The policy implications

The appearance of a mania or a bubble raises the policy issue of whether
governments should seek to moderate the surge in asset prices to reduce
the likelihood or the severity of the ensuing financial crisis or to ease
the economic hardship that occurs when asset prices begin to decline.
Virtually every large country has established a central bank as a domestic
‘lender of last resort’ to reduce the likelihood that a shortage of liquidity
would cascade into solvency crisis. The practice leads to the question
of the role for an international ‘lender of last resort’ that would assist
countries in stabilizing the foreign exchange value of their currencies and
reduce the likelihood that a sharp depreciation of the currencies because
of a shortage of liquidity would trigger large numbers of bankruptcies.
During a crisis, many firms that had recently appeared robust tumble
into bankruptcy because the failure of some firms often leads to a decline
in asset prices and a slowdown in the economy. When asset prices de-
cline sharply, government intervention may be desirable to provide the
public good of stability. During financial crises the decline in asset prices
may be so large and abrupt that the price changes become self-justifying.
When asset prices tumble sharply, the surge in the demand for liquidity
may drive many individuals and firms into bankruptcy, and the sale of
assets in these distressed circumstances may induce further declines in
asset prices. At such times a lender of last resort can provide financial sta-

bility or attenuate financial instability. The dilemma is that if investors

knew in advance that governmental support would be forthcoming un-

der generous dispensations when asset prices fall sharply, markets might

break down somewhat more frequently because investors will be less

cautious in their purchases of asset and of securities.

The role of the lender of last resort in coping with a crash or panic is

fraught with ambiguity and dilemma. Thomas Joplin commented on the

behavior of the Bank of England in the crisis of 1825, ‘There are times

when rules and precedents cannot be broken; others, when they cannot

be adhered to with safety.’ Breaking the rule establishes a precedent and

a new rule that should be adhered to or broken as occasion demands.

In these circumstances intervention is an art rather than a science. The

general rules that the state should always intervene or that the state

should never intervene are both wrong. This same question of interven-

tion reappeared with whether the U.S. government should have rescued

Chrysler in 1979, New York City in 1975, and the Continental Illinois

Bank in 1984. Similarly, should the Bank of England have rescued Baring

Brothers in 1995 after the rogue trader Nick Leeson in its Singapore

branch office had depleted the firm’s capital through hidden transac-

tions in option contracts? The question appears whenever a group of

borrowers or banks or other financial institutions incurs such massive

losses that they are likely to be forced to close, at least under their

current owners. The United States acted as the lender of last resort at the

time of the Mexican financial crisis at the end of 1994. The International

Monetary Fund acted as the lender of last resort during the Russian

financial crisis of 1998, primarily after prodding by the U.S. and German

governments. Neither the United States nor the International Monetary

Fund was willing to act as a lender of last resort during the Argentinean

financial crisis at the beginning of 2001. The list of episodes highlights

that coping with financial crises remains a major contemporary problem.

The conclusion of The World in Depression, 1929–1939, was that the

1930s depression was wide, deep, and prolonged because there was no

international lender of last resort.2 Great Britain was unable to act in

that capacity because it was exhausted by World War I, obsessed with

pegging the British pound to gold at its pre-1914 parity and groggy

from the aborted economic recovery of the 1920s. The United States

was unwilling to act as an international lender of last resort; at the time

few Americans had thought through what the United States might have

done in that role. This book extends the analysis of the responsibilities

of an international lender of last resort.

The monetary aspects of manias and panics are important and are

examined at length in several chapters. The monetarist view—at least

one monetarist view—is that the mania would not occur if the rate

of growth of the money supply were stabilized or constant. Many of

the manias are associated with the surge in the growth of credit, but

some are not; a constant money supply growth rate might reduce the

frequency of manias but is unlikely to consign them to the dustbins of

history. The rate of increase in U.S. stock prices in the second half of the

1920s was exceptionally high relative to the rate of growth of the money

supply, and similarly the rate of increase in the prices of NASDAQ stocks

in the second half of the 1990s was exceedingly high relative to the

rate of growth of the U.S. money supply. Some monetarists distinguish

between ‘real’ financial crises that are caused by the shrinkage of the

monetary base or high-powered money and ‘pseudo’ crises that do not.

The financial crises in which the monetary base changes early or late

in the process should be distinguished from those in which the money

supply did not increase significantly.