11

The Domestic Lender of Last Resort

The hallmark in the development of ‘the Art of Central Banking’ over the last two hundred years has been the evolution of the concept of a lender of last resort. The expression comes from the French dernier ressort, and centers on the last legal jurisdiction to which a petitioner can take an appeal. The term has become thoroughly anglicized, and now the emphasis is on the responsibilities of the lender rather than the rights of the borrowers.

The idea is that the lender of last resort can and should forestall a run by depositors and other investors from real assets and illiquid financial assets into money by supplying the amount of money that is needed to satisfy the demand; the concept is of an ‘elastic supply of money’ that expands to meet the demand in panics. How much money? To whom? On what terms? When?

The dilemma for the lender of last resort – the moral hazard argument – is that if owners and managers of banks believe that their firms will be supported in moments of distress, they will be less cautious in the extension of loans during the next boom. The public good that credit may be available from the lender of last resort weakens the responsibility of private lenders to ensure that they make ‘sound’ loans. If, however, in a panic the rush from the securities and commodities into money cannot be halted, the fallacy of composition takes center stage. The sale of these assets by investors leads to declines in their prices with the consequence that a large number of otherwise previously solvent and well-capitalized firms may be dragged into bankruptcy.

The opposition to a lender of last resort has been made continuously. Napoleon’s minister of the public treasury, François Nicholas Mollien, wrote strongly against the interventionist instincts of his mentor, who wanted to save the failing manufacturers damaged by the Continental System (blockade); he asserted that a start in this direction would only get the Treasury in deeper and deeper.¹ Louis Antoine Garnier-Pagès, French minister of finance in 1848, claimed later that it was useful to precipitate a crisis to render it less durable: ‘Do nothing to save the rente, clean out stocks; sell merchandise.’ The policy, he asserted, contributed to the brilliance of the French recovery from 1850 to 1852.² Murray Rothbard asserted that ‘any propping up of shaky positions postpones liquidation and aggravates unsound conditions’.³ The most trenchant formulation is that of Herbert Spencer: ‘The ultimate result of shielding man from the effects of folly is to people the world with fools.’⁴

Such a view is understandable in a Darwinian age.

Origin of the concept

The development of the lender of last resort evolved from the practice of the market. Ashton asserted that the Bank of England was already the lender of last resort in the eighteenth century,⁵ although this statement does not entirely square with his statement that ‘long before the rules for the treatment of crises were laid down by economists, it was recognized that the remedy [for a financial crisis] was for the monetary authority (the Bank of England or the British government) to make an emergency issue of some kind of paper which bankers, merchants and the general public would accept. When this was done the panic was allayed’.⁶

The indecision about whether the central bank or the government was the final monetary authority remains to this day and qualifies the statement that the Bank of England emerged as the lender of last resort in the 1700s. E.V. Morgan maintained that the Bank of England’s realization of its responsibility was delayed by the government’s action in issuing Exchequer bills in 1793, 1799, and 1811, and that the Bank assumed the role as lender of last resort only gradually during the first half of the nineteenth century ‘in spite of the opposition of theorists’.⁷ The same evolutionary process can be seen in the Bank of France. In 1833 the majority of the Conseil General overrode Hottinguer’s idea for a policy on the English model as well as Odier’s plea for an entirely new policy and concluded that the major function of the Bank of France was to defend the French franc. Capital outflows were not to be feared. Interest rates should not be held artificially low or speculation will be encouraged and crises intensified. When a crisis occurred, however, the Bank should provide abundant and cheap discounts to moderate its intensity and shorten its duration.⁸

The role of the lender of last resort was not respectable among theorists until Bagehot’s Lombard Street appeared in 1873, although Sir Francis Baring called attention to the idea at the end of the eighteenth century⁹ and Thornton’s classic, Paper Credit, developed both the doctrine and the counter-arguments in his discussion of the financial problems of the English country banks.¹⁰ Bagehot traced the origin of the doctrine to David Ricardo in his statement before the Parliamentary Select Committee on Banks of Issue in 1875: ‘The orthodox doctrine laid down by Ricardo is that there is a period in a panic at which restrictions upon the issue of legal tender must be removed.’¹¹ Bagehot had articulated the doctrine in his first published article, written in 1848, when he commented upon the suspension of the 1844 Bank Act in the panic of 1847:

It is a great defect of a purely metallic circulation that the quantity of it cannot be readily suited to any sudden demand ... Now as paper money can be supplied in unlimited quantities, however sudden the demand may be, it does not appear to us that there is any objection on principle to sudden issues of paper money to meet sudden and large extensions of demand ... This power of issuing notes is one excessively liable to abuse ... It should only be used in rare and exceptional cases.¹²

Some analysts continue to reject the doctrine and powerful minds have argued both sides of the issue. Should one worry about the present panic or the next boom, the condition or the principle? ‘There are times when rules and precedents cannot be broken; others when they cannot be adhered to with safety.’¹³ The dilemma is that breaking the rule creates a new precedent and a new rule. Lord Overstone, the distinguished Currency School theorist, strongly opposed expansion of the money supply in a crisis but reluctantly admitted that a panic may require ‘that power, which all governments must necessarily possess, of exercising special interference in cases of unforeseen emergency and great state necessity’.¹⁴ On one occasion he produced a ringing metaphoric defense: ‘There is an old Eastern proverb which says, you may stop with a bodkin a fountain, which if suffered to flow, will sweep away whole cities in its course.’¹⁵ Friedman and Schwartz similarly and metaphorically flirted with lender-of-last-resort doctrine:

The detailed story of every banking crisis in our history shows how much depends on the presence of one or more outstanding individuals willing to assume responsibility and leadership ... Economic collapse often has the characteristics of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development ... Because no great strength would be required to hold back the rock that starts a land-slide, it does not follow that the landslide will not be of major proportions.¹⁶

The paradox is equivalent to the prisoner’s dilemma. Central banks should lend freely to halt the panic, but leave the market to its own devices to reduce the likelihood of future panics. A dilemma: actuality inevitably dominates contingency, today wins over tomorrow.

The Bank Act of 1844 represented a victory for the Currency School, which stood for a fixed supply of money, over the Banking School, which thought it useful for the money supply to grow as output and trade grew. Both schools were concerned with the long run rather than with the short run, and neither approved of increasing the money supply as a temporary expedient to meet a crisis. When the Bank Act was being considered, the idea that the government has the power to suspend its provisions in an emergency was rejected. After 1847 and again after 1857, when it proved necessary to suspend the Bank Act and issue more money as a last resort, parliament conducted inquiries to determine whether there was a need to change the legislation. Both inquiries concluded that it was not desirable to have built-in provision for suspending the act even though the suspension had been useful and necessary. To limit precedent-setting, the bill brokers who had been sudden borrowers ‘wanting incalculable advances in 1857 were told not to expect the like again’.¹⁷ The principle of having a rule but breaking it if one had to was so widely accepted that after the suspension in 1866 there was no demand for a new investigation.

In the 1850s Jellico and Chapman had proposed rules for adjusting the discount rate of the Bank of England to the state of its reserves by a mathematical formula written into the legislation. Wood criticized them as having no real grasp of Bank transactions and methods of procedure.¹⁸ Robert Love, Chancellor of the Exchequer in June 1875, introduced a bill that would authorize a temporary increase in Bank of England notes in exchange for securities (under certain contingencies, including panic), a bank rate above 12 percent, and the foreign exchanges favorable. The bill was tabled and given a first reading on 12 June but it never received a second reading and was withdrawn in July.¹⁹ Hard-and-fast rules were agreed not to be workable. The Economist and Bagehot thought it proper that the Bank of England rather than the banks themselves should hold the reserves necessary to get the country through a panic. Mr Hankey, a former governor of the Bank, called this ‘the most mischievous doctrine ever broached in the monetary or banking world in this country; viz. that is the proper function of the Bank of England to keep money available at all times to supply the demands of bankers who have rendered their own assets unavailable’.²⁰ The public, however, sided with Bagehot and practice against Hankey and theory. If the expansion of credit in boom periods cannot be controlled, then measures should be adopted to halt the contraction of credit in crisis.

Who is the lender of last resort?

The lack of clear agreement in Britain about whether the Treasury should relieve panics through the issue of Exchequer bills or whether instead the Bank of England should discount freely at a penalty rate, even if it is necessary to suspend the limits imposed by the Bank Act of 1844, has already been noted. Uncertainty about the answers to these questions may be optimal, along with the question of whether the government authorities will rescue firms in distress and whether they will arrive in time. Thus there was no explicit provision for a lender of last resort in Britain and no fixed rule as to which agency should fill this role. In 1825 the Exchequer was not the selected agency. The task was given resolutely to the Bank of England whose reluctant acceptance was ‘the sulky answer of driven men’.²¹ In 1890 guarantees were used rather than the Bank or the Exchequer. Gradually the responsibility devolved on the Bank, which led Alfred Marshall to write that ‘its directorate came to be regarded at home and abroad as a committee of safety of English business generally’.²²

The Bank of France had agreed by the 1830s that it had responsibilities in a crisis but it thought it had other responsibilities as well, such as to ensure monopoly of the bank note circulation which permitted it to let the regional banks fail in 1848 and then to convert them into subsidiaries (comptoirs). The provinces feared Paris; their concern was that in a crisis Paris would take care of its own needs first at the expense of the regions and hence they wanted the privilege of note issue. But after Le Havre needed assistance, after it acquired its own bank, which made too many illiquid industrial loans including some to shipyards and to importers of cotton, the Banque du Havre went to Paris in 1848 seeking help. ‘The return was not glorious. The Bank of France had been impitiable.’²³ It refused to lend on mortgages, saying: ‘The statutes forbid it, and you have refused to accept a comptoir.’²⁴

The Bank of France wavered over this question even as it wanted to destroy the regional banks. From America, Chevalier observed that the Bank of France had discounted freely in 1810, 1818, and 1826 – with Jacques Laffitte as governor for the first two years – making great efforts to sustain commerce; but it lacked the same courage in the crisis of 1831–32.²⁵ In 1830, after the revolution, the task was left to local authorities. A regional bank, conducted with honesty but not prudence, threatened a provincial crisis. The local receiver-general undertook to discount its doubtful paper, apparently after consulting Paris, where, Thiers testified, after ‘mature reflection the public interest was put above that of the Finance Minister, M. Louis’, ‘with happy results’, that is, the avoidance of the collapse of the bank and a resultant disturbance.²⁶

After the Bank of France achieved its monopoly of the note issue and the conversion of the banks in the regions into its branches, the Bank began to act as a lender of last resort. Its statutes required it to discount only three-name paper; the task became one of producing acceptable names. Sixty comptoirs d’escompte were established throughout France, as well as a number of sous-comptoirs organized by various branches of trade to hold stocks of goods and issue paper against them. With the names of the merchant, the sous-comptoir, and a comptoir, the Bank of France could discount the paper and relieve the liquidity crisis. Louis Raphael Bischoffsheim of Bischoffsheim & Goldschmidt mocked the requirement of three names: ‘The number is not important. With bad signatures one can collect 10 instead of three. I prefer one good to 20 bad.’²⁷ After the crisis was over, a number of the comptoirs were taken over by bankers, merchants, and industrialists and became regular banks. The most famous of this group, the Comptoir d’Escompte de Paris, took its place among the leading banks in the country.²⁸

The Crédit Mobilier of the Pereire brothers was not saved in 1868; the Bank of France refused to discount its paper, which might be interpreted as the revenge of the establishment on an outsider as punishment for not conceding the Banque de Savoie note issue to the Bank of France when the Pereires took over the Savoy bank after the region had been ceded to France by Italy in 1860.²⁹ The alternative interpretation was that this was the entirely normal refusal of a lender of last resort to bail out an insolvent institution.³⁰ Cameron accuses the Bank of France of conducting guerrilla warfare against the Pereire brothers in the interest of a quarrel between the Rothschilds and the Pereires that went back to the 1830s.³¹

The Bank of France and Paris bankers did not come to the rescue of the Union Générale in 1882 but seven years later they rescued the Comptoir d’Escompte de Paris. Critics of the Bank of France ascribe the difference in outcomes to venality. A less emotional position asserts that a second large bank failure in seven years might have completely destroyed the French banking system and that on this account Rouvier, the minister of finance, took the necessary measures to have the Bank of France and the Paris banks advance 140 million to the Comptoir d’Escompte.³² In the Union Générale operation, as was noted in an earlier chapter, the Paris banks withdrew from the speculative activity when it began to peak in August 1881 and advanced 18.1 million francs to the Union Générale after the crash the following January to permit its more orderly liquidation rather than to save the bank.³³ Led by the Rothschilds and Hottinguer, and including the Comptoir d’Escompte and the Société Générale (but not the Lyons rival of Bontoux, the Crédit Lyonnais), the consortium represented the establishment, in which it was not really necessary to distinguish the Bank of France from the leading private banks (hautes banques) and deposit banks.

In Prussia in 1763 the king was the lender of last resort. In 1848 various state agencies, including the Prussian Bank, the Seehandlung, and the Prussian lottery vainly tried to help the Cologne bank, A. Schaaffhausen, before it was allowed to reorganize as a joint-stock bank. In the absence of a central bank in 1763, 1799, and 1857 the Hamburg city government, the chamber of commerce, and the banks – any and all leading agencies took part in the rescue operation.

The experience of the United States is especially pertinent to the question of the identity of the lender of last resort. There was some ambiguity as to whether the First Bank of the United States and then the Second Bank of the United States were lenders of last resort despite the designation of the Bank in each case as the chosen instrument. On various occasions, the US Treasury assisted the banks by accepting customs receipts in post-dated thirty-day notes (1792), by making special deposits of government funds in the banks that were in trouble (1801, 1818, and 1819), and by relaxing the requirement that a commercial bank pay the Bank of the United States in specie (1801).³⁴ After the failure to renew the charter of the Second Bank of the United States in 1833, the US Treasury was even busier, both before and after passage of the 1845 law that required the Treasury to keep its funds out of the banks. In times of crisis and in periods of stringency caused by crop movements, the US Treasury would pay interest or principal on its debt in advance, make deposits in banks, offer to accept securities other than government bonds as collateral for deposits of government funds. Banks began to look to the Secretary of the Treasury for help in emergencies and to relieve seasonal tightness. In the fall of 1872, Secretary of the Treasury George S. Boutwell served as a lender of last resort by reissuing retired greenbacks – which may have been illegal. His successor, William A. Richardson, did the same thing a year later.³⁵

The US Treasury could absorb money in deposits and pay out surplus cash that it had previously acquired but apart from the greenback period it could not create money. Thus the Treasury was unsatisfactory as a lender of last resort, unless it had built up its holdings of cash from budget surpluses. In 1907, when its cash holdings were low, the Treasury issued new bonds – $50 million of Panama Canal bonds, which were eligible for collateral for national bank notes, and $100 million of 3 percent certificates of indebtedness – that it hoped would entice existing cash and specie from hoards. In the end, the crisis was averted by a flow of more than $100 million from Britain.³⁶ Moreover the devices used to cope with a crisis were ad hoc. An analysis of the crisis of 1857 suggested that the Federal government was incapable of intervening effectively and that the public, including the banks, was left without guidance to stem the crisis.³⁷ In fact intervention proved to be too much and too early.

The complex record of involvement by the US Treasury raises the question of whether the market should not have regulated itself and, if so, how. O.M.W. Sprague, the historian of crises under the National Banking System for the 1910 Aldrich Commission, believed that the banks should have taken responsibility to ensure that they had enough reserves to meet all needs.³⁸ But Sprague was vague on which banks should take this responsibility or why the duty fell on them in the absence of responsibility embodied in legislation. Noblesse oblige? Duty? Several statements by Sprague indicate why a limited number of New York banks had the obligation to stabilize the system and behave differently from other banks:

During the period before the crisis of 1873 some 15 of the 50 New York banks held practically all the bankers’ deposits in the city, and 7 of them held between 70 and 80 percent of these deposits. These 7 banks were directly responsible for the satisfactory working of the credit machinery of the country. (p. 15)

It must always be remembered that in the absence of any important central institution, such as exists in other commercial nations, the associated banks are the last resort in this country, in times of financial extremity, and upon their stability and sound conduct the national prosperity greatly depends. (From the New York Clearing House report of 11 November 1873; p. 95)

The fundamental characteristic of our banking system was illustrated [in 1890], that for any extraordinary cash requirements the reserves of the country banks are an unused asset. Evidence was again given which should have brought home to city institutions the heavy responsibility which they have incurred in attracting the reserves of other banks. (p. 147)

The New York banks did not normally maintain the large reserves which the responsibilities of their position demanded. (p. 153)

... there was the possibility that the contraction of loans by outside banks, trust companies and foreign lenders might come together, creating a situation ... well nigh impossible if in normal times the important clearing house banks failed to exercise great caution and maintain large reserves. (p. 230)

The failure of the banks holding the ultimate reserve of the country to live up to the responsibilities of their positions is evident in still another direction. While the exact moment of the outbreak of the crisis of 1907 could not be foreseen, the imminence of a period of trade reaction had for many months been so probable that precautionary measures might reasonably have been expected from these banks if not from banks and the public in general. (pp. 236–7)

The outside banks feel no responsibility for the course of the market. They will naturally withdraw from it when affairs at home require more of their funds or when they come to distrust its future. It therefore becomes necessary for the local banks to be able at all times to shoulder at least a part of the loans that may be liquidated by outside banks, and also to supply the cash which they thus secure the power to draw away. (p. 239)

It is certainly an element of weakness in our central money market that influential credit institutions should have to be dragooned into doing what is after all in their own interest as well as to the general advantage. (p. 255)

... feeling common among New York bankers that they cannot reasonably be expected to remit funds which are the proceeds of loans made in the New York money market by outside banks and liquidated in an emergency ... It should be remembered, however, that responsibilities are incurred in return for the advantages which accrue to the New York banks from their peculiar position. London holds its commanding position because it is known that money lent there can be instantly recalled. Similarly, New York is not meeting the obligations of its position as our domestic money center, to say nothing of living up to future international responsibilities, so long as it is unable or unwilling to respond to any demand, however unreasonable, that can lawfully be made upon it for cash. (pp. 273–4)

Sprague believed that the market needed a stabilizer and that the banks could not depend on the US Treasury to help supply the seasonal needs for cash, but he also did not believe that the biggest and most profitable US banks should take on the responsibility. These banks should be aware of seasonal currency requirements, the prospect that the out-of-town banks may withdraw deposits, and the state of the international balance of payments. Not all New York banks should take on this responsibility but only those that charged interest on out-of-town deposits, or the largest, or those with intimate connections with the stock exchange, or the leading members of the New York Clearing House.

The leading bankers in New York drew a different conclusion; they believed that the difficulties arose from lack of elasticity of the money supply and thus they fell into the trap of the Banking School. This was the real-bills doctrine, the idea that the money supply should expand and contract on the basis of changes in the supply of trade bills, which represented goods moving in domestic and foreign trade. Thus increases in the money supply would not be inflationary, and would have the necessary elasticity as long as they were discounted at banks and rediscounted at the central bank. There could be no doubt about it: ‘The laws of finance are as well known, and as sure in their operation as the laws of physics.’³⁹ The lesson that Frank Vanderlip, Myron T. Herrick, William Barret Ridgely, George E. Roberts, Isaac N. Seligman, and Jacob H. Schiff drew from the panic of 1907 was that there should be a central bank that could respond to increases in demand for currency by producing more currency.⁴⁰

Some ambiguity as to location of ultimate responsibility for the supply of currency may be helpful because it leaves some uncertainty so that the bankers are more self-reliant – provided there is not so much uncertainty that the market is disoriented. In London it was vaguely understood that there should be no formal provision for a lender of last resort but that there should be one in time of crisis. The intuitive politicians in the British government and the merchant bankers who ran the Bank of England thought it best to give power to grant relief neither wholly to the Bank nor wholly to the government, but to leave it uncertain.⁴¹ If giving relief were formally within the power of either the Bank or the government, it would be difficult to resist the pressure from the public.⁴²

No one would bear the responsibility in too large a group. If only one entity were responsible, pressure for action might become irresistible. The optimum may be a small number of actors, closely attuned to one another in an oligarchic relation, like-minded, who apply strong pressure to keep down the chiselers and free-riders and who are prepared ultimately to accept responsibility. To give a more up-to-date example, tension in 1975 and 1976 among New York City officials, the unions, bankers, the State of New York, and the Federal government as to who would be the lender of last resort for New York City may have ensured uncertainty at a high level, and to have encouraged Yonkers, Buffalo, Boston, Philadelphia, and others not to slacken in their efforts to right themselves; yet action to save New York was eventually taken.

During the early stages of the 2008 crisis the Federal Reserve provided credit to facilitate the acquisition of Bear Stearns by JPMorganChase. This facility may be a credit, but if the losses are large, then this commitment would be viewed as an investment. Thereafter the Chairman of the Federal Reserve, Ben Bernanke, suggested that the Bush Administration needed congressional authorization before it could make further investments in banks.

Bonelli’s statements about the 1907 crisis in Italy offer a moving account of a muddle. The Società Bancaria Italiana was failing, and dragging down a host of small financial, mercantile, and industrial firms. A consortium of the larger banks put together a support fund. The Bank of Italy was involved early and deeply, and almost became too heavily committed. The Treasury finally came to the rescue, at the insistence of Bonaldo Stringher, governor of the Bank of Italy, and paid the interest on the national debt early and thus relieved the liquidity crisis. Bonelli saw that the episode inevitably involved both the Bank of Italy and the government and suggested that this indecision might develop when the economy works for more than ten years with no one in charge.⁴³ Part of the difficulty may reflect the lack of sufficient cohesion among Turin, Genoa, Milan, and Rome and the resulting uncertainty, buck-passing and indecision.

Some uncertainty was inevitable because as a House of Commons committee noted in 1846 ‘looking to the impossibility of foreseeing what the precise character of the circumstances might be’ it was thus ‘more expedient to leave to those with whom the responsibility of government might rest at the time, to adopt such measures as might appear to them best suited to the emergency’.⁴⁴ Consider Sir Robert Peel’s statement on the Bank Bill on 4 June 1844:

My Confidence is unshaken that we have taken all the Precautions which legislation can prudently take against the Recurrence of a pecuniary Crisis. It may occur in spite of our Precautions; and if it be necessary to assume a grave Responsibility, I dare say Men will be found willing to assume such a Responsibility.⁴⁵

George Harrison, then president of the Federal Reserve Bank of New York in the late 1920s, opened the discount window wide during the October 1929 stock market crash and then was criticized by the Board of Governors in Washington when the New York Fed bought $160 million in government bonds on the open market in October and another $210 million in November. The Board of Governors resented the New York bank because of the earlier high-handed dominance of the system by Benjamin Strong (who died in 1928), and had little compunction in reining in Harrison when he tried to emulate Strong’s penchant for filling a power vacuum by strong leadership. Ambiguity as to whether there will be a lender of last resort, and who it will be, may be optimal in a close-knit society. The division in experience and outlook between Washington and New York handicapped more effective action in coping with the collapse of stock prices in 1929.

There was no hint of criticism or second-guessing when the Federal Reserve Board, under the new chairmanship of Alan Greenspan, set about expansive open-market operations immediately after the 19 October 1987 crash, and poured in high-powered money ‘right and left’, to use Bagehot’s expression. The Fed under Greenspan provided liquidity to cope with the Asian Financial Crisis in 1997, the debacle in Russian finances and the collapse of Long-Term Capital Management in the summer of 1998, in anticipation of the Y2K crisis in the last few months of 1999, and in response to the sharp decline in stock prices in 2000 and 2001.

The Federal Reserve under the chairmanship of Ben Bernanke was slow to recognize the sharpness of the housing bubble and impacts of the implosion of real estate values on the banks and financial markets and the economy. Only after the panic triggered by the failure of Lehman Brothers in mid-September 2008 did the Fed open ‘all of its windows’. The Fed was willing to accept many different types of collateral for loans at the discount window. The Fed, moreover, made money at the discount window available to non-banks. The Fed became a direct lender to business and the Fed’s assets nearly tripled in a year.

To whom on what?

The rule laid down by Bagehot was that loans should be granted to all comers on the basis of sound collateral ‘as largely as the public asks for them’.⁴⁶ But in his testimony before the 1875 inquiry, two years after the publication of Lombard Street, Bagehot resisted the suggestion that last-resort lending be turned over to a body of commissioners appointed by the government on the grounds that they might make loans to ‘improper persons’. They would be subject to political pressure while the Bank of England is ‘a body withdrawn from the political world and not subject to political pressures’.⁴⁷

Bagehot’s suggestion that central banks are immune from political pressure seems naive. The dilemma about collateral is that its soundness depends on when and whether the panic is stopped; the longer the panic continues, the sharper the decline in the prices of securities and bills of exchange and commodities and hence the less sound the collateral. In this case, it becomes necessary to look at the character of the borrowers, something that J.P. Morgan was reported to consider exclusively. Here the dilemma relates to the wry comment that bankers lend money only to those that do not need it.

Central banks typically have rules.⁴⁸ When the rules cannot be easily broken – as in the Federal Reserve Act of 1913, which permitted only gold and negotiable bills of exchange but not government securities to be held as reserve against Federal Reserve notes and demand deposits – there is frequently trouble. There is also trouble when rules are too readily broken. The beauty of the Chancellor of the Exchequer’s letter of indemnity was that it preserved the rule while violating it and did not create a precedent, at least not for a while. The Bank of France and the Reichsbank occasionally discounted only three-name paper. But discretion to reject paper because it was ‘unsound’ or the borrower because of his character gave the lender of last resort a life-or-death power that might not always be used with complete objectivity. The literature is filled with accusations of venality on the part of the directors of central banks. Protestant and Jewish directors of the Bank of France were alleged to have punished the Catholic (and worse-off) supporters of the Union Générale in 1882, while saving the insider Comptoir d’Escompte in 1888.⁴⁹ In the crisis of 1772, the Bank of England’s issuance of new regulations about discounting and refusal to discount doubtful paper were interpreted as an attempt to break the Jewish houses in Amsterdam that had been most involved in the speculation. Then there was the Bank’s decision to refuse the bills of Scottish banks, and finally to stop discounting altogether, which was probably ‘a step taken quite deliberately to break up a group of Dutch speculators’.⁵⁰ Outsiders particularly suffered. The Bank of the United States was allowed to fail in New York in December 1930 by a syndicate of banks amid accusations that the Bank was being punished for its pushy ways.⁵¹

The rule of discounting for everyone with good paper evolved slowly in Britain. For a time ‘the invariable practice’ was respectable London names on paper with no more than two months to run; but this description of 1793 is accompanied by a statement that while a request from Manchester had been turned down (along with one from Chichester, where refusal helped to bring a bank down), £40,000 had been advanced to banks in Liverpool. Only in July 1816 did the Bank, breaking a rigid precedent, agree to accept ‘country securities of undoubted respectability if the firm cannot get enough London names’.⁵²

The Bank of England made advances on a wide range of different types of assets much beyond two-name paper. In 1816 the Bank broke its rule against lending on mortgages, undertaking a ‘Transaction quite out of the ordinary course of Business’ to relieve the distress of poor people in the Black Country. The Bank resolved to lend only in the old way ‘on notes of respectable parties’ but a few years later the Bank began a regular mortgage business on the ground that the volume of discounts and especially the income from discounts had collapsed – a private rather than a public purpose.⁵³ At one stage the Bank made loans on the security of a mortgage on a plantation in the West Indies (ultimately the Bank foreclosed on this loan⁵⁴) and on unimproved land in England. The land was unencumbered by a mortgage but belonged to a duke, an indication that collateral and the character (or status) of the borrower were not unrelated. Loans were not made on land in Scotland and in Ireland.⁵⁵

With the growth of railroads, the discounts of the Bank of England were made on the collateral of railroad debentures. In 1842, as the second railway mania got underway, the Bank voted to make occasional loans to firms in difficulty and to well-tried firms for development.⁵⁶ The Bank of France began lending to a railroad syndicate in 1852; in fact, it was accused of supporting, if not starting, the feverish speculation in railroads.⁵⁷ Bagehot thought the Bank of England mistaken for not lending on railroad debentures when it did so on Consols and Indian securities; Bagehot stated that a railway was less liable to unforeseen accidents than the Empire of India.⁵⁸ But Indian securities were guaranteed by the Colonial Office and in effect were British government obligations.

Exchequer bills were issued on the collateral of goods, as were Admiralty bills in Hamburg. Clapham observed that many of the Bank’s advances in 1825 were not actually on goods but rather on personal security;⁵⁹ the Bank loaned freely and was not ‘over-nice’.⁶⁰ In a few weeks in 1847 the Bank advanced £2.25 million in both usual and unusual ways, including the securities of the Company of Copper Miners, through which it involuntarily acquired a copper works.⁶¹

The rule is that there is no rule. One does not lend to insolvent banks, except to avoid the mischief that would occur if the Lord Mayor of London were to go bankrupt (1793),⁶² or to maintain for a time a payroll in Newcastle, a town used to banking disasters.⁶³ The Bank of France had never discounted as much as 4 million francs for anyone but Jacques Laffitte when Samuel Welles, an American banker, applied in 1837; he proved to be an exception.⁶⁴ (The Laffitte transaction had also been exceptional, with a political motivation.) The Conseil General could not abandon such an important bank, so the bank received a line of credit of 15 million francs.⁶⁵ In the crisis of 1830 the Bank of France discounted royal and municipal bonds, customs receipts, woodcutting receipts, obligations of the city of Paris, and canal bonds repayable by lottery.⁶⁶

Some of the decisions that the lender of last resort must make are easy, such as whether to discount Treasury bills. Some are difficult, such as whether to discount shaky collateral from shaky banks. The record is full of firms that were refused help, failed, and paid off 20 shillings to the pound, and of banks that were helped in one crisis and failed in the next. The 241-page appendix to Evans’s book on the commercial crisis of 1857 was devoted to court records of bankruptcies in Britain between 1849 and 1858. The reading is doleful. G.T. Braine, who was refused accommodation by the Bank of England in 1848, paid 20 shillings to the pound and finished with a surplus that was twice that originally estimated. One also finds petitions in bankruptcy brought by the Bank, such as that against Cruickshank, Melville and Co., for the unpaid residue of a bill it drew on another bankrupt firm that had paid only 12s. 6d. to the pound.⁶⁷

Even the judgment of history is not always helpful. The Bank of England first refused to help the three American ‘W banks’ (Wiggins, Wilsons and Wildes) in the fall of 1836 and then relented and advanced them credit in March 1837. Andréadès noted that the Bank took a bold step and had no occasion to regret its courage.⁶⁸ Clapham held, on the contrary, that the Bank lent most reluctantly and was not surprised when Wilsons and Wiggins failed at the end of May and Wildes thereafter and the consequence was ‘a long, dreary tale of debt lasting 14 years’.⁶⁹ To Matthews, the Bank of England’s aid to the three banks ‘in the vain hope of avoiding their suspending was a matter of faulty judgment but the principle on which they operated was a sound one’.⁷⁰

When and how much?

‘Too little, and too late’ is one of the saddest phrases in the lexicon of central banking. But how much is enough? When is the right time?

Bagehot’s rule is to lend freely at a penalty rate. ‘Freely’ means only to solvent borrowers and with good collateral, subject to the inevitable exceptions. It means rejecting the expedients that various central banks are tempted to indulge in crises. Early in 1772 the Bank of England tried to apply the brakes to overtrading by selective limitation of discounts and was criticized.⁷¹ In 1797 the Bank began to pro-rate discounts, and Foxwell thought that might have been undertaken again in 1809.⁷² Another technique when a central bank feels it is getting overcommitted is to tighten eligibility requirements for collateral, shortening the maturity of eligible bills from 95 or 90 days to 65 or 60 days, or adding to the number of names required. In May 1783 the Bank of England had discounted so heavily for its own clients that it departed from its regular practice and refused to make advances on subscriptions to government bonds issued that year. Clapham commented that fortunately no public or private catastrophe of the sort that starts a panic occurred that summer since the Bank had limited its capacity to meet one.⁷³ In this case the Bank was behaving like a private bank worried about its own safety rather than a public institution with the responsibility to provide for the stability of the system.

The lender of last resort might supply funds to the system through open market purchases rather than through the discount mechanism. How much should the central bank expand the money supply? Were the $160 million in October 1929 and the additional $210 million through November 1929 adequate? In the view of the Federal Reserve Bank of New York they were not. The New York Fed was operating under a directive from the Board of Governors that permitted it to buy $25 million of government bonds each week. It violated this rule in October by buying $160 million, and on 12 November recommended to the Board that the limit of $25 million a week be removed and that the Open Market Investment Committee be authorized to buy $200 million of bonds for the system. After considerable negotiation, the Board reluctantly approved this request on 27 November, and $155 million was purchased between 27 November and 1 January 1930. By this time, discounts were running off rapidly, interest rates had fallen sharply, and the need for a lender of last resort – to accommodate the liquidation of call loans in the market – was over.⁷⁴

Some monetarists seem ambivalent on the role of the lender of last resort. Friedman and Schwartz quoted Bagehot approvingly on not starving a panic.⁷⁵ They asserted that the action taken by the Federal Reserve Bank of New York in buying $160 million in October 1929 was ‘timely and effective’ although they were gently skeptical about Harrison’s claim that the open market purchases kept the stock exchange open.⁷⁶ Friedman was opposed to all discounting.⁷⁷ An ultra-monetarist view maintains that the open market operations of the period constituted a renewal of the credit inflation of the 1920s.⁷⁸ But most monetarists believe that there is no need to have a lender of last resort as long as the money supply increases at a constant rate. In retrospect the open market operations were woefully inadequate in the weeks from mid-October to the end of November 1929. They enabled the New York banks to take over the call loans of out-of-town banks but at the cost of reducing the amount of credit available for purchases of stocks, commodities, and real estate, which led to declines in their prices and unleashed the depression.⁷⁹

The timing of the Federal Reserve Board under the chairmanship of Alan Greenspan in the Black Monday crash of October 1987 was impeccable, as was the help for the US capital market when Long-Term Capital Management collapsed in September 1998.

Timing presents a special problem. As the boom mounts to a crescendo, it must be slowed without precipitating a panic. After a crash has occurred, it is important to wait long enough for the insolvent firms to fail, but not so long as to let the crisis spread to the solvent firms that need liquidity – ‘delaying the death of the strong swimmers’, as Clapham put it.⁸⁰ In a speech during the debate on the indemnity bill on 4 December 1857, Disraeli quoted the leader of an unnamed ‘greatest discount house in Lombard Street’ who said that ‘had it not been for some private information which reached him, to the effect that in case of extreme pressure there would be an interference on the part of the Government, he should at that moment have given up the idea of struggling any further, and [that] it was only on that tacit understanding that he went on with his business.’⁸¹ Questions could be raised about the equity of private information and of tacit understandings for insiders but not outsiders. Still, the remark underlines the importance of timing. Whether too soon and too much is worse than too little and too late is difficult to answer.

In 1857 the US Treasury came to the rescue of the market too early and helped it inflate still further. In 1873 the response was too slow, no steps were taken during the first part of the year.⁸² Sprague refers to ‘the unfortunate delay of the Clearing House’, that is, the slowness of any authority to respond to the 1907 crisis, in which as in no other crisis since the Civil War, things were allowed to drag on too long.⁸³

If the need for a lender of last resort is accepted after a speculative boom and it is believed that restrictive measures are not likely to slow the boom without precipitating a collapse, the lender of last resort faces dilemmas both of amount and timing. The dilemmas are more serious with open market operations than with a system of discounts. In the latter case, Bagehot specified the right amount: all the market will take – through solvent houses offering sound collateral – at a penalty rate. With open market operations the decision for the authorities is more difficult, but Bagehot was right not to starve the market. Given a seizure of credit in the system, more is safer than less since the excess can be mopped up later.

Timing is an art. That says nothing – and everything.