banking crises in the nineteenth and early twentieth centuries were widely viewed as evidence of defects in the U.S. banking system, including the absence of an official lender of last resort.

Panics had been met by ad hoc actions by bankers (from Nicholas Biddle to J.P. Morgan), Secretaries of the Treasury (e.g., Leslie Shaw), and private clearinghouses, but these actions did not obviously reduce the frequency or severity of the panics. The Fed’s founders sought to prevent panics from arising in the first place as well as provide a mechanism for limiting any crises that did occur.

To achieve this objective, the Fed’s founders desired to create an “asset-backed” currency whose supply was tied to the level of commercial activity rather than to the stock of government bonds held by banks, and establish reserve banks to hold the reserves of the banking system and to provide additional currency and reserves as needed by rediscounting commercial paper.

[RGE: To anyone other than economists, an "asset-backed currency" is an odd concept unless the asset in question is defined as the most valuable asset of all, the return-on-coordination. The "level of commercial activity" is a pale reference to the general concept of return-on-coordination - and one that leaves the essential distinction between static & dynamic value unclear. It's a mistake to use such an arbitrarily defined base for the unit of account meant to supply commercial liquidity nationwide. That choice constitutes an endless source of confusion, and mistakes waiting to happen. We could do far better today. Lets start by redefining the national currency as a monopoly unit automatically denominating any and all commercial transactions, NO MATTER HOW RAPIDLY NET COMMERCIAL ACTIVITY GROWS.  Nomisma?]

The Fed’s founders expected that discount window lending would be the principal means by which the Federal Reserve would serve as lender of last resort to the banking system. However, the founders gave the Fed other tools as well, notably the ability to invest in government securities and bankers acceptances, which subsequently were used to take lender of last resort actions as well as to implement monetary policy. ....


Roger Erickson said...

Randy Wray disputes at least one assertion from this working paper. Randy says that [while there was some idea of adopting a "real bills doctrine" to try to tie lending to "real" commercial activity, there was never an "asset backed currency". It was a "tax driven currency", as all of them always have been.]

So, it's long past time to formally redefine our currency unit of account?

Tax-driven and return-on-coordination-driven currency definitions converge to the same goal, through smart policy.

However, with confused policy paradigms, there's constant confusion about preferred operational definitions, and hence periodic outcome failures. If we can't get clarity on Public Purpose, everything else will remain disorganized.

Fiscal and monetary policies are far too important to be left to economists and financial lobbies.

Adam2 said...

No difference between asset backed currency and a tax driven currency. They are different ways of saying the same thing.

Roger Erickson said...


It all depends on what asset you try to use, and how you define it.