Lender of Last Resort

Posted by on 11/16/09 in America, Debt, Global Politics, Governance, Markets, Risk

Dear Friends,

In 1978, economist Charles Kindleberger published his seminal history of financial crises, “Manias, Panics and Crashes.” (Basic Books, Inc., New York) Kindleberger explored financial crises throughout Europe and the Americas in the 18th, 19th and 20th centuries, looking for patterns that might be instructive in identifying and remedying extreme systemic financial distress.

In October 2001, just weeks after 9/11, we picked up a used copy of Kindleberger’s book at an airport bookstore in Raleigh, North Carolina. While the NASDAQ bubble had on not fully popped (there was still a year to go), Kindleberger’s observations were shockingly relevant. Clearly, when economists of the future reflect back on financial crisis in the early 21st century, the dot.com bust will barely register a blip; all eyes will be on the current recession of 2007-200?.

Like any thoughtful student of crises, Kindleberger closes the book with a chapter on “The Lessons.”  His essential question is, “Do we need a lender of last resort?” when we seek to prevent or mitigate the impact of financial crises. And his response is an emphatic though qualified “yes.” He is no extreme fan of interventionist policies and is well aware of what we now call the “moral hazard” of socializing individual risk. At the same time, he is pragmatic about the need to calm a financial pandemic once it has taken hold. He sums it up most clearly when he writes:

“It seems evident that the remedy of letting the fires burn out, the flood subside of its own accord, is not satisfactory. Responsibility for stability is a public good. Public goods, though notoriously difficult to produce are nonetheless called for. One must recognize that the stronger the provision of public benefits, the less the incentive to produce them privately—in stability as in welfare, social security, housing or hospital care. True, self-reliance is undermined by reliance on others. Self reliance itself is a weak reed, however, in a world of contagion. It is not a contradiction simultaneously to emphasize the importance of personal health care to and to work on public health problems. Both preventive medicine and epidemic control are important.” (Page 220)

We have been mulling over the implications of Kindleberger’s assumption this week as we encounter headlines dominated by President Obama’s first state visit to China and public anger about the bailout of Goldman Sachs, both direct and indirect (e.g. AIG). These two themes reflect a major concern that we have about the current situation.

Much has been made about the role of the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”), the United States Treasury Department, and Congress authorizing tremendous loans (Goldman, Morgan Stanley) and bailout funds (Citi and AIG) to financial institutions, forced mergers (e.g. Merrill/Bank of America), subordination of previously unsubordinated debt (e.g. Chrysler), absorption of the cost of failed assets, and whole new classes of securities in an effort to re-stimulate consumer lending and borrowing. But our effort here is not to weigh in on the appropriateness of these interventionist strategies or critique how such decisions have been made; that discussion will be explored for many years to come.

Our concern is that many have come to perceive the Federal government as Kindleberger’s “lender of last resort.” That is not true. The United States does not actually have the resources to provide the lending or cash infusions we have authorized. At this point in our economic history, new funds authorized by the Fed or Congress must be borrowed from elsewhere; thus the US government’s broadly defined stimulus is really just a pass through. The real lenders of last resort right now are primarily the Chinese government and its proxy banks (which have become much larger in market capitalization than our domestic banks), and to a lesser degree other governments around the world.

By making China the lender of last resort in this crisis we have accelerated a trend toward shifting the global balance of economic—and thus political—power from West  to East. Granted, the codependence between the US and China significantly complicates the situation and prevents China from treating the US with impunity. To some degree, the situation reflects that between the US and Western Europe than first took shape in the early 20th century and solidified post WWII.

Thus, as pundits dissect the diplomatic exchanges this week in Beijing, looking for Chinese concessions on domestic human rights, Tibet, Taiwan, North Korea, Sudan, Iran or other matters important to the US, let’s understand the broader context of how the power dynamic has shifted. There will not be major concessions because we have very little leverage with which to extract them. Anyone who has read our sentiments over time knows that we recognize and accept the trend toward globalization, and that we see it as one of the most powerful tools to alleviate extreme poverty and ultimately promote human rights. And you would know that we believe strongly in the work ethic, innovation, enterprise, and philanthropy that has marked America’s growth over time.

Yet, this crisis has underscored that as a country, we are no longer the masters of our collective destiny. Our poor policies and judgment (individual, corporate, government) have transformed the landscape; thus, we Americans need to be asking difficult questions about what we each can do to reaffirm and promote the collective strength of our communities and thus reinvigorate the whole. And the answers must be far more rigorous than what we are doing so far.