The Eurozone Tea Party and the Lender of Last Resort

The Tea Party is much more powerful in Europe than in the US. Read Ambrose Evans-Pritchard to see an example. It's just they don't call it the "Tea Party" in Europe. It doesn't seem to have a name over there, but that's what it is.

The basic philosophy underlying the Tea Party is, at its crudest: "We're not paying for them". Who's "we" and who's "them" differs across two centuries and across the Atlantic Ocean, but it's still recognisably the same philosophy. The Tea Party makes life difficult for the Lender of Last Resort, because the Tea Party wants some sort of guarantee it will get its money back. And that guarantee can never be made cast-iron. If it could, you probably wouldn't need a Lender of Last Resort in the first place.

We like to make a distinction between an entity that is illiquid and an entity that is insolvent. An illiquid entity can't pay what it owes right now. An insolvent entity can't ever pay back what it owes, even if you lend it some more to tide it over. Ideally, a Lender of Last Resort lends freely to entities that are illiquid but solvent. It lends enough to tide the entity over until it can pay what it owes.

Solvency refers to the future, and you can never know the future, so you can never know for sure that an entity is solvent.

Solvency also depends on the interest rate that the Lender of Last Resort will charge. At a high enough interest rate, the entity won't be able to pay what it owes, including what it owes to the Lender of Last Resort. At a low enough interest rate, the entity may be able to pay back what it owes. But that interest rate must also be high enough to compensate the Lender of Last Resort for the risk it undertakes. This feedback may be especially strong if the Lender of Last Resort is a central bank, so its monetary policy has macroeconomic consequences. So, even if we agree on the equations about the future, those equations may give more than one right answer.

And the Lender of Last Resort must act quickly, and be expected to act quickly and resolutely, even if it cannot quickly determine whether the entity is solvent, or what would be needed to make the risks worth the interest rate on the bridging loan.

This is not what the Tea Party wants to hear.

Despite my British North American bias, I have some sympathy for the Tea Party. The Lender of Last Resort function is perhaps antithetical to deliberative rule-bound democracy. It's a judgement call, and can't be anything else. If "we" are all in this together, so we sink or swim together, we can perhaps set aside these problems. If worst comes to worst, and it's a bail-out not a loan, we are only bailing out ourselves. But as soon as you start asking "Who, whom?", you never stop. Are Finnish taxpayers bailing out the Greek government, German banks that own greek bonds, French pensioners with funds in German banks, or Finns selling cellphones to those French pensioners?

It's hard deciding these things when there is one central bank governor, one finance minister, and one country. With 17, it's a lot harder. As I have said before. Mish says it's "17 veto points".

Comments

[Min]

"But that interest rate must also be high enough to compensate the Lender of Last Resort for the risk it undertakes. This feedback may be especially strong if the Lender of Last Resort is a central bank, so its monetary policy has macroeconomic consequences."

Err, why should the interest rate compensate a central bank for the risk that it undertakes? Isn't the point of a Lender of Last Resort that it is not like other lenders? Particularly with a fiat currency?

[Marc Labbe]

Right now, most immediate concern is WATER

[Simon van Norden]

Interesting post, Nick. I like your definition of the Tea Party as the one who says "We won't pay for Them."

But doesn't that make it clear that the Tea Party is not about economics, its about politics? Put another way, its not about whether the policy is Pareto Optimal or welfare enhancing; it's just about how you can define "Us" and "Them" (and you can be sure someone will be trying to define them for political advantage.)

Or is that just what you're driving at in your 2nd to last paragraph?

[Mike Sproul]

Nick:

If a bank has positive net worth it doesn't need a lender of last resort.

If a bank has negative net worth then it can be liquidated, with bank customers getting back (say) $.90 (valued in base money) on the dollar.

Or that same bank could suspend convertibility, and the market will price its dollars at $.90 (base money) each.

But if that bank gets a loan of last resort (i.e., a gift from the government), bank customers lose nothing but taxpayers lose $.10 on the dollar.

Conclusion: The lender of last resort only transfers the $.10 loss from bank customers, where it belongs, to taxpayers, where it doesn't belong.

[Nick Rowe]

Min: "Err, why should the interest rate compensate a central bank for the risk that it undertakes? Isn't the point of a Lender of Last Resort that it is not like other lenders? Particularly with a fiat currency?"

The central bank can print unlimited amounts of paper, and spend it or lend it without incurring any liability. But, there's still an opportunity cost. Given that it is printing the optimal amount to keep aggregate demand on target, if it lends more to one entity it cannot lend as much to others. If it takes a loss on its loans, it cannot remit as much profits to the government as it would otherwise. Does the helicopter fly over me, or over you?

Simon: thanks! I have drawn perhaps an overly crude caricature of Tea Party sentiment. I can only figure it out vaguely, from reading conservative/populist blogs. The "Them" could be banks, Wall Street, unions, or anybody really. And underlying that crude caricature is I think the idea that it is only legitimate to make Us pay for Them if there's some sort of due process involved. Some sort of Rules of the Game. That's what I was getting at (or trying to) in the penultimate paragraph. "No taxation (of Us, to pay Them), at least without representation". "You didn't consult Us!". They have a point, but it's one not easily reconciled with the Lender of Last Resort function.

The inflation targeting aspect of monetary policy has a political legitimacy. It was signed off by the government. There are very clear and transparent rules of the game. We know exactly what the Bank of Canada is trying to do, and how it is trying to do it. We leave the implementation to the Banks' judgement. Just like an independent judiciary.

But the Lender of Last Resort function is something else again. Zero transparency or rules of the game. Smoke-filled anachronisms in the back room and Bagehot. We don't worry too much about it because it's all for the good of us Canadians, we tell ourselves. And the Bank of Canada never really took on any risk on our behalf anyway. But if it really had taken on some risk, and if we had (say) a currency union with the US, things would have been very noisy here this last 3 years. Canadian nationalists waving maple leafs about Us bailing out the Americans.

I have some sympathy with the Tea Party. (Even if that 1776 mob just hated the thought of a French catholic Quebec, and that was their real number 2 reason for rebelling. ;-) )

[Guillaume]

Nick, I must say that I really enjoy your posts on Europe. I have a feeling that European leaders are losing the race against time before politics turn populist ; not that I have no sympathy for populist politics in this context.

And I'm glad I'm not the only one reading Evans-Pritchard. Even though he apparently made his name as a right-wing hack in the 90s (sorry, I'm too young) and is sometimes a little over the top in his euroskepticism, he has covered this specific issue better and more relentlessly than any other journalist.

[Nick Rowe]

Mike: there's the Diamond-Dybvig model of bank runs, even if the bank is solvent. If it's a small bank, another bank could take it over, but if it's large, or there are a lot of similar banks? Suspension of convertibility would be one solution, but not a very good one if people need a medium of exchange. And, as I said, solvency is not a clear cut issue. It may be insolvent in a fire-sale of assets, but solvent as a going concern.

I really wish we could do away with the lender of Last resort function. (And do away with banks too maybe). But Finance keeps on trying to convert illiquid long risky complex assets into liquid short safe simple assets, because that's what people want to hold. And it just can't be done, which is why we need a LOLR.

Guillame: thanks! I think the Eurozone leaders have lost. I don't think it was winnable.

Ambrose Evans-Pritchard is very good. Yes, I fear he might cater to my Eurosceptic prejudices a little. Middle England sprawled out on the settee reading the Daily Torygraph, bloated from enjoying the Sunday joint (not *that* sort of joint). But he's still very good.

[Patrick]

What concerns me is that Them is too often defined as "the people who don't look like us, speak the same language as us, and go to the same church as us. So long as those criteria are met, Bagehot is still in play.

If I remember the Bagehot reading assignment correctly, the idea was to lend freely against good collateral at a punitive rate. Those are loose rules, but they are rules nonetheless.

Practically, maybe the problem is that unlike in Walter's day, anything that really is good collateral is very unlikely to be illiquid, so by the time a Lehman or AIG stumbles into the rom (unshaven and stinking of gin), asking Ben to hide him from the coos and the large, well dressed gents with baseball bats, it's already way too late.

[Patrick]

Damn this tablet thingers on screen keyboard! "coos" should be cops.

[Nick Rowe]

Patrick: sometimes I think right-wing populism is not so different from left-wing populism. "Them" is bankers, fat cats, and the monied elite. Shades of Social Credit? People who drink Starbucks rather than Tim Hortons.

Quick question: Stephen Harper, Sarah Palin, Barack Obama,...and I was going to say Jack Layton. Starbucks or Tims? I would say Obama is the only Starbucks drinker there.

[White Rabbit]

Nick: one thing that you seem to miss about right wing vs. left wing populism is the issue of who is closer to the truth.

And if we think about the debt traps today, and the fundamental unbalanced creditor-friendly and debtor-hostile policies, and the resulting quasi-hard-money driven slavery, both for indebted individuals and indebted sovereigns (note how Spain was fiscally balanced before the debt spiral pushed it into the abyss), then the truth is a lot closer to the under-represented debtor, for whom the left stands, than the well-lobbied for creditor, whom the Tea Party ultimately stands for.

And then we haven't even talked about accounting identities a decade of creditor-friendly lending policies, which were sucking jobs out of the European south and transferring them to the north. The north now claiming that a decade of strong euro and easy credit for the south only benefited the south is disingenuous and plain out false.

[White Rabbit]

So basically the European Tea Party stands for:

"This bubble money we earned while everyone was partying is ours only, the long term costs that built up and are showing up during the bust is theirs. Oh, and by the way: during the bust we insist on hard, sound money so that our past bubble income can also profit from debt deflation..."

The U.S. variant does not differ much.

And yes, from a macroeconomic policy POV it's a selfish, short-sighted, cruel, destructive and ultimately dumb position, so let's not pretend it's just another, equivalent partisan opinion.

In the stag hunt game theory scenario the Tea Party stands for forcing others into austere hunting of hares, while they lean back and enjoy their stockpiles of frozen stags, so to speak.

All in one the Tea Party stands for inequitable and parasitic policies.

[Nick Rowe]

White Rabbit: there's looser monetary policy, and then there's bail-outs. Some (many?) Tea-Partiers can't distinguish the two.

Who is being bailed out? Debtors, creditors, or both?

And then there's people like Social Credit and William Jennings Bryon(?) (Monkey trial, cross of gold, Wizard of Oz man). These were pro debtors, but normally seen as right-wing populist?

I have only heard very slight mumblings from the Canadian left about what low interest rates are doing to the solvency of defined-benefit pension plans. So far.

I strongly support looser monetary policy for the US and Eurozone. (Canada is not quite so obvious right now). I think this would benefit both creditors and debtors, overall (not every single one). If we/they had looser monetary policy, the lender of Last Resort wouldn't be needed as much.

[Nick Rowe]

Or, put it this way: if I'm a Finnish taxpayer, why should I be asked to bail out Greek borrowers and/or German lenders? Both borrowers and lenders made their own stupid decisions. Why should I carry the can for either?

[Mike Sproul]

Nick:

That fire-sale/long-term point is a false distinction. When we calculate a bank's net present value, we automatically adjust for the terms of cash flows. If NPV<0, then the firm is insolvent, period. If it has some long-term cash flows coming that would make NPV>0, then that would have already entered the NPV calculation and given a positive NPV.

Suspension of convertibility accomplishes one thing: preventing a bank run. But if the economy is facing a cash shortage, then banks must add new money to circulation. That's easy: just issue more money to anyone who brings in assets of adequate value. As long as suspension has prevented a bank run, and as long as banks willingly issue new money to anyone who offers assets of adequate value, any shortage of cash would be self-correcting. As long as banks are free to issue money, the invisible hand works in the money market just like it works in any other market.

[Nick Rowe]

Mike: the NPV depends on the interest rate used in the calculation. The interest rate for that entity will depend on the probability that NPV>0. You can get a coordination failure where no individual wants to lend at a low interest rate unless lots of other individuals want to lend at a low interest rate. One big individual, with deep enough pockets, can solve that coordination failure. In extremes, the only individual with deep enough pockets is a central bank with a printing press.

[Jon]

White rabbit does does not seem to get that the creditors are pension funds of little guy, but I don't blame him for forgetting that; most studies of how assets are distributed usually neglect the same point.

I have a sense that peoples notions of who is them are usually wrong. For instance, it appears that German and french banks are on the hook as the conduits of Greek debt. That's probably the only reason merkel hasn't said shove it yet. Whats surprising is that they insist still as presenting it as a Greek bailout. I suppose that's to try to get the most they can from the Greeks.

Now if anyone is up for puzzlers, why did the US bailout the European banking system via the AIG rescue? Seems to me that was someone thinking it's "us" when it was really "them".

[Will]

"And then there's people like Social Credit and William Jennings Bryon(?) (Monkey trial, cross of gold, Wizard of Oz man). These were pro debtors, but normally seen as right-wing populist?"

Nick, as a student of American history, I must say that this is the first time that I've seen William Jennings Bryan described as a right-wing populist. That is certainly not how people at the time saw him, nor how historians have seen him. Bryan's creationism was motivated by opposition to social darwinism. In his three campaigns for president, Bryan championed not only easy money (his most famous issue), but also nationalization of monopolies, labor laws, and opposition to the wars against Spain and the Philippines. The one thing that substantially separated him from the Socialists of the time was his apparent apathy on the race question (despite that, he was the one Democratic candidate before Roosevelt who drew interest from black voters).

I will remind you that Milton Friedman gave his belated blessing to Bryan's campaign, in his great essay "William Jennings Bryan and the Cyanide Process".

[Nick Rowe]

Will: OK. I was guessing. I guessed wrong.

Oh, on a side-issue, as a student of American history, what about my claim that one of the reasons behind the colonists' dissatisfaction in 1776 was Catholicism in Lower Canada? I vaguely remember reading that somewhere. Is my memory correct?

[hosertohoosier]

I think the problem is that bubbles create interests that are invested in high-risk banking policies. Bagehot rules may get around moral hazard, but they keep alive groups likely to lobby for under-regulation. This goes double when we are talking about states (eg. EU members) as opposed to firms, because electoral motives tend to be more short-term than the survival imperatives facing CEOs (ie. four year terms vs. indefinite ones).

Since some posters are in a Bryan mode, lets consider a counterfactual version of the Panic of 1893. The Panic was preceded by a bubble in the west driven by the Sherman Silver Purchase Act of 1890. Had a lender of last resort existed, you would have seen support for the ailing western banks that bore the brunt of the crisis. This would have given William Jennings Bryan a far greater base from which to draw financial support in the 1896 campaign - possibly enough to win* (and spur on yet another bubble in the west).

*He was outspent something like 7-1 in the 1896 campaign.

[Simon van Norden]

About the lack of representation in the LoLR function; I'm not sure that I understand. In the context of banking, the Bagehot Rule is to lendly freely at high rates against good collateral. This accomplishes two things; high interest rates discourage liquid banks from such borrowing, while the need for collateral separates the solvent and insolvent. If a bank is insolvent and TBTF, you nationalize them; that largely solves the public cost/private benefit problem.

So what's going on in Europe? Part of the problem is a sovereign debt crisis; you can't just "nationalize" an insolvent foreign nation (unless its Newfoundland.) And unlike a corporate failure, there's much bigger welfare loses by citizens when a government goes bankrupt. But another part is the worry of many governments that they may face a domestic banking crisis if defaults on its debt. The above rule suggests a tea-party-consistent approach to dealing with this second problem.

Greece is not really a LoLR problem; A LoLR problem is when providing bridge loans will more or less permanently solve problem. Greece is probably insolvent....yet again. Reinhart and Rogoff's 2011 AER piece singles them out as one of the most important serial defaulters over the past two centuries. Classifying Greece as an LoLR problem requires believing that "This Time is Different."

[Simon van Norden]

Jon: Perhaps Paulson bailed out AIG because he thought it a collapse would gravely further undermine confidence in US banks at a time when he was desperate to bolster it. As I recall, (1) Goldman Sachs benefited as much or more from the AIG bailout than any other bank in the world, and (2) at the time, individual bank exposure to credit derivatives (which AIG insured) was largely unknown and spooking investors. I guess I'm saying that in such a situation, he could have wound up bailing out European banks largely by accident and felt it was not worth worrying about.

[Nick Rowe]

Simon: "About the lack of representation in the LoLR function; I'm not sure that I understand."

Thinking about an analogy: suppose your broker invested some of your funds, not to give you the highest possible return, but for some supposedly wider good. And did this without asking you. If that wider good meant saving some of the other assets in your portfolio, or letting you keep your job, you would probably say "OK, it needed to be done". But if it was saving someone else's assets, or job, you might not be so happy. I think that's the Tea Party perspective.

Even if the LOLR makes a profit in the expected value sense, it isn't trying to get the highest possible profit it can.

BTW, do LOLR tend to earn profits on their activities, in the long run? Like the IMF, for example? My hunch is they do, and if I'm right, that would seem to be a *sufficient* argument for their continued existence. Or is that question answerable, empirically?

Yep, Greece doesn't look like a good bet for solvency. Even then though, a bridging loan might increase the value that is eventually repaid.

[Jacques René Giguère]

Nick: on Québec and catholicism. Yep.
The independance movement was mostly from the South. The New England merchants were aghast at the disruption of trade ( and like capitalists everywhere always sided with power). The South knew that slavery was gonna get the boot and anti-catholicism was thrown in as a sop to the poor whites.(Washington and others were deists and didn't gave a flying whatnot about religion...)
Of course, without independance, the U.S. would now go from Trinidad to the North Pole and under the name of Great Britain would control Europe...
Simon: right about Greece. A few years back , the Economist ran a piece showing the similarities amongst EU countries, demonstrating what should be the conditions of admission. According to these , Greece shoud not have been in.
Everyone: Bryan was on the left, as left was understood in the U.S. at the times. Free silver to liberate farmers and small businessmaen from the Eastern banks, prohibition so the workers would be conscious enough to fight, creationism to fight the "scientific proof" that the poors, farmers, workers and Southerners were naturally inferior.

see Daniel Okrent Last Call: the rise and fall of Prohibition

http://www.amazon.com/Last-Call-Rise-Fall-Prohibition/dp/074327704X/ref=sr_1_1?s=books&ie=UTF8&qid=1314628538&sr=1-1

[Mandos]

You know, this past couple of weeks on this blog and in the world seemed to be a continuous demonstration of why we should not take economists seriously. The roots of a large and influential economically-motivated right-wing populist movement and what it portends is so fundamental to any realistic understanding of economic relations in the world, that any policy prescription must make reference to it to have any real value.

[Patrick]

Nick: Fair enough. People like to wear the colours of their tribe. Or the colours the marketers tell them is their tribes. In the context of Europe, I was actually thinking about nationalism and not so much rich vs poor or bourgeoisie vs proletariat. Not sure about Obama's preferred caffeinated beverage.

Honestly, I'm surprised that the German's haven't already taken their ball and gone home. Their choice seems to be to either give money to PIIGS or to give it to German bankers. I'd have expected them to choose their own tribe. Of course, if there were no TBTF banks they probably would have long ago BK'd their insolvent banks and said "screw you guys" to the PIIGS.

[Luis H Arroyo]

Thanks, Nick. Brilliant!!

[David Pearson]

Nick,

We are discussing the necessity for a transfer of value from tax payers to bank shareholders and creditors. The insurance against such a transfer needing to occur is bank capital and liquidity. The time to raise bank capital levels is prior to a crisis, not during it. Europe had months of relative stability during which Soc Gen or Intesa or Dexia could have done a hugely dilutive rights issue. Similarly, BofA could have been forced to recapitalize when its share price was $16. Instead, the Fed allowed most banks to erode capital by approving dividends and share buybacks, and the EU conducted a "stress test" that told us banks were A-OK.

So we have a choice other than screwing the taxpayer (through LOLR) to help the banks. We can screw the banks (through forced recapitalizations) to help the taxpayer. We refuse for reasons of interest group politics, and that -- not the LOLR function -- is why Tea Parties are ultimately in ascendancy.

[David Pearson]

BTW, I realize there are ancillary costs to treating bank shareholders roughly. What were the ancillary costs of treating them with kid gloves?

[Simon van Norden]

Nick (and maybe David Pearson): Okay, I should confess that I'm now confused. I *thought* the Tea Party was PO'ed about having their tax dollars flushed down some rat-hole (e.g. TARP, Greece, probably Libya) without due process (debate and a vote.) The problem is (a) now Nick tells me that the Tea Party is actually upset about the process even if no money is lost, and (b) a LOLR makes money. (Think about it.....you're lending at high rates against good collateral. Put another way, you're investing when the cost of risk -- or the demand for liquidity -- is high, knowing from experience that such states are highly transitory. That's a predictable return.)

To clarify, Nick, can you explain how you see the Tea Party being different from people who believe that they should be able to veto spending on things that they personally don't like?

[Determinant]

Nick:

History-Determinant to the Rescue!!!

The Quebec Act, 1774 was counted as one of the "Intolerable Acts" which led to the Revolution. Quebec's boundary was defined as not only present-day Quebec within the St. Lawrence watershed, but Ontario and much of the present American Midwest within the Great Lakes watershed, including Michigan and Ohio. It was this territorial definition, which cut off American expansion which was the most intolerable. American colonists wanted to get over the Appalachians....

The fact that the 1774 Act also legalized and regularized Roman Catholicism in Quebec and reinstated French civil law were also points of irritation, but the main thing was the huge swath of territory given to Quebec instead of the American colonies which had conquered that land in the Seven Year's War in hopes of settling it.

The American Revolution was as much as civil war between colonists as it was a war against Britain, but that fact was disregarded by everyone except a few Canadians who never forgot it, until the last two decades.

We exist because we were settled by the people who lost that civil war.

[David Pearson]

Simon,

Its easy to cast doubts the intelligence of Tea Partiers. However, their intelligence is not the question; they operate at the level of heuristics. "Debt is bad" is a heuristic; so is, "constantly offering to bail out bankers is bad".

Are these useful heuristics? If you look at it from the standpoint of the LOLR operation's P&L, the answer is, "no". Of you look at it from the standpoint of moral hazard contributing to the crisis in the first place, then the answer might be different.

[Patrick]

In the US, the Tea Party thing started with Rick Santelli's rant.

http://www.youtube.com/watch?v=zp-Jw-5Kx8k

It's pretty incoherent. Mostly, he's ranting against relief for underwater mortgages. I don't remember if the plan in question involved flushing tax money down a rat hole or not. It probably involved haircuts for banks though, and heaven forbid that a bond holder should ever take a haircut for making a dumb lending decision.

And it's not surprising that the rich signed-up for the tea party. The rich really are nasty.

[Richard Besserer]

Patrick: sometimes I think right-wing populism is not so different from left-wing populism. "Them" is bankers, fat cats, and the monied elite. Shades of Social Credit? People who drink Starbucks rather than Tim Hortons.

You're not the first to think this. Even Murray Rothbard, the favourite economist of the "End the Fed" crowd opposed to all government-sponsored lenders of last resort, had misconceptions about money and banking not that different from those of Major Douglas. See the discussion at http://ozrisk.net/2007/10/05/what-is-money/ on "Are Bank Deposits Money?, or Why Murray Rothbard and the Social Credit Theorists are Wrong."

[Jacques René Giguère]

Determinant: territories west of the Appalachians had not been conquered during the 7 Years war,they were still in French hands, such as it were, which was the reason the Brits left it under "Canadian" (by the Brits but from former New France) administration. Yep they knew the Americans wanted it.
Yes, restauration of Catholic's rights ( already granted in the Montréal capitulation of 1760 and the 1763 St-Germain-en Laye peace treaty) was a point of contention but not for Washington,Franklin , Jefferson and their gang. They couldn't care less about religion and devised the 1st amendment about separation of Church and State to protect themselves from the crowds. Crowds who would later beget the Know-Nothings of the 1840's, the Nativists of 1880-1920 ( part of the Prohibition coalition because Germans drank beer and Italians drank wine), the anti-marijuana of the 1930's ( from supposed use by Mexicans) and the Tea Party.
Tea Party don't care that much about Catholics ( Muslims are a great substitute) and anyway many Catholics now profess the American religion

http://www.amazon.com/American-Religion-Harold-Bloom/dp/0978721004.

Jews as such are still vaguely suspect but Zionism let you feel and say about Palestinians what can no longer said in public about First Nations and African-Americans. And Armageddon in the Middle East is needed for the Rapture...

[Martin]

Nick:

"I strongly support looser monetary policy for the US and Eurozone. (Canada is not quite so obvious right now). I think this would benefit both creditors and debtors, overall (not every single one). If we/they had looser monetary policy, the lender of Last Resort wouldn't be needed as much."

On a side-note: I don't see that happening. Both from a perspective of inflation-targeting and level targeting (2002-2011), the price-level is exactly where the ECB wants it to have at ~ 2%. There is therefore no justification for looser monetary policy under the ECB charter: it has achieved its policy goal.

[Determinant]

Um, not wanting to start too much of a tangent, but New France in its entirety was ceded to Britain. The French Army was gone and it was the British who called the shots after 1763.

Lt. Col. George Washington started the whole Seven Years War with his venture up into what is now Pennsylvania to eject the French.

Washington and others were investors in the Ohio Company, which was looking to sell land in the Ohio Valley. But the 1763 Royal Proclamation and the inclusion of the Great Lakes watershed into Quebec instead of the lower colonies put those plans on hold. Virginia land grants would be invalid in Quebec.

You do remember that the assault on Quebec City itself included a number of American militia regiments? As did the Seige of Louisbourg?

By 1774 it Westminster legislating for British North America, from Cap Diamant to Savannah. Everybody was a subject His Britannic Majesty.

[K]

Nick: "But Finance keeps on trying to convert illiquid long risky complex assets into liquid short safe simple assets, because that's what people want to hold. And it just can't be done, which is why we need a LOLR."

Can too! Given any reasonable asset process: for any required default probability (credit spread), no matter how low, there exists an amount of equity (bank stock, repo haircut, PB margin, whatever) big enough that the default probability will lower than the requirement.

[rsj]

"for any required default probability (credit spread), no matter how low, there exists an amount of equity (bank stock, repo haircut, PB margin, whatever) big enough that the default probability will lower than the requirement."

But even if the distribution was known (which it isn't, as this would require an accurate model of the entire world), still you would experience tail events in which the equity is insufficient, and a LOLR is necessary.

For anything other than 100% equity financing, you need a LOLR.

Arguing that, probabilistically speaking, you expected to have enough of an equity cushion doesn't help much when your debtors declare bankruptcy and your creditors come a knocking.

[K]

rsj: "For anything other than 100% equity financing, you need a LOLR."

But nothing is ever 100% sure. Even the LOLR. Maybe Ron Paul will end the Fed, or President Palin will appoint Rick Perry as Fed Chairman. Anything *can* happen. The road to hell is paved with the pretense that some things are impossible. Robustness in a private seignorage money system can only derive from the knowledge that bad things are not only possible but probable. Rather than a LOLR what you really need is the knowledge that there is no cavalry coming to save you and if you screw up you are going to eat your well deserved losses.

The real problem is that because of the private/public division of profits/losses intrinsic in fractional reserve fiat money there's a real probability that the public wont want to bail out even the depositors, especially if they benefited from high deposit rates (see e.g. some depositors in Iceland banks). It's not very hard to design robust and efficient systems of money creation that do not depend on a LOLR (or private ownership of seignorage profits for that matter). Of course, there isn't much call for that from the banking sector.

[rsj]

"But nothing is ever 100% sure. Even the LOLR."

Yep.

I said for anything other than 100% equity financing, you need a LOLR.

I didn't say you would get a LOLR. Which is the topic of the post.

Nor did I say that the LOLR would perform its role well.

I don't think this problem is easy to solve; sure, there is a lot of low hanging fruit if we assume away the political economy aspects, but these cannot be assumed away.

[Ralph Musgrave]

Evans-Pritchard does not make a comparison to the Tea Party and quite right: it’s a poor comparison. The Tea Party is anti stimulus and anti big government, whereas German opponents of Euro bail outs are not specifically anti stimulus or anti big government. They are anti PIG bail outs because that transfers resources from Germany to PIGs.

[Mike Sproul]

Nick:

Financial economists naturally use different discount rates for firms with different levels of risk. Using those procedures, some firms come out with NPV>0 and others not. NPV<0 still means insolvent all the same. It's like a farmer who says "I'm solvent, except for that crash in crop prices." No. Insolvent is insolvent, regardless of the cause.

If some institution has deep pockets then yes, it can bail out insolvent banks. But bailouts are bad. They only transfer wealth from the bailing institution to the insolvent firm, putting the loss where it doesn't belong.

But then you raise the issue of monopoly. Correct me if I got you wrong, but you seem to say that the lender of last resort might be big enough to manipulate interest rates, and at that manipulated interest rate the bank might be solvent. That's like saying that the department of agricultural can manipulate crop prices until farmers become solvent. Clearly the loss from price manipulation will exceed the gain to the farmers. Same with banks.

Don't forget that free markets can handle bank runs. If some bank collapses, and the money it issued disappears, then some other bank comes along and issues money to fill the gap---at least if they are not thwarted by a lot of crazy regulations coming out of the central bank that was supposed to protect us from bank runs.

[Min]

Mike Sproul: "Don't forget that free markets can handle bank runs. If some bank collapses, and the money it issued disappears, then some other bank comes along and issues money to fill the gap"

Sounds like wishful thinking. Did that happen in the US in 1837?

[Mike Sproul]

RSJ:

Let me put it another way: Bank runs are bad under free markets. Government attempts to protect us from bank runs are worse.

[White Rabbit]

Nick asked:

Or, put it this way: if I'm a Finnish taxpayer, why should I be asked to bail out Greek borrowers and/or German lenders?

Because during the 10 years Euro project Finnish exports benefited from Greek (and Italian, Spanish, etc.) demand created by German loans.

How fewer Nokia phones would have sold in Italy if a flexible exchange rate would have made them 30%-50% more expensive?

Would Italy have created a viable competitor to Nokia, with a (much) cheaper Italian work-force than Finnish workforce paid in Euros?

We probably cannot determine how big this positive effect was for Finland, but it was very likely a significant factor that kept Finland a viable high-tech exporter to southern Europe - especially in the early days of Nokia.

[kevin quinn]

Nick: as usual, interesting post. I'm not convinced that LOLR in practice can be successful at averting panics if it is trying to lend "only against good collateral." After all, the reason that a solvent bank may fail if forced to realize its assets is presumably adverse selection. Why should the CB be any better at evaluating the bank's assets then the market? And if I am a depositor, and the CB follows Bagehot, I will run if others run if 1) I don't know whether my bank has good collateral to borrow against (even if it in fact does) and even, 2), if I do know the bank is solvent but don't have confidence that the CB will be able to see that it is. So I think successful LOLR's in fact are expected to, and actually do, "lend without stint."

[Max]

"But then you raise the issue of monopoly. Correct me if I got you wrong, but you seem to say that the lender of last resort might be big enough to manipulate interest rates, and at that manipulated interest rate the bank might be solvent."

The point is that solvency is not independent of credit availability. The more liberally the central bank lends, the lower the probability of default. This is especially true in a financial panic. The CB can guarantee its own success.

Because of the large social gains from such "bail outs", the government can't credibly commit to not doing them. That is why you need strong regulation (unfortunately in the real world regulation is pro-cyclical).

[Mike Sproul]

Max:

That's like saying that a farmer's solvency is not independent of crop prices. The more liberally the agriculture department buys crops, the lower the probability that a farmer will default.

It's clear (to us micro guys anyway) that this would be bad agricultural policy. But the idea that the same thing might be true of the banking industry seems only to be accepted by rabid free bankers like me.

Here's one of my favorite quotes about how private banks can handle bank runs once the government regulators get out of the way:

“Looking back from the safety of 1798, ‘A Proprietor of Bank Stock’ thus summarized the transition: ‘In this desponding state, when all men dreaded, with the utmost anxiety, the event that was seen to be inevitable, and not far distant, and which it was supposed would involve the kingdom in general bankruptcy and intire ruin, the 26th February, 1797, was the crisis that gave the happy turn, and almost instantly dismissed all the horrors and fears that surrounded us; restored complete confidence…’” (Horsefield, 1944, quoted in Ashton and Sayers, 1953, p. 19).

[Gareth Morley]

There's a reference to the Quebec Act in the Declaration of Independence: "For abolishing the free System of English Laws in a neighbouring Province, establishing therein an Arbitrary government, and enlarging its Boundaries so as to render it at once an example and fit instrument for introducing the same absolute rule into these Colonies: "

[Nick Rowe]

Gareth: good find!

kevin: I may run if others run, even if I know the bank has good colateral, because I may need liquidity in the next few days/weeks/months. I don't think it's just an adverse selection problem.

White Rabbit: maybe, but do you think you can convince the Finns to see it that way? Everyone like to think his successes are due to his own virtue, and his failures are due to vice in others.