Bagehot’s Lessons for the Fed

Apropos to our earlier criticism of the US Central Bank is this piece by Stanford prof Ronald McKinnon, titled Bagehot’s Lessons for the Fed.

In today’s WSJ, McKinnon writes:

"By slashing interest rates too much in 2007-2008, the
Fed has accentuated the foreign drain and thus made the alleviation of
the domestic drain more difficult. Yet, despite this mistake, Bagehot
would approve of other actions the Fed has taken to deal with the
domestic drain by unblocking specific impacted domestic markets. These
include (1) swapping Treasury bonds for less safe private bonds, (2)
opening its discount window to shaky borrowers, and (3) maybe even
rescuing Bear Sterns. He would also approve of the relaxation of
capital constraints on Fannie Mae, Freddy Mac and so on, for mortgage
lending. Yet these measures will be insufficient if the foreign drain

To repeat Bagehot’s Rule: "very large (domestic) loans
at very high rates are the best remedy for the worst malady of the
money market when a foreign drain is added to a domestic drain." The
Fed, and the U.S. government more generally, have so far got it only
half right."

The entire piece is worth a read . . .


Bagehot’s Lessons for the Fed
WSJ, April 25, 2008

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What's been said:

Discussions found on the web:
  1. Alan Greenspan commented on Apr 25

    This is only common sense…and our last exceptional man who was chairman of the Fed, Paul Volcker, would absolutely agree with the Stanford professor’s comments. I simply do not understand why Greenspan and Bernanke have decided that the recessionary part of the business cycle is to be avoided at all costs….in the long history of the United States, this has not been possible in the past and it won’t be now…

    Won’t somebody please put a balanced budget amendment on the books for this year and stop these people from turning our yearly national budget into just another un-collateralized debt obligation?

  2. Philippe commented on Apr 25

    The US central bank has mandate to maintain price stability, employment and the preservation of the payment system.
    Whilst these mandates do not conflict at time of BOP surplus, under employment and even inflationary pressure, they become contradictory in a situation of inflation, employment going through attrition and BOP deficit, a payment system in havoc if not in bankruptcy.
    Robert Mundell was not very prolix when outlining the alternative solution for this configuration.
    The Fed may have to choose at some point of time between higher unemployment and higher inflation and Bankruptcies.
    It is difficult homework to breed in harmony a cat and a fish.

  3. cinefoz commented on Apr 25

    As hard as I try, I just can’t understand the mentality that causes people to buy at a top. Nor can I understand those who refuse to sell and take profits. I have a relative who is still (or so he says) using capital losses from Y2K to shelter the current capital gain income he accidentally makes.

    I suspect there is a mental defect in some people that works on an unconscious level. Some buy at a top because they somehow think that the gain is locked in if a stock falls, and their quarterly statements are wrong. Others are aggressive followers who think markets ‘know something’.

    Well, thanks to you people who are defective, because you’re the ones I profit from. Momentum buyers are wonderful people. You may be dumb, but you are certainly lovable.

  4. Moses commented on Apr 25

    I am not buying into exports will save the day.

    That is basically what this guy is saying,
    who else in a weak dollar era can afford high rate domestic loans?

    This concept is seeping into various places these days. But it is hard for me to imagine that the world consumer could bail the US out.

    Which leaves you back to the world cannot survive without the audascious US consumption. I don’t really think this academics solution is going to help much in that regard.

  5. Ken commented on Apr 25

    The Fed has a very difficult job of dealing not only with inflation, communists in ECB, unjustified uber pessimism, but with ultra left-wing opinionated US media constantly injected their pessimistic propaganda again and again and again…

    For example, Consumer Confidence was better than expected today (62.6 vs. 62 expected), but the media is spinning it as the worst in 25 years (not to mention opinionated imbeciles from Bloomberg (re: Monica and Scarlet), they have been using their own based on a smaller number of economists estimates and have been spinning it as “weaker than expected”).

    The media (most of them are ultra left liberal democrats) wants people to feel bad about the economy and to vote for a bogus “change” (Obama). The media is out of control with their gloom and doom propaganda. The left-wing liberals are having wet dreams about a US recession and Obama in the White House.

    I think the Fed is doing relatively good job, considering all the factors.

  6. Pete commented on Apr 25

    Possible explanation of this administration’s behavior?

    Two cars race toward each other on an empty freeway; the first to swerve is the chicken. How should you play if you want to preserve both your status and your life? The answer is clear: in full view of your opponent, rip out your car’s steering wheel, blindfold yourself, down a bottle of Jack Daniels, scream. If you can persuade your opponent that you’re incapable of making the decision to swerve, then he has to swerve. In other words: the stupider, more ignorant, more irrational you can prove you are, the better the chance you have of winning.

  7. E commented on Apr 25

    If the housing/CRE market is the root of all of the problems for the banking system, then an FOMC rate hike is the solution. Such a hike would reduce inflation expectations, which would drive down the yield on the 10-year, which would drive down mortgage rates, which would increase buyers in the RE market, which would stabilize housing prices, which would stop the bleeding of MBS values on bank balance sheets.

    My take on the Fed the past 9 months is they’ve been trying to save the banking system, so a rate hike here would be in character.

  8. bonghiteric commented on Apr 25

    Ken, c’mon you can do better than that. You’re left-wing media propaganda spiel is so nineties.

  9. Philippe commented on Apr 25

    Very shrewd analysis I would differ on the political status of the ECB as I suspect is closer to the dadaisme in its monetary policy

  10. sk commented on Apr 25

    The Fed got it “Half-right” ? The prescription is large loans for good collateral at high rates surely. Purely mechanically, they got it 1/3 right – they didn’t take good collateral and they didn’t charge high rates but they DID make large loans. But in actually you can’t separate the three clauses – the point is to ensure liquidity not bailout insolvent institutions.

    Half-right? They just screwed it up royally.


  11. me commented on Apr 25

    So what are these “exports” that are going to bail us out? TVs/ Radios? Computers? Chips? Memory? Airplanes (that are mead elsewhere and assembled here)? Auto (big worldwide demand for SUVs)? Cell phones? Clothing? Shoes? Energy?

    The only thing we exported was fraudulent debt, our jobs, and our manufacturing base, and we are running out.

    We do export beef until we slip in a few spines.

  12. DL commented on Apr 25

    The Fed’s decision to accept mortgage backed securities as collateral will probably help matters in the short run. But it’s only going to encourage the investment banks to create more securities (of questionable value) in the future, and to take on more risk. They will come to believe that the Fed will accept whatever toxic waste they have to offer. At the top of the next credit cycle, adverse effects of the current Fed action may come home to roost.

  13. BG commented on Apr 25

    Tax Rebate

    President George Bush said each one of us would get a $600.00 tax rebate. It was previously slated to be $800.00, but they dropped it to a $600.00 tax rebate because of various budget problems.

    Now, if we spend that money at Wal-Mart, all the money will go to China.

    If we spend it on computers, most of the money will go to Korea or India.

    If we spend it on gasoline it will all go to the Arabs and none of these scenarios will really help the American economy.

    We need to keep that money here in ….. so the only way to keep that money here at home is to drink beer, have a party, gamble, or spend it on prostitution.

    Currently it seems that these are the only businesses still left in our Great City of ……

    I’m Mayor …… of …… and I approved this message.

    -Author unknown-

  14. DonKei commented on Apr 25

    The problem w/ Bagehot’s analysis of what to do in the foreign exchange markets is that all currency is fiat–we don’t do balance of payments transactions w/ gold.

    Therefore, the absolute first priority for the fed, since at least 1973 when we abandoned the gold standard, has to be protecting the value of the currency. Period.

    All this nonsense about protecting against deflation is just that. Unless you run out of printing presses and paper, there is absolutely no way that a fiat currency economy can ever unintentionally suffer deflation. Intentionally, yes (think Japan). Unintentionally, no.

    It’s time we found a new paradigm for what to do in a credit crisis w/ a fiat currency economy. Even Milton Friedman recognized that a strictly fiat currency regime was a brave new world, but one that would lead like all others, to the ultimate debasement of the currency.

  15. Peter Davis commented on Apr 25

    Can’t we just abolish the Fed and end this nonsense once and for all? The Fed IS the problem. Either we’re a free market or we’re not. Having a quasi-free market isn’t exactly what I’d call “ideal”. Of course, I also don’t think that either E-Z Al or Uncle Ben are what I’d called “competent”. I believe “delusional” would be the word I’d choose. Actually, it is the word I choose.

    The markets are constantly searching for a state of equilibrium. In essence, all this really is is a true free market where buyers and sellers jointly determine price. Yet, the Fed, ever fearful of things actually going down in price (Oh, the humanity!), has – as well all know – decided to try to circumvent that for a state in which buyers and sellers get together to determine price, provided that this price is higher than the previous.

    And this, my good friends and neighbors, has given us the quasi-free market we have today, in which the Fed, Treasury and Congress act selectively, but always on one side of the curve, ignorant of the fact that central planning never works. Particularly when undertaken by a bunch of knuckleheads who couldn’t plan a high school graduation party, much less an economy.

    Seriously, why is it we place so much faith in government, particularly Congress, who, to the best of my knowledge, are really only useful if the country requires massive injections of hookers and lawsuits? This is something that will likely boggle my mind until it begins to resemble my Uncle Eddie. Which is to say dead.

    Maybe we can organize the Million Trader March, in which we all descend upon Washington, burn the Federal Reserve and give Hank Paulson a huge wedgie. I don’t know. Maybe it’s just me.

  16. Thomas Shawn commented on Apr 27

    I’ve got a hunch that the $600 is specifically designed to prop up not our economy but China’s.

    If you wanted to help American business (i.e. American employers) you’d lower the corporate tax rate. Exports would expand even further and business would hire more.

    This $600 is designated for Walmart cash registers which means a little overtime for the $8/hr cashiers, a little for WMT stock owners and the rest for Red Chinese.

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