The story of the 2008 financial crisis begins somewhere shortly after the death of Jesus Christ himself. Not 33 years after Christ’s passing did Emperor Tiberius of the Roman Empire have to rescue his constituents’ financial sanctity through the age-old process of quantitative easing. The Roman Empire was in shambles following a severe economic downturn caused by the deteriorating value of ivory and ostrich feathers. By distributing 100 million sesterces from the imperial bank to reliable bankers around the Empire and dropping interest rates to zero for three years, Tiberius saved Rome and the other affected nations of Egypt, Greece, and France.
This same tale has repeated time and time again.
The 2008 financial crisis saw Ben Bernanke, the then chairman of the Federal Reserve, providing money to banks across the United States following the collapse of the housing market and subsequent defaults of mortgage backed securities.
Will humanity ever learn its lesson?
Perhaps not in the prediction of crises, but our responses to these inevitable crises have been studied and tinkered with over the past two millennia.
Financial crises typically follow similar patterns: a key resource in the economy takes a major hit to its value, banks panic and sell their other assets, reducing asset values across the board, and mass panic ensues. In the midst of the panic, individuals attempt to withdraw funds from the banking system and, as rumours circulate that banks may not have enough money to repay deposit holders, a bank run ensues. Even if a bank has enough assets to be considered solvent, it can quickly face a cash crunch as it takes time to sell off its long term assets. In the face of illiquidity a bank cannot repay current liabilities or their depositholders. The bank will likely fail unless urgent measures are taken.
One of these urgent measures comes in the form of a ‘lender of last resort’, a third party who provides liquidity to the bank in its hour of need. Lender of last resort policies are not one size fits all, and ever since Tiberius used his LOLR power the policies have twisted and turned to cope with new crises in a variety of ways. One curious use of liquidity provisions occurred in the forgotten 1929 financial crisis of Florida.
In the prelude to this crisis, Floridian farmers were devastated by conniving Mediterranean fruit flies. These flies made their way into the citrus farms, destroying crops, causing a government quarantine and destruction of infected fruit. The year’s haul was ruined for many farmers, and they quickly rushed to the banks to withdraw their deposits. As often happens with mass withdrawals, liquidity became scarce, and banks began to suspend withdrawals and fail altogether. This led to more panic, prompting still more people to withdraw their deposits.
At this point, the Atlanta Federal Reserve could sense a crisis brewing. Thus, they decided to step in and send funding to the two main banking institutions in Tampa and promised to guarantee any customer deposits at the two banks. Illiquidity crises are often a psychological battle as much as a tangible one, so the greater the gesture the more likely to stem the flow of withdrawals. The cause of the panic is withdrawals, and the cause of withdrawals is panic. To break this cycle is difficult, but the Atlanta Reserve had a rather unique plan. In law, Federal Reserve money was not allowed to be kept anywhere outside the premises of the Reserve itself, but the Atlanta Reserve wanted to show the public that they had put the money where their mouth was. As such, the Atlanta Reserve instructed six million dollars to be sent down and put on display within the actual banks in cordoned off corners that were designated as property of the Reserve. Panicked depositors rushed into the bank to withdraw their deposits, but upon seeing the stack of cash the outflow of deposits was reversed within three days. Federal Reserve money is not limitless, and that sum would not have covered the entirety of the withdrawals, but the transparency and display of cash changed public opinion so much that the bank run was stopped. The crisis was stopped in its tracks by a bold move from the Atlanta Federal Reserve.
This situation begs the question, is the most important aspect of a lender of last resort to provide liquidity, or to increase public confidence in financial institutions? Does a convincing promise from a LOLR of liquidity provisions have the same effect as an actual liquidity provision? The US Federal Reserve spent around 3.7 trillion dollars buying troubled assets and bonds in order to provide liquidity to banks from 2008 to 2015. Ultimately, this has proven to be an effective way of responding to the 2008 financial crisis. Moreover, balance sheet data from the Federal Reserve shows that the acquired assets have remained fairly consistent in value, indicating that the underlying assets were not altogether a lost cause.
One could argue, however, that these provisions were not enough. The Federal Reserve let Lehmann Brothers fail based upon a 4.5-billion-dollar cash shortage [pdf p90-91]. As it is a criminal offense to operate a firm without sufficient cash under British Law, Lehmann Brothers had to either meet its cash requirements or file for bankruptcy. The Federal Reserve decided that Lehmann Brothers was insolvent and did not provide it with liquidity. Post-failure balance sheets show that Lehmann Brothers actually had twenty billion dollars of assets in excess of its debts. Thus, Lehmann Brothers was merely illiquid, and could have been saved.
Providing liquidity is a very tangible tactic with a history of success, but the output gaps caused by crises remain prevalent for years [pdf]. Stopping crises at an earlier stage or by different means, prior to exercising LOLR facilities, may have an even greater positive economic effect. However, this is a lofty ambition, and the complexity of instruments that caused the 2008 financial crisis makes it very difficult to draw any conclusions. Would improving public opinion of the assets underlying this crisis have stopped the panic before it became a crisis? Crisis maintenance, it seems, is a very psychological game.
My next article will delve into the causes of the 2008 financial crisis and show further parallels with historical crises.
Dean Franklet is a third year economics and finance student at the University of Canterbury where he is President of the largest commerce society on campus. Spending his life in Texas and then New Zealand with a few other stops along, he gives a unique global viewpoint to portray in his writing.
Image: Flickr