WHAT CAN WE LEARN FROM HISTORY

In his classic book on central banking,?Lombard Street,?Walter Bagehot argues a central bank can prevent crises by lending vigorously to banks in trouble. Further, he states these loans should be made at a very high interest rate. Specifically, “there are two rules. First. That these loans should only be made at a very high rate of interest…

Second. That at this rate these advances should be made on all good banking securities and as largely as the public ask for them. ?This created a big liquidity problem for many banks. On a normal day, some banks are short of liquidity because their payments coming due exceed their reserves. They may borrow through the interbank market from other banks that have excess liquidity. By lending directly to banks through the discount window, or by lending to the market through open market operations, the Federal Reserve and other central Banks can influence the total amount of liquidity available to banks. Because of the difficulties in communications described above, banks with large liquidity needs were unable to secure funds on the interbank market.

The Federal Reserve and other central Bank in previous crisis like the one of 2,008 stepped in and provided a large quantity of funds both to banks directly and also to the market. Hence, the policy followed by the Federal Reserve resembled Bagehot’s prescription but for one important detail: the Fed and others Central Banks provided funds at a very?low?interest rate.

The biggest problem has been that from 2,008 to 2,018 The Fed and other Central Banks have provided Tapering and QE *Quantitative Easing * to the financial system for more than 10 years and at a very low rate bordering negative lending..

These apparently incompatible differences concerning the cost at which funds should be provided to banks can be justified and that Bagehot’s basic insight remains relevant today but we are going to pay the price of too much liquidity in the Market for too long in an inflationary environment and with commodities and Energy prices never seen before.

The increase of Energy prices affect all industry, transport, logistics, factories , computers and Agriculture Farmers who are obliged to raise their prices but by doing so increasing drastically the inflationary wheel.

To understand Bagehot, it is important to remember that his lending policy was designed for the Bank of England in the 19th century. At that time, the Bank of England operated in a?commodity money?environment. In such an environment Central Bank money is backed by a commodity—gold in this particular case—and must be redeemed in that commodity at a pre-specified rate. The ability of the Bank of England to provide liquidity was thus limited by its gold reserves. Because there was a risk of running out of reserves, the Bank of England was faced with a difficult problem. On the one hand it wanted to make sure that all banks needing liquidity would have access to sufficient funds, as this was the only way to prevent the panic. On the other hand the Bank needed to protect its reserves from banks that might be overly careful and borrow even though they did not really need to. If too many such banks were able to obtain liquidity, the Bank of England could run out of reserves before all seriously troubled banks were helped.

One way to screen banks that need liquidity most is to set a high rate of interest. Bagehot writes “[a very high interest rate] will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who don’t 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 precaution without paying well for it; that the banking reserve may be protected as far as possible.

This policy works because banks that are more likely to need liquidity are willing to pay more for additional funds from the Central Bank than other banks. If the interest rate is sufficiently high, banks facing a low probability of needing funds will prefer to abstain from borrowing and take their chances, leaving more liquidity for banks facing a high probability. This self-selection mechanism is necessary in a commodity money regime because Central Bank reserves are limited.

If the problem is that the Central Bank might run out of reserves, why not make sure that it always holds enough funds to satisfy the needs of all banks? The reason is that such a policy might be too costly in a commodity money environment. Gold held as reserves by a Central Bank has an opportunity cost. It could be used to purchase consumption goods or invested in some productive way. Hence, increasing the Central Bank’s reserves decreases consumption, either directly or indirectly. If severe crises are very rare the cost of additional reserves might exceed the expected benefit of preventing an event that is extremely unlikely to happen.

Today, the United States nor other country worldwide has been working on Gold Backed Fiat Currency till Russia done so in June 2022 to sustain the Ruble, the US therefore in these turbulent times as well as mayor economic powers find themselves prone to a credibility issues as none of them have a commodity money system. Instead, it functions with?fiat money.?A fiat money system is one in which money has no intrinsic value. The dollar bills the Euros Banknotes, the Pound Sterling or the Swiss Franc we carry in our pockets are just pieces of paper which cannot be exchanged for gold or any other commodity at the Federal Reserve. They are valued in exchanges, not because they represent a claim on some intrinsically valuable commodity, but only because we believe others will accept them later.

The situation with Global Debt both at a Federal, States, corporate and consumers it’s at a level that the credibility of the system is coming into play.

In a fiat money system there is virtually no limit to the ability of the Central Bank to increase liquidity. It can just “print” additional pieces of paper. Of course, increasing the money supply too fast for too long would eventually create inflation. However, even massive liquidity injections should have little effect on prices as long as they are quickly reversed. That being the case, a Central Bank does not have to worry about running out of reserves. Consequently, since it can guarantee that all banks will have access to additional reserves, and since the opportunity cost of these reserves is very small, the Central Bank should provide liquidity at a very low cost. This is also desirable because a high interest rate induces a transfer from the banks to the Central Bank which hurts banks and their depositors.

Finally, it is interesting to note that Thornton (1802) does not take exception to the forgoing argument and would probably have concurred. Thornton, who wrote before Bagehot, also recommends lending vigorously in times of panics: “If any one bank fails, a general run on the neighboring ones is apt to take place, which if not checked at the beginning by a pouring into the circulation a large quantity of gold, leads to very extensive mischief. However, he never mentions lending at a high interest rate. In the face of the argument presented in this paper, the reason might be that England was off the gold standard at the time Thornton wrote. Indeed, from 1797 until 1821, the Bank of England was prohibited from paying its notes in gold.

However, the Bank was not prohibited from printing notes. Hence, it was functioning in a fiat money environment similar to that of the Federal Reserve today and could provide liquidity by simply issuing new notes. Thus we should not expect Thornton to recommend lending at a high rate.

Bagehot would probably have congratulated the Federal Reserve for doing a good job Indeed, he would have recognized that preventing liquidity crises requires a different policy in a commodity money world than in a fiat money world.