Bagehot, as in Walter Bagehot, was mentioned no less than seven times in the decision splitting the baby in the AIG trial.[1]   A nineteenth century British commentator, Bagehot was among the first to recognize that too little liquidity could wreak havoc on a financial system. [2]  In a series of admonitions, known today as Bagehot’s dictum, he admonished central banks to lend freely to any solvent institution with good collateral, but at a penalty rate to minimize the attendant moral hazard.[3] In invoking Bagehot, Judge Wheeler was in good company.   Ben Bernanke and other leading policymakers regularly invoked Bagehot’s dictum to defend their actions during the recent financial crisis, and outside experts similarly invoked Bagehot to assess the appropriateness of those actions.[4] The implicit affirmation of these outdated and ambiguous guidelines may be the most lasting and harmful aspect of the decision just rendered.

First, some basics about the lawsuit: At issue in the case was whether the government exceeded its legal authority or otherwise violated the rights of AIG shareholders when it provided emergency liquidity support to AIG during the height of the financial crisis in September 2008. Spearheaded by former AIG chief Maurice “Hank” Greenberg, the suit sought to hold the government liable for taking a nearly eighty percent equity stake in AIG and imposing other onerous terms. In siding with Greenberg and the other shareholders while denying them the right to any recovery, Judge Wheeler seemingly hoped to send a message that even amidst a financial crisis, there are limits to the Federal Reserve’s authority. Depicting the Fed’s actions as an effort to nationalize a nonbank financial institution in a way that intentionally avoided the need for shareholder approval and on terms that were harsher than those imposed on others, the court concluded that the Fed went a step too far. (For a great critique of the court’s analysis, see the post by John Coffee, available here.) Nonetheless, the court also recognized that had the Fed withheld support, AIG would have been forced to file for bankruptcy, so the shareholders suffered no harm as a result of the Fed’s supposedly unlawful actions.

Given the complexity of the legal issues before the court and the unprecedented nature of the Federal Reserve’s decision to provide such massive support to an insurance company, it is not surprising that the court implicitly looked beyond the legal issues at stake in the case to find some principled guideline for assessing the legitimacy of the Fed’s actions. As I have written about elsewhere, principled guidelines about how the Fed should use its vast discretion in the face of particular circumstances play a critical role facilitating Fed oversight and promoting accountability.

Principled guidelines, like the monetary policy guidelines embodied in the Taylor Rule, can guide Fed policymakers and, when used appropriately, can enhance accountability. Neither Bagehot’s dictum nor the Taylor Rule are, or ought to be, coded in law. The dynamism of the financial markets and the potentially dire consequences if the Fed lacks authority to respond effectively to those developments may justify the significant discretion that the Fed enjoys. Nonetheless, principled guidelines have long played an important role shaping how the Fed uses that discretion. They also promote accountability by creating reference points against that Congress, the financial press, and the public can use to assess the Fed’s actions.

Part and parcel with these benefits, principled guidelines about how the Fed should act in a given set of circumstances can also have significant costs. Precisely because they do shape Fed action, bad guidelines can lead to bad decisions. The Fed’s failure to do more to prevent the Great Depression, for example, has been attributed in part to Fed policymakers’ adherence to the now-discredited real-bills doctrine, an influential principled guideline during that era. Understanding the flawed reasoning inherent in the real bills doctrine was critical to displacing it as a principled guideline and to enabling the Fed to respond more effectively during the recent crisis.[5]

The time is ripe for Bagehot’s dictum to join the real bills doctrine in the dustbins of history. The danger is less that it leads to bad decisonmaking—though it very well might. The real challenge is that it is abused more often than used, it obfuscates more than clarifies, and it thus does more to compromise than promote meaningful accountability.

Former Fed Chairman Ben Bernanke, for example, invoked Bagehot’s dictum regularly to defend two of the Fed’s most controversial decisions during the financial crisis—its decision to provide a massive amount of liquidity support to nonbanks and its decision to allow Lehman Brothers to fail despite bailing out AIG and Bear Stearns.[6] Significantly, the basis that Bernanke invoked to justify allowing Lehman alone to fail—that Lehman was insolvent, the others were not, and Bagehot’s dictum provides that only solvent firms should receive support—was belied by Judge Wheeler’s opinion. According to the court, at the time the government saved AIG, market participants “perce[ived] that AIG’s borrowing needs exceeded AIG’s value by tens of billions of dollars,” and the broader record shows that the Fed officials had more questions than answers about AIG’s financial health when making the loan.[7] Also notable is that the court (potentially more true to Bagehot’s original writing than others who invoke Bagehot’s dictum) made no mention of solvency as an element of Bagehot’s dictum.

To be sure, in theory, there are good reasons supporting the principle that a central bank should lend only to solvent institutions. To do otherwise is to court moral hazard and enable socially destructive risk taking. In practice, however, more than a year into an ongoing financial crisis when assets are selling at fire sale prices and the institutions in question are nonbanks outside the Fed’s supervisory scope, such distinctions are so inherently judgment laden as to invite arbitrariness. And, because the decision to save a firm enhances its value while a decision to allow it to fail destroys value, it is almost impossible even with the benefit of hindsight to know whether a borderline firm was solvent or not.

The other tenets of Bagehot’s dictum—that a central bank should lend freely, against good collateral, but at penalty rates—all have similar shortcomings. Judge Wheeler’s opinion, for example, highlighted that the “penalty” terms of the Fed’s original loan to AIG impeded its ability to regain financial health. The government responded, contrary to the Bagehot’s dictum but in accord with the teachings of Milton Friedman and other scholars, by subsequently relaxing the terms. [8]   More generally, penalty rates deter borrowing—a good thing when financial markets are functioning well but often a very bad thing in the mist of a financial crisis.

Mandating that all loans be fully collateralized has similarly mixed effects. It reduces the government’s credit risk (a good thing) but potentially scares off other creditors (a very bad thing). Lending freely is similarly questionable. Too little liquidity can wreak havoc on a financial system, justifying sometimes widespread liquidity support. But the more widespread the support, the greater the moral hazard and the greater the regulatory challenge that must be addressed once a crisis ends. Widespread liquidity support can also put a financial system on life support, which is helpful if the underlying problems ailing the financial system are also being treated, but can lead to costly delays in identifying and responding to those problems when they are not.

The Fed was not blind to the very mixed effects of adhering too closely to Bagehot’s dictum, and it often honored Bagehot more in word than in practice during the recent crisis.[9] But this is the core of the problem: Bagehot’s dictum is used as a cover as often as it used as a meaningful policy guide.   The financial system and the tools available to a central bank have evolved dramatically since the nineteenth century. Bagehot merits his place in history, and his dictum may even remain the appropriate principled guideline for a central bank to follow when liquidity shortages first appear. But they make far less sense as a policy guide during an ongoing financial crisis.

The continued invocation of Bagehot’s dictum—by Fed policymakers and now the judiciary—is doing more to prevent than facilitate an honest assessment of the legitimacy of the Fed’s actions. Judge Wheeler’s strategic invocation of Bagehot with respect to certain points (and strategic silence as to others) is not unique. Rather, it is representative of the ways that Bagehot’s dictum has been abused to preclude meaningful discussion of when and how the Fed should provide liquidity support to troubled financial institutions. Rather than grasping for nineteenth century straws as a means to provide cover for controversial twenty-first century actions, we should devise a more appropriate and up-to-date set of guidelines for how the Federal Reserve should use the vast discretion it continues to enjoy.

ENDNOTES

[1] Starr Int’l Co. v. United States, No 11-779C (United States Court of Federal Claims, June 15, 2015) (Slip Opinion).

[2] Walter Bagehot, Lombard Street: A Description of the Money Market 56 (1873).

[3] The solvency requirement is not clear from Bagehot’s writing, as his focus was on collateral, but in part because collateral quality was the primary determinant of solvency at the time, the notion that a central banks should lend only to solvent institutions is regularly cited as a central component of Bagehot’s dictum. E.g., Ben S. Bernanke, The Federal Reserve and the Financial Crisis: Lectures by Ben S. Bernanke (2013); Brian F. Madigan, Dir. Div. of Monetary Affairs, Speech at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium: Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis (Aug. 21, 2009), available at http://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm.

[4] Brian F. Madigan, Dir. Div. of Monetary Affairs, Speech at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium: Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis (Aug. 21, 2009), available at http://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm; Neil Irwin, The Alchemists: Three Central Bankers and a World on Fire 10 (2013) (noting that Trichet (the head of the European Central Bank), Bernanke, and King (the head of the U.K.’s central bank) “often invoked Bagehot’s words as a model for their own crisis response almost 150 years” after he wrote).

[5] E.g., Charles W. Calomiris, Volatile Times and Persistent Conceptual Errors: U.S. Monetary Policy 1914–1951 11 (Am. Enter. Inst., Working Paper No. 26097, 2010), available at http://www.aei.org/files/2010/11/22/CalomirisMonetaryPolicyNovember2010.pdf; William Troost & Gary Richardson, Monetary Intervention Mitigated Banking Panics During the Great Depression: Quasi-Experimental Evidence from a Federal Reserve District Border, 1929–1933, 117 J. POL. ECON. 1031, 1040–1068 (2009); Ben S. Bernanke, Chairman of the Fed. Reserve Sys., Speech at “The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future,” conference sponsored by the National Bureau of Economic Research (July 10, 2013), available at http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm.

[6] Ben S. Bernanke, The Federal Reserve and the Financial Crisis: Lectures by Ben S. Bernanke (2013).

[7] Starr Int’l Co. v. United States, No 11-779C (United States Court of Federal Claims, June 15, 2015) (Slip Opinion) at 19.

[8] See, e.g., Friedman, Milton, and Anna J. Schwartz A Monetary History of the United States, 1867-1960 323-24 (1963).

[9] E.g., Brian F. Madigan, Dir. Div. of Monetary Affairs, Speech at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium: Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis (Aug. 21, 2009), available at http://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm (describing the numerous ways the Fed’s policies did not adhere to the classic form of Bagehot’s dictum).

The preceding post comes to us from Kathryn Judge, Associate Professor of Law and Milton Handler Fellow at Columbia Law School.