Promoting Stability

The Lender of Last Resort Through History

Chinese Bank of China
Promoting Stability : The Lender of Last Resort Through History - Gregor Feige

"There have been three great inventions since the beginning of time: fire, the wheel, and central banking." - American Humorist Will Rogers

The global integration of financial markets in the final three decades of the 20th century bares a striking resemblance to the pe­riod of internationalization that took place under the gold standard from the 1870s to the outbreak of World War I. Integration of mar­kets, specifically capital markets, during both eras parallel a prolif­eration of international financial crises and underscore the need for a lender of last resort to promote stability in the international financial structure.

This paper analyzes the history, theory and practice of cen­tral banks and other institutions as lenders of last resort in domestic and international financial crises. It thereby shows the precarious nature of the international financial system and highlights the con­tinued relevance of developing a sound, institutionalized organiza­tion beyond the typically perfunctory roles played today by the International Monetary Fund and the Bank for International Settlements.

The first step is to investigate the emergence of the phenom­enon of central banking in Europe and the United States, paying particular attention to the development and performance of the Bank of England and the Federal Reserve System in the United States. This Anglo-American bias is more a function of history than any­thing else, since the United Kingdom and the United States have been the two states most capable of acting as an international lender of last resort during the period since the rise of central banking in the 19th century until the end of World War II.

In addition, a brief discussion of how the lender of last resort functions domestically in other European states yields valuable les­sons regarding the operation of central banks and the practicality and efficacy of central banks as lenders of last resort. The theoretical underpinnings of a lender of last resort and an exploration of the implementation of this function at the domestic and international level along with an investigation of its greatest failures generates instructive lessons as to how the current global economy can avoid the potential disaster of a world financial meltdown like that of the 1930s.

For the purposes oft his paper, an institution can be seen as a lender of last resort if, in a situation where the market for a given financial instrument, typically money, stocks or bonds, has become sufficiently unstable as to create a run on financial holdings and there­fore a liquidity crunch, the institution pumps liquidity back into the market by way of loans to financial institutions that act to shore up the financial system and avert or quell the financial panic.

Origins of Central Banking

While the development of commercial banking, both during antiquity and again in the Renaissance is clearly associated with the Italian peninsula, first under the Romans and later in the grand city ­states of Venice and Genoa and in the Po Valley,1 the origins of cen­tral banking belong to northern Europe. The Sveriges Riksbank, which evolved into the National Bank of Sweden was founded in 1656 and was the first bank to issue true banknotes.2 The Riksbank did not entirely fit the modem conception of a central bank. In fact," like other early central banks a name, incidentally, not applied to them at the time, the Riksbank was simply a public bank with a special rela­tionship to the state..."3 That is, "... the Riksbank evolved, like most early forerunners of central banks, as a commercial bank with the government its biggest customer,"4 fairly humble beginnings and most certainly a far cry from the current emphasis placed on inde­pendent central banking.

The Bank of England was in the words of American econo­mist John Kenneth Galbraith,"... in all respects to money as St. Peter's is to the Faith. And the reputation is deserved, for most of the art as well as much of the mystery associated with the management of money originated there. The pride of other central banks has been either in their faithful imitation of the Bank of England or in the small variations from its method which were thought to show origi­nality of mind or culture."5 Like most other central banks, the Bank of England was established out of necessity rather than high-minded economic theory. Ushered in along with the Glorious Revolution of William and Mary of Orange in 1688-89 was the "... establishment of a funded debt, the creation of the Bank of England, a recoinage of the nation's money, and the emergence of an organized market for public as well as private securities."6 The Bank of England was for­mally established by act of Parliament based on a design proposed by a Scotsman, William Paterson, in 1694.7 Of the passage of the Bank of England Act of 1694, as it came to be known, no less than the Bank's designer described it as being done,"... solely to avoid embarrassment to the Government, which desperately needed the money it promised and could see no other way of getting it."8

Despite its now divine reputation, the Bank of England en­dured a rather inauspicious youth. The new financial system estab­lished following the rise of William and Mary was subject to"...a number of financial crises, culminating in the famous South Sea Bubble of 1720."9 Wild speculation in the various products and in­vestment opportunities offered by the South Sea Co. led to a massive financial bubble, subsequent panic and eventual crash that has been described as, "... the first of those catastrophic breakdowns which have from time to time bedeviled the financial market, to the mod­em world since they were first set up..."10 As a reaction to this fi­nancial meltdown, the Bubble Acts were enacted and in order to keep enterprises, similar to the South Sea Co., from encouraging the sort of financial speculation and mania that led to the panic and financial disaster of 1720.11

The aftermath of the South Sea Bubble left the Bank in an insecure position; however, in the decades that followed the Bank of England gradually recovered from the stigma of the bubble and "...emerged as the guardian of the money supply as well as of the financial concerns of the government of England. Bank of England notes were readily and promptly redeemed in hard coin and, in con­sequence, were not presented for redemption..."12 This eludes to one of the key elements of central banking: credibility. A bank note remains credible so long as holders of the currency believe that it either holds explicit value, by way of being readily redeemable for a precious metal, or the holder can reasonably assume it will be a stable means of exchange.

By the final quarter of the 18th century, the Bank of England had established itself as "... the nearly sole source of paper money in London, although the note issues of country banks lasted well into the following century."13 It was only "beginning about 1825, [that] the Bank of England recognized its responsibility to be 'lender of last resort,'"14 and not until the establishment of the Bank Charter Act of 1844, which forbade the establishment of new note issuing banks, that the Bank of England monopolized currency production.15 Ironically it was the suspension of the 1844 Act during crises in 1857 and 1866 that acted as a type of lender of last resort as it made an infusion of liquidity into the market possible.16 By the end of the 19th century, Britain was at the center of geopolitics and financial affairs and the Bank of England was firmly entrenched as guardian of the domestic fortunes of the worlds most advanced industrialized country as well as the informal supervisor of the international gold standard.

While not playing the preeminent role of the Bank of England, central banks in other European nations sprang up as part of the rapid political, social, and economic evolution of the continent during the 19th century. Napoleon Bonaparte established the Bank of France in 1800 in order to fulfill the financial needs of his military campaigns and the institution quickly established a monopoly on note issue and formed a close relationship with the state.17 The Bank of Spain was initially formed in 1782 to help finance the American War of Independence; although it was not until Jan. 28, 1856 that royal decree officially named it the Bank of Spain.18 The Dutch Central Bank became the sole issuer of bank notes in the Nether­lands in 1814. Following the political unification of Italy in 1861, an attempt was made to establish a standard currency granting privi­leges to an existing bank rather than a central bank. This attempt was not fully successful, and the Bank of Italy was finally estab­lished as a public institution in 1893 through the merger of three other private banks.19 In Germany, the Reichsbank was created in 1875 as a result of the Prussian victory over France. In truth, the establishment of the Reichsbank was little more than a renaming of the Prussian State bank that had enjoyed a monopoly on note issue and acted as a de facto central bank prior to German unification.20 This brief survey of the formation of various central banks in Europe is far from comprehensive, but it sufficiently illustrates the extent to which central banks were formed for pragmatic rather than theoreti­cal economic reasons. The majority of European central banks were formed to tackle governmental fiscal shortfalls, most often associ­ated with war, rather than in an attempt to ensure domestic financial stability or other lofty economic goals. It is also important to note that these banks typically conducted a large chunk of the banking business in the given country and therefore were able to directly in­fluence monetary and credit conditions, unlike the Bank of England, which was forced to engage in more modem techniques, such as adjusting the discount rate, or the interest rate a central bank charges private banks in need of short term loans, in order to pursue a given monetary policy.

The Federal Reserve System of the United States was only formed in 1913, well after its European counterparts. This later development is the function of a number of factors, not least of which is the general suspicion of banking held by the Founding Fathers. One should recall that the Constitution of the United States forbids both state and the federal government from issuing bank notes.21 This Constitutional ban was enforced rather selectively, flatly being ignored during the War of 1812 and the Civil War of the 1860s.22 The Constitutional provision was not entirely coherent with the goals of America's first Treasury Secretary, Alexander Hamilton. Hamilton aimed to develop a central bank in the United States akin to the Bank of England, for which he had a great deal of admiration. Hamilton represented a party known as the Federalists and saw the bank as another way to strengthen the role of the Federal govern­ment. Brought before the U.S. Congress in late 1790 the charter for the First Bank of the United States was passed and signed into law in early 1791 by President George Washington. The bank, established in Philadelphia, developed into a successful financial institution ca­pable of exerting significant influence over the rapidly developing U.S. economy. The first twenty-year charter of the bank expired just prior to the War of 1812 and was not immediately renewed, how­ever, in the years following the war it became clear that a Second Bank of the United States was necessary to ensure the financial sta­bility of the young nation.

Chartered in 1816, the Second Bank of the United States, again seated in Philadelphia, was a larger and more ambitious ver­sion of its predecessor. While it suffered a fair share of misfortunes, it emerged as a success under the stewardship of Nicholas Biddle. By emphasizing the commercial side of the bank and increasing the number of branches, Biddle legitimized the bank and continued the practice of exercising discipline on state banks by sending notes back for redemption. Second Bank became the most significant note issu­ing institution in the country. Congress passed a bill re-chartering the bank in 1832, but President Andrew Jackson, a Democrat op­posed to a strong federal government who had a general distaste for banking, vetoed the bill. The establishment of a central bank in the United States would have to wait another 81 years.23

Signed into law in late 1913 by President Woodrow Wilson, the Federal Reserve Act finally created a central bank in the United States. In reality the Federal Reserve System was not a single central bank, but rather a group of twelve banks, each bank representing one region of the country. When the Fed opened for business in late 1914, the Washington Board, the presidents of the various regional banks, was not given nearly the type of broad power now associated with Alan Greenspan, current Chairman of the Federal Reserve Sys­tem. The Board was only able to persuade, not force, the various branches to change their discount rate, was unable to alter reserve requirements oft he branches, and could not force the member banks to engage in open-market operations, the buying and selling of gov­ernment securities as to influence macroeconomic conditions.24 It was only with the Banking Act of 1935 that the Federal Reserve finally took on its more familiar powers as the Federal Open Market Committee was established and the general powers of the system were reinforced, while some functions formerly executed by the De­partment of Treasury were brought into the domain of the Fed.25 By the outbreak of World War II, the Federal Reserve System came into maturity and stood alongside its European counterparts, all fulfilling the fundamental roles of a central bank: issuing bank notes, fixing the discount rate, supervising the banking system and exchange rates, engaging in open-market transactions and acting as the lender of last resort.

This briefs ketch oft he rise of central banking in Europe and the United States provides frame of reference for a theoretical dis­cussion of the lender of last resort and an examination of the short­comings of a global financial system regulated by national banks primarily designed to ensure domestic stability.

Theoretical Underpinnings of the Lender of Last Resort

The role of the lender of last resort during financial crises has been a source of theoretical economic debate since the late 18th cen­tury. Derived from the French dernier ressort, meaning the final le­gal jurisdiction beyond which no appeal is possible, the lender of last resort has become a key element of financial regulation and attempts at ensuring domestic and international financial stability.26 "Sir Francis Baring called attention to the concept in 1797; and Henry Thornton's classic Paper Credit developed both the doctrine and its counterarguments in his discussion of the English country banks."27 Walter Bagehot, editor oft he Economist newspaper in Great Britain, offered the most famous discussion of the lender of last resort func­tion. Bagehot's 1873 tract Lombard Street is considered by many to be the landmark analysis of the lender of last resort function as it relates to central banks. In his analysis of financial crises, Bagehot extracts two rules regarding the Bank of England as a lender of last resort in the case of an extreme financial crisis.

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 precautions 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 asks 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. The news of this will spread in an instant through all the money market at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides, and will intensify the terror everywhere."28

Bagehot's contention is that in a situation of real financial cri­sis where the vast majority of the liquidity in the market is gone, it is the responsibility of the central bank to infuse liquidity into the sys­tem by freely offering loans to banks at a penalty rate on good collat­eral. The penalty rate is designed to help avoid the emergence of banks attempting to secure loans even if they are not truly in need merely as a type of safeguard. The goal oft he loans is to shore up the financial system, which dissuades individuals from succumbing to their base fears and instincts and making a run on the bank. So long as the central bank can legitimately be expected to come to the aid of commercial banks, the panic associated with a run on the banks tends toward zero.

In his now classic work Manias, Panics and Crashes Charles Kindleberger explains: "If, however, there is no authority to halt the disintermediation that comes with panics, with forced sales of com­modities, securities, and other assets, and a scramble for the limited supply of money, the fallacy of composition takes command. Each participant in the market, in trying to save himself, helps ruin all."29 Kindleberger is illustrating a standard collective action problem. Once there is even the slightest hint of a financial crisis, it is individually rational for each participant in the market to liquidate their assets and protect him or herself from any potential exposure to the crisis. This action in tum puts added strain on the market fueling the crisis, making it a type of self-fulfilling prophecy. The action is individu­ally rational, but collectively irrational as it leads to the propagation of the financial crisis and destroys the market, which in the end ben­efits no one. It is the responsibility of the lender of last resort to calm the panic, rational or irrational, by offering loans to protect financial institutions thus ensuring the stability of the system writ large.

The most cutting "argument against the intervention in finan­cial crises contends that by acting as a lender of last resort produces a type of moral hazard that will actually make the financial system less stable in the long run. Moral hazard is a term used within the insurance industry to describe "the adverse effects, from the insur­ance company's point of view, that insurance may have on the insuree's behavior."30 That is, if an individual or institution knows that it will be bailed out, it is more likely to engage in risky behavior because it knows ultimately it will be rescued and not be held fully responsible for its misdeeds. Kindleberger frames the situation in a slightly different manner: "The paradox is equivalent to the prisoner's dilemma. Central banks should act one way (lending freely) to halt the panic, but another (leaving the market to its own devices) to improve the chances of preventing future panics. Actuality inevita­bly dominates contingency. Today wins over tomorrow."31 In the end, Kindleberger argues that the lender of last resort will act to stop a financial crisis because the current panic is real and immediate, while the potential for moral hazard is a problem that can be dealt with down the road.

The risks associated with moral hazard can be partially abro­gated via the existence of legal regulation, private sector monitor­ing, self-regulation and imposing costs on institutions that make mistakes (penalty rate),32 however the risk of developing moral haz­ard is very much implicit in any lender of last resort action. In total, moral hazard must simply be accepted in a limited sense. It would not be possible to eliminate the potentiality for moral hazard while still acting as a lender of last resort, therefore moral hazard is some­thing to control and deal with rather than attempt to eliminate abso­lutely.

The Lender of Last Resort in Practice

A discussion of the lender of last resort in practice hinges on an important distinction between domestic and international lenders of last resort. In a domestic context the lender of last resort has historically been played by a central bank, although there are ex­amples of financiers and other private entities playing the role at one point or another.33 Bagehot's theory of a lender of last resort was formulated based on the Bank of England's internal actions to stabi­lize the British financial sector at different points during the middle of the 19th century, although he also identified the possibility of "ex­ternal drain" and the need for central banks to take action in an inter­national context.34 The primary focus of lender of last resort func­tions was domestic in nature until international capital flows became sufficiently large during the late 19th century. Due to the potentially extreme volatility of international capital flows it became clear that an international lender of last resort was necessary to " miti­gate the effects oft his instability and, perhaps, the instability itself."35

The period of economic globalization or, perhaps more accu­rately, internationalization that characterized the final quarter of the 19th century and the first fourteen years of the 20th century was based primarily on the maintenance of the international gold standard. The orthodox explanation of the functioning of the system is British economist David Hume's price-specie flow model.36 The model warrants a brief explanation. If nation A begins experiencing a trade surplus, it receives an inflow of gold from country B to pay for the surplus goods country B receives, which in tum drives country A's domestic prices up as the quantity of money (gold) has increased in the economy, the price level in country B, experiencing a trade 'deficit, falls along with its diminishing gold reserves and therefore there is a discrepancy in relative prices, making goods in country A relatively more expensive and goods in country B relatively cheaper. As a re­sult of the difference in relative prices, country A now begins buying more from country B, and this leads to a flow of gold from country A to country B, which brings the system back into equilibrium. This is the basic mechanism that governed the international economic sys­tem known as the international gold standard during the late 19th and early 20th centuries.

Under this international economic regime the role of lender of last resort became not just a domestic issue, but also a truly inter­national one. "Though central banks could prevent widespread fi­nancial collapses, so long as they maintained precious metal stan­dards with small reserves, they could not prevent the international transmission of crises. In many instances, the crises occurred simul­taneously from similar causes in different countries, and it is there­fore difficult to distinguish the extent to which a depression origi­nated at home or abroad."37 The process of financial international­ization brought along with it the potential for a contagion-effect, that is, the spread of economic crises from one nation to another, and in an international situation an individual central bank, consortium of central banks, or potentially some sort of international institution would have to play the role of international lender of last resort.

Kindleberger's Manias, Panics, and Crashes offers a con­cise history of financial crises from 1618 to the end of the 20th cen­tury and has conveniently identified the lender of last resort, if one existed, in the nearly fifty crises he investigated. The Bank of En­gland acted as a lender of last resort in a variety of financial crises, the aforementioned South Sea Crisis of 1720, in 1772 following speculation in housing, turnpikes and canals being built in the decade following the Seven Years' War, in 1825 following the success of the Baring loan and speculative investment in Latin America, in 1836 due to a textile boom and speculative investment in cotton and railroads, and in the 1847 crisis related to the potato blight and specu­lation in wheat futures.38 While these crises may have had an inter­national aspect, the Bank of England primarily dealt with them as domestic problems. As has been previously noted, it was only fol­lowing the establishment of the gold standard internationally that international capital flows became significant enough to warrant in­tervention by an international lender of last resort.

Ironically, perhaps the greatest argument in support of the need for an international lender of last resort is not the successful implementation of such a project, but rather cases where a lender of last resort either failed to emerge or did not fulfill the role completely and was therefore doomed to failure. Kindleberger argues "that a lender of last resort does shorten the business depression that fol­lows financial crisis. The evidence turns mainly on 1720, 1873, 1882 in France, 1890, 1921, and 1929. In none of these was a lender of last resort effectively present. The depressions that followed them were much longer and deeper than others. Those of the 1870s and 1930s were both known as Great Depressions."39 Kindleberger tem­pers this contention by admitting that beyond the existence or per­formance of a lender of last resort "other variables, especially the factors affecting long-term investment: population growth, the ex­istence of a frontier, demands arising from war, exports, the pres­ence or absence of innovations that are not fully exploited, and the like..."40 can influence recovery that follows a financial disaster.

The most studied and arguably most clear example of a fi­nancial disaster that snowballed into a drawn-out depression due to the lack of a lender of last resort is the Great Depression of the 1930s. Karl Polanyi's The Great Transformation published in 1944 offers a scathing critique of the international gold standard as it relates to the development of the Great Depression. Polanyi asserts that following World War I: "Nineteenth-century civilization has collapsed."41 He defined 19th century civilization as being based upon four institu­tions: the balance-of-power, the international gold standard, the self-regulating market and the liberal state. 42 Polanyi contends that "the gold standard proved crucial; its fall was the proximate cause of the catastrophe. By the time it failed, most of the other institutions had been sacrificed in a vain effort to save it."43 It is his position that the collapse of 19th century civilization, represented by the economic ruin of the interwar years was a direct result of an over reliance on the self-adjusting market and the liberal economic principles that underlie it. To quote Polanyi:

"If the breakdown of our civilization was timed by the failure of world economy, it was certainly not caused by it. Its origins lay more than a hundred years back in that social and technological upheaval from which the idea of a self-regulating market sys­tem sprang in Western Europe."44

The overarching reliance on the self-regulating market was ultimately the downfall of 19th century civilization. The lack of a lender of last resort internationally to effectively regulate the flow of international capital or at least provide a needed source of liquidity during panics forced the international gold standard to collapse un­der the weight of World War I and the Treaty of Versailles.

In relation to the economic disaster of the interwar years, in The World in Depression 1929-1939 Kindleberger argues that while central banks were able to maintain a reasonable level of stability domestically, in the international dimension "the lender of last resort was most conspicuously missing."45 While Great Britain attempted to resurrect the gold standard and maintain the pound sterling at an inflated exchange rate following the end of World War I, it became clear by 1931 that this would no longer be possible. The United States, which had been generally untouched by the economic hardship seen in parts of Europe most notably the hyperinflation within Germany's Weimar Republic, was shocked by the stock market crash of Octo­ber 1929. A number of explanations have been offered for both the crash and the depression that followed. However it is disingenuous to assert that the depression was a result of the crash, rather the crash was just one of the numerous sparks that pushed the world toward massive depression. Kindleberger offers a particularly compelling explanation of the depression:

"...the 1929 depression was so wide, so deep, and so long because the international economic system was rendered unstable by British inability and U.S. unwillingness to assume responsibility for stabi­lizing it by discharging five functions: maintaining a relatively open market for distressed goods; providing counter-cyclical, or at least · stable, long-term lending; policing a relatively stable system of ex­change rates; ensuring the coordination of macroeconomic policies; acting as a lender of last resort by discounting or otherwise provid­ing liquidity in financial crisis."46

Britain was willing and unable and the United States was able but unwilling to provide the necessary leadership and this ultimately doomed the world economy. Kindleberger identifies this list of five as the essential functions of an international economic hegemon. The role had been played by Great Britain throughout the history of the international gold standard; however following World War I, the United States was the only nation capable of playing the role of in­ternational economic hegemon and it failed to do so. This most strik­ing example of economic crisis pressed the United States and other major world powers of the world to reassess their commitments to maintaining stability in international finance and move to develop an international framework to avoid any future economic disaster.

Lessons Learned

The most important lesson of the 1930s was that inactivity can prove fatal. Even prior to the world economic meltdown of the 1930s, the Bank for International Settlements (BIS) was established in 1929 to "depoliticise and to manage the payment of German reparations, the Bank set out to become an instrument of international monetary cooperation, by improving the collective management of the gold standard. The date of foundation was not auspicious for achieving this end, nor was the imbalance in the supplies of world gold re­serves."47 Obviously in its first year in existence, the BIS was grossly unprepared to deal with the sort of economic turmoil that engulfed the major economies of the world. However it was a first step toward a more responsible and stable international financial system with an institutionalized lender of last resort.

The Bretton Woods Conference of 1944 establishing the World Bank and International Monetary Fund set the tone for the regula­tion of financial markets during the post-World War II world. In place of the fiduciary gold standard system of 1870-1914, Bretton Woods established a gold exchange standard with the U.S. dollar fixed to gold and other currencies then fixed to the dollar. This sys­tem along with various capital controls placed on the flow of inter­national capital trading served to make the system reasonably stable until 1973 when the United States was forced to end the linkage of the dollar to gold under pressure from currency trading in the Euro­markets and the fiscal burden of Lyndon Johnson's Great Society and the Vietnam War. While relative stability in the international financial arena was maintained from 1947 to 1973, as the U.S. and the BIS system acted as a lender of last resort, following 1973 the system faltered and combined with the emergence of economic glo­balization to place a high degree of strain on the international financial system.

The historical necessity of a lender of last resort appears quite clear. The increasing number of financial crises, notably in the de­veloping world over the past three decades, only serves to reinforce the point that an international organization with the sole responsibil­ity of acting as a lender .of last resort is needed. While a world finan­cial and economic meltdown on the scale of the 1930s is extraordi­narily unlikely, recent experiences in Mexico, East Asia, Russia, Brazil and Argentina underscore the fact that in a global system with free capital flows the current program of IMF structural adjustment pack­ages and World Bank loans to developing countries is woefully ill-­equipped to deal with a major financial crisis involving the major economies of the developed world. This paper did not aim to dis­cover an answer to world financial crises, but was rather an attempt to call attention to the historical and theoretical underpinnings of the central banking and the lender of last resort function and emphasize the necessity of further inquiry into the potential structure and influ­ence of a supranational organization capable of promoting stability in the increasingly volatile global economy of the 21st century.