I am still reading about why the financial meltdown occurred. This piece in the Weekly Standard strikes me as another piece of the puzzle.
[W]e ought to recall that there was one candidate who did foresee our predicament with considerable accuracy when it still lay far in the future. Ron Paul, in almost every speech he made during the Republican primaries, spoke of bubbles, reckless credit growth, and the “unsustainability” of present policy. So why isn’t there more demand for the common-sense solutions he put forward? Because common sense is not much use in a financial panic.
I think Ron Paul had some loopy ideas but he did have one good point. Every time the government gets involved in business or the financial markets, it screws things up. That is the fundamental divide between Republicans and and Democrats. When I see someone make a derogatory remark about free markets, I know I am seeing a Democrat, no matter what protestations follow.
This article refers to an 1873 book on banking that is still in print and sounds pertinent to the present discussion. Walter Bagehot, the author, was the editor of The Economist in the 19th century.
Lombard Street was published in 1873, seven years after the sudden collapse of Overend, Gurney & Co., a bank that lost £11 million, spread panic among investors, sparked a run, and became “the model instance of all evil in business.” The crisis made such a deep impression on British finance and government that the country did not have another bank run for 141 years–not until Northern Rock collapsed in the summer of 2007. (English investors must have longer memories than American ones.
He goes into the issue of moral hazard and the dilemma faced by a central bank which, if it offers to be “the lender of last resort” will stimulate the sort of reckless behavior that requires such intervention. I submit that the Mexican bailout of 1995, presided over by Robert Rubin when he was Clinton’s Secretary of the Treasury, was the event that led to the present crisis more directly than the Congressional foolishness about affordable housing.
This analysis suggests that international bailouts encourage governments to engage in such risky behavior, just as deposit insurance encouraged weak U.S. banks to engage in risky behavior, worsening the failures and raising the costs to taxpayers.
In Bagehot’s book, the fact that the Bank of England, as lender of last resort, was acting contrary to basic rules of financial prudence, and even contrary to law, could not alter its responsibility in the crisis.
The worst was that the bank could carry out its necessary duties as a lender of last resort only by breaking the law. The basis of the bank’s operating procedure–and of its soundness–was the Bank Act of 1844. We would call it a regime of sound money. It included stringent caps on the ratio of notes issued to reserves held. These caps were hewed to when the economy was running smoothly. Yet at the time Bagehot was writing, a quarter century later, the law had already been suspended three times. Not just that. “No similar occasion has ever yet occurred,” Bagehot wrote, “in which it has not been suspended.” So the law on which the solvency of the British nation rested was ironclad, except when someone felt a need to break it.
Stranger still, never did the Bank of England acknowledge its duty as the lender of last resort. Some of its governors even denied that any such duty existed. Bagehot thought the bank should come clean about what it really was:
There should be a clear understanding between the Bank and the public that, since the Bank hold our ultimate banking reserve, they will recognise and act on the obligations which this implies–that they will replenish [the reserve] in time of foreign demand as fully, and lend it in times of internal panic as freely and readily, as plain principles of banking require.
But there was a reason for the central bankers’ dissembling. If the bank ever acknowledged a duty to rescue banks by generous extensions of credit, it would create a form of moral hazard.
This is what happened with the Mexican bailout. The banks that were headed by Rubin’s friends were “too big to fail.” That event led straight to today’s crisis. Yes, Congress was foolish but that is always true of Congress. A more sober consideration is whether this is a fundamental failing of democracy.
Read the rest of the article. I have already ordered the book.