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In Crisis, Fed Applied Liquidity Lessons from Depression, Says Historian

As the Fed sought to blunt the effects of the financial crisis and Great Recession, the central bank successfully applied lessons it learned from the Great Depression nearly a century earlier, Michael Bordo, a Rutgers University economic historian, said during a recent interview at the Federal Reserve Bank of Atlanta.

During a May 20 visit to the Atlanta Fed headquarters, Bordo discussed the history of central banks as lenders of last resort. That role—as a place financial institutions can turn for credit when it's unavailable elsewhere—was conceived in England in the 19th century as a means to head off or at least limit the impact of financial panics, explained Bordo.

The lender-of-last-resort function still serves as a backstop for financial systems. The main channel through which the Fed lends to financial institutions is the discount window. During the recent crisis, as the enormous complexity of the challenges became clear, the Fed devised additional means of injecting liquidity into the troubled financial system.

Different instruments helped stem recent panic
"They came up with all these different kinds of instruments, and they were successful in allaying the panic," Bordo said of the Fed's work during and after the financial crisis of 2007–08. "I had some criticisms of some of the legacies that will come out of it, but they were successful."

One of the major lessons learned from the Great Depression was that it is critical during a crisis that a central bank stands ready to make funding freely available. The Fed generally took the opposite approach during the 1930s.

History has shown that the presence of a guaranteed source of liquidity—a lender of last resort—usually helps to stem financial panics, he said.

"In fact, if people understand in advance that the central bank is there to do that job, then the fact that the central bank says, 'We're ready, we're waiting, we're going to do it'...that can often, in many cases—and historically—allay the panic," Bordo told Amy Hennessy, the Atlanta Fed's director of economic education.

Recent regulatory changes could alter the way the Fed extends credit in the future. The Dodd-Frank Wall Street Reform and Consumer Protection Act restricts the Fed's latitude in lending to nonbanks. In the future, the central bank would have to clear any unusual credit programs with the Treasury Department.

"I'm not sure that's such a good idea," Bordo said. "The reason is because a lender of last resort, by definition, needs to move fast."