The Role of the Fed as the Lender of Last Resort Transcript

Jekyll Island Conference

November 5, 2010

Charles Davidson: Welcome to the podcast of the Jekyll Island conference sponsored by the Federal Reserve Bank of Atlanta and Rutgers University. We're in Jekyll Island, Georgia at the Jekyll Island Club Hotel with conference panelists who gave presentations on the Fed's role as lender of last resort. Moderator Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, talks with presenter Michael Bordo, professor of economics at Rutgers, and panel discussant Ellis Tallman, professor of economics at Oberlin College.

Sandra Pianalto: Michael, how did the Federal Reserve Act end up differing from what Senator Aldridge and Paul Warburg proposed when they were here at Jekyll Island?

Michael Bordo: It differed primarily in the structure that they thought the Federal Reserve system would be like. In a sense, what Warburg wanted and what was incorporated in the Aldridge Plan was a system which would be centralized in Washington and then there would be these branches, twenty branches across the country, and that the control in Washington, in a sense, would be run by bankers, and the government would have a very limited role. And what we got was, in a sense, the Federal Reserve System. We had these twelve reserve banks. The reserve banks were very independent. Their boards were made up of local bankers and other business people and labor people, and then you had this coordinating Federal Reserve Board in Washington, which was appointed by the government, by the President, and that was supposed to coordinate between the banks. So, in a sense, Warburg wanted something he called the United Reserve Bank. He wanted something which would be like what they had in Europe, but it would account for the fact that the U.S. is a big place. We had 20 branches, but it really was going to be a monolithic central bank.

Pianalto: Ellis, do you have any thoughts about this?

Ellis Tallman: There was a sense in which the Aldridge Plan was an adaptation of the clearinghouse system that existed in the National Banking Era. Similar to what Mike just said, the governance of clearinghouses was bankers. So the inferences that bankers would have about when a financial panic was arising was because they were bankers and they saw it. And I think the governance story that Mike describes is exactly that: that you had in some way a dilution of the expertise from the banking sector.

Pianalto: Michael, the Federal Reserve Act had no explicit instructions on what the Fed should do in the event of a financial panic. What was the effect of this gap in the legislation?

Bordo: Well, I think the effect was that when push came to shove, and we really had a crisis in the 1930s, that the Fed basically didn't do what it was originally intended to do. In my paper with Dave Wheelock, we sort of come up with some reasons why this was the case. We talk about the fact that they didn't create the kind of money market that market and banker's acceptances that Warburg wanted for the Federal Reserve. It would be like the Bank of England or another European central bank. It would freely discount acceptance. And so we had this mechanism of discount window lending that was based on discounting eligible real bills by member banks at Federal Reserves, at the Federal Reserve banks. It left out a good chunk of the banking system because it was only member banks that were actually able to go to the window. And also what happened was there was a stigma; that people of banks were afraid to go to the window. In part, it's was because the Federal Reserve really discouraged lending in the 1920s, and then when they really needed lending to take place in the 1930s, it didn't happen. So you didn't get the kind of automatic lender of last resort response that these people wanted. There is huge literature on why the Great Depression happened and all the mistakes of the Federal Reserve, and I'm not going to go into all those stories, but I think the story is that the lender of last resort mechanism didn't really work.

Tallman: I'll just go on the same line with Michael, that there was essentially no view that it was the Fed's obligation to prevent banking panics, that the Fed relied on the expertise of those that were in the system, there was a lot of discretion. And because of the decentralized structure that arose with allowing a lot of different discretion, depending on who was running the different districts, you had very different policies implemented by different participants of the system.

Pianalto: Michael, why were the Fed's credit market interventions during the Great Depression so ineffective?

Bordo: In part because they really didn't have a concerted policy to follow. They were reacting to the demands by member banks, and when the member banks didn't come forth, because they were afraid to borrow and also because the Federal Reserve had this sort of flawed doctrine of member-bank borrowing, and they thought that if people aren't coming to the window, and if interest rates are low, then this shouldn't be a problem. So they didn't act in an aggressive manner. The times that the Fed actually did something—in 1932 they conducted open market operations, and these were effective, but only for a few months, and the Federal Reserve Board, in a sense, discontinued them, in part because the Congress which had been pressuring them to do this went on recess in the summer and in part because they were worried about rekindling speculation. In the doctrine that they followed, they thought that speculation or bank finance, to finance stock purchases, would not only lead to an asset price boom, a stock market boom, but would lead to inflation. For these reasons—the reasons were that they were largely passive, that they misinterpreted what was going on with their discounts, and third because they in a sense had a strong aversion to stimulating the economy—this is why it didn't work.

Pianalto: Ellis, your thoughts?

Tallman: To a larger extent—this is echoing a previous answer—they really didn't see their role as providing large-scale increases in reserves; supporting the banking system to prevent crises. It was not a concerted effort because of the structure, as Michael had suggested, and because they didn't really have the courage of their convictions because they didn't really have this conviction. They didn't have this recognition that it was their role to step in and prevent what might seem like a regional banking crisis from eventually deteriorating the confidence that, "Well, the Fed. is the lender of last resort, and if I'm in a situation where I need liquidity, I know where to get it." It actually became a situation of, "Hmm. Where do I get liquidity? Well, from what I observe, I'm probably not going to be able to get long-term liquidity from the Fed."

Pianalto: Michael, how did subsequent legislation address some of the shortcomings of the original Federal Reserve Act?

Bordo: Yes, there were two acts that were passed after the Great Depression, one in 1933 and one in 1935, and these acts did deal with some of the problems. One of the issues was that the Reserve Banks, in a sense, sort of had the initiative in conducting lender of last resort policy. So what the legislation in 1935 did was, it sort of consolidated power in the board. So you weren't going to have this problem of some Reserve Banks doing the right thing and others not. And so that was a very important thing. Secondly, it increased the type of lender of last resort actions, or the type of lending that the Fed was allowed to do—discount lending—it was allowed to do. In this famous article, 13-3, which basically allowed the Fed to engage in discount window lending to any type of entity. And so it sort of got around this problem, which was a serious problem, in that they were only allowed to discount eligible paper from member banks. Now, the Fed could discount from anybody: not just member banks, all types of banks, and it could operate in any market that it wanted to. So this was a major improvement, and in fact it was used as the legal justification for what the Fed did in 2008, when they engaged in all these credit market facilities. So that was very important.

Pianalto: Ellis?

Tallman: On this one I have very little to add. I'd rather, actually, leave that with Michael's answer and go back to one thing that I forgot that I really wanted to mention: where the Federal Reserve Act differed from what Aldridge and Warburg's proposal, and it's one that I just love to throw in. And it's that, in order for William Jennings Bryan to support the Federal Reserve Act, he insisted that Woodrow Wilson insert that Federal Reserve notes would be legal tender. And we're one of the few countries where Federal Reserve notes are actually obligations of the Treasury. So I just thought I'd mention that.

Pianalto: Thank you. That's great.

Davidson: This concludes our podcast of the Jekyll Island Conference sponsored by the Federal Reserve Bank of Atlanta and Rutgers University. Thanks for listening, and please return for more podcasts. If you have comments, please e-mail us at