"Bagehot’s preferred, practical solution "

Via Cafe Hayek, an interesting post by George Selgin:

"The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the “Old Lady of Threadneedle Street,” as it was called, Bagehot’s preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at “penalty” rates. The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid.

Bagehot’s recommendation has since become a sort of master precept of central banking—albeit one that’s mainly honored in the breach by central bankers.

To be fair to today’s central bankers, there’s never been much agreement on how to apply Bagehot’s rule in practice. Just what do “good collateral” and “penalty rates” mean in times like these?"

I feel like Bagehot about the Fed, and completely agree with his remedy, if necessary, as I feel it to be in this case. Too bad it's not happening.

Here's my comment:

"But rescuing insolvent firms is the least of it. The real damage comes from the Treasury’s utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this."

Exactly. We can no longer accept the system of implicit guarantees. We need to debate and have publicly declared what, if any, the explicit guarantees are by the government for intervention.

The main cause of the current crisis is the system of implicit guarantees that investors were counting on in a crisis, which led to a whole host of otherwise very risky investments. The whole point is to understand what the conditions the investors believed that they were actually investing under, and the Lehman response shows that clearly.

Posted by: Don the libertarian Democrat | Oct 21, 2008 10:29:16 AM