I doubt a week has gone by since last summer during which I haven't seen some pundit or other trot out Walter Bagehot's dictum that in the event of a credit crunch, the central bank should lend freely at a penalty rate. More often than not, this is contrasted with the actions of the Federal Reserve, which seems to be lending freely at very low interest rates.
Ben Bernanke, in a speech today, addressed this criticism directly:
What are the terms at which the central bank should lend freely? Bagehot argues that "these loans should only be made at a very high rate of interest". Some modern commentators have rationalized Bagehot's dictum to lend at a high or "penalty" rate as a way to mitigate moral hazard--that is, to help maintain incentives for private-sector banks to provide for adequate liquidity in advance of any crisis. I will return to the issue of moral hazard later. But it is worth pointing out briefly that, in fact, the risk of moral hazard did not appear to be Bagehot's principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnecessary borrowing and thus to help protect the Bank of England's own finite store of liquid assets. Today, potential limitations on the central bank's lending capacity are not nearly so pressing an issue as in Bagehot's time, when the central bank's ability to provide liquidity was far more tenuous.
I'm no expert on Walter Bagehot, and in fact I admit I've never read Lombard Street. But I'll trust in Bernanke as an economic historian on this one, unless and until someone else makes a persuasive case that Bagehot's penalty rate really was designed to punish the feckless rather than just to preserve the Bank of England's limited liquidity."
Jeff Sachs seems to be pleased with the new administrations commitment to "a new age of sustainable development":
A better, or, at least, different view:
"Rightwing pundits bemoan the evident intention of Obama and team to "tell us what kind of car to drive". Yet that is exactly what they intend to do (at least with regard to the power source under the hood), and rightly so."
This post is a plan for disaster. A massive commitment to spending without assessment along the way is foolish. It's much better to start off slow and show how the spending is working, both for reasons of common sense and political backing. It is also foolish to start telling people we're in the business of micromanaging more and more of their lives. At the very least, an approach like Sunstein and Thaler's would be more likely to work and gather approval.
Fortunately, I don't see our President as likely to follow Sach's advice. I like what he says about more money for the third world, but this clarion call for massive government intrusion and spending is off base.
By the way, I'm trying to understand how our current crisis leads one to believe that we need to spend massively for all time going forward. Sachs seems to believe that our current crisis shows that government can effectively spend and manage our money going forward. How does this follow?
Posted by: Don the libertarian Democrat | January 29, 2009 at 07:13 AM