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Rules for a lender of last resort: An historical perspective

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  • Bordo, Michael D.

Abstract

The Federal Reserve was established in 1913 to be a lender of last resort. Paul Warburg, its principal architect had in mind that a U.S. central bank would follow Bagehot׳s strictures ‘to lend freely at a penalty rate’ in the face of a scramble for high powered money. Yet the Federal Reserve Act never spelled out how the Fed was supposed to act as an LLR. This omission came to the fore in the Great Contraction 1929 to 1933 when the Fed failed to prevent four banking panics which turned a serious recession into the Great Contraction. Reforms in the 1930s corrected some of the Fed׳s failures but clamped down on financial activity for 40 years. The financial crisis problem returned in the 1970s with financial liberalization. The Fed abandoned Bagehot׳s strictures and adopted the ‘Too big to fail’ doctrine and ‘creative ambiguity’. This policy shift contributed to moral hazard and created new threats to financial stability with the rise of the ‘shadow banking system’. The subprime mortgage crisis prompted the Fed to take unprecedented LLR activities which have opened up a Pandora׳s box of perils. The Fed has moved away from rules based policy in its LLR function.

Suggested Citation

  • Bordo, Michael D., 2014. "Rules for a lender of last resort: An historical perspective," Journal of Economic Dynamics and Control, Elsevier, vol. 49(C), pages 126-134.
    • Handle: RePEc:eee:dyncon:v:49:y:2014:i:c:p:126-134
    DOI: 10.1016/j.jedc.2014.09.023
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    Citations

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    Cited by:

    1. Nedelchev, Miroslav, 2015. "Coordination of banking regulation in the EU," MPRA Paper 66073, University Library of Munich, Germany, revised 2015.
    2. Michael D. Bordo, 2017. "An historical perspective on financial stability and monetary policy regimes: A case for caution in central banks current obsession with financial stability," Working Paper 2018/5, Norges Bank.
    3. Makoto (M.) Watanabe & Tarishi Matsuoka, 2019. "Banking Panics and the Lender of Last Resort in a Monetary Economy," Tinbergen Institute Discussion Papers 19-002/V, Tinbergen Institute.
    4. Laurent Le Maux, 2021. "Bagehot for Central Bankers," Working Papers hal-03201509, HAL.
    5. Anson, Mike & Bholat, David & Kang, Miao & Thomas, Ryland, 2017. "The Bank of England as lender of last resort: new historical evidence from daily transactional data," Bank of England working papers 691, Bank of England.
    6. Michael D. Bordo & John V. Duca, 2020. "How New Fed Corporate Bond Programs Dampened the Financial Accelerator in the Covid-19 Recession," NBER Working Papers 28097, National Bureau of Economic Research, Inc.
    7. Duca, John V., 2017. "The Great Depression versus the Great Recession in the U.S.: How fiscal, monetary, and financial polices compare," Journal of Economic Dynamics and Control, Elsevier, vol. 81(C), pages 50-64.
    8. Rockoff, Hugh, 2022. "Milton Friedman on bailouts," Journal of Financial Stability, Elsevier, vol. 63(C).
    9. Anne-Marie Rieu-Foucault, 2017. "Point sur la fourniture de liquidié publique," EconomiX Working Papers 2017-27, University of Paris Nanterre, EconomiX.
    10. Christian Pfister, Natacha Valla, 2018. "‘New Normal’ or ‘New Orthodoxy’? Elements of a Central Banking Framework for the After-Crisis," Working papers 680, Banque de France.
    11. Sargent, Thomas J., 2014. "The evolution of monetary policy rules," Journal of Economic Dynamics and Control, Elsevier, vol. 49(C), pages 147-150.
    12. Michael D. Bordo, 2016. "Some Historical Reflections on the Governance of the Federal Reserve," Book Chapters,in: John H. Cochrane & John B. Taylor (ed.), Central Bank Governance & Oversight Reforminancial Crisis, chapter 5 Hoover Institution, Stanford University.
    13. Bordo, Michael D. & Duca, John V., 2022. "How new Fed corporate bond programs cushioned the Covid-19 recession," Journal of Banking & Finance, Elsevier, vol. 136(C).
    14. Makoto WATANABE & Tarishi Matsuoka, 2023. "A Monetary Equilibrium with the Lender of Last Resort," CIGS Working Paper Series 23-010E, The Canon Institute for Global Studies.
    15. Alexandr Patalaha & Maria A. Shchepeleva, 2023. "Bank Crisis Management Policies and the New Instability," Finansovyj žhurnal — Financial Journal, Financial Research Institute, Moscow 125375, Russia, issue 6, pages 43-60, December.
    16. Anne-Marie Rieu-Foucault, 2017. "Point sur la fourniture de liquidié publique," Working Papers hal-04141643, HAL.
    17. Steven Ambler, 2016. "Toward the Next Renewal of the Inflation-Control Agreement: Questions Facing the Bank of Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 453, July.

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    More about this item

    Keywords

    Federal Reserve; Lender of last resort; Banking crisis; Moral hazard;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises

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