Must Central Bankers Undermine Financial Markets?

Must Central Bankers Undermine Financial Markets?

The Federal Reserve Bank helped obtain a buyer for Merrill Lynch and in so doing may have undermined rival investment bank Lehman Brothers. Do double standards create uncertainties that weaken the integrity of the financial system? If so, why does the bailout bill expand, rather than reduce, the discretionary powers of U.S. financial regulators? Were he alive today, Walter Bagehot, the esteemed early editor of The Economist magazine, would be crying to the heavens!

Bagehot's bête noire was the Bank of England, which he said created problems for the economy by dispensing special favors to select banks during financial crises. If England's central bank couldn't be abolished, he argued, the next best alternative would be for it to stop playing favorites. Bagehot recommended that the Bank of England offer loans to all troubled banks, but only at penalty interest rates and only if the borrowers put up good collateral to secure those loans. This advice is just as valid today, according to Independent Institute Research Fellow George Selgin, author of Good Money. (No less an authority than the late Milton Friedman called the book "a splendid piece of historical analysis" of how private enterprise solved a monetary problem that threatened seriously to retard the Industrial Revolution.)

Bagehot's advice is helpful even if we don't know exactly what "good" collateral looks like. That's because we often recognize inadequate collateral when we see it. Selgin writes in a new op-ed: "While no one may precisely be able to define good collateral, and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, plus 8 percent constitutes a 'penalty' rate, who even pretends that recent central bank lending has been based on good collateral?"

Wasn't the relaxation of loan requirements a key factor that got us into this mess in the first place?

Independent Institute Research Fellow Jeffrey A. Miron also notes that the bailout creates uncertainty in the banking system. "Government ownership means that political forces will determine who wins and who loses in the banking sector," he writes in a piece published on CNN's website.

"The government, for example, will push banks to aid borrowers with poor credit histories, to subsidize politically connected industries, and to lend in the districts of powerful members of Congress," he continues. "All of this is horrible for economic efficiency. Government pressure will be difficult for banks to resist, since the government can both threaten its ownership stake or promise further injections whenever it wants to modify bank behavior. Banks will respond by accommodating government objectives in exchange for continued financial support."

"Central Bankers Still Don't Get It," by George Selgin (Modesto Bee, 10/14/08)
http://www.independent.org/newsroom/article.asp?id=2345

"Why This Bailout Is as Bad as the Last One," by Jeffrey A. Miron (CNN.com, 10/14/08)
http://www.independent.org/newsroom/article.asp?id=2346

Purchase Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage, 1775–1821, by George Selgin.
http://www.independent.org/store/book_detail.asp?bookID=75

For an analysis of the U.S. government's leading role in weakening mortgage lending standards, see "Anatomy of a Train Wreck: Causes of the Mortgage Meltdown," by Stan J. Liebowitz (10/3/08)http://www.independent.org/publications/policy_reports/detail.asp?type=full&id=30