Myth 10: Fiat Money is Necessary to Have a Lender of Last Resort

Barry Eichengreen (2011) writes:

Under a true gold standard, moreover, the Fed would have little ability to act as a lender of last resort to the banking and financial system. The kind of liquidity injections it made to prevent the financial system from collapsing in the autumn of 2008 would become impossible because it could provide additional credit only if it somehow came into possession of additional gold. Given the fragility of banks and financial markets, this would seem a recipe for disaster. Its proponents paint the gold standard as a guarantee of financial stability; in practice, it would be precisely the opposite.

Briefly, the classical conception of the “lender of last resort,” spelled out by the English journalist and banking historian Walter Bagehot (1871) during the classical international gold standard era, is an institution that lends reserves to illiquid (but solvent) commercial banks in a period of peak demand for currency or bank reserves, in the extreme during a period of bank runs.  Its aims are to prevent regrettable bank insolvencies due to hasty asset liquidations, and to satisfy the public’s demand for currency or reserve money so that the runs cease and the market calms.  This seems to be the notion that Eichengreen has in mind.

Assuming that the Federal Reserve exists and is the agency to which the role is assigned, Professor Eichengreen takes a true gold standard to imply that “it could provide additional credit only if it somehow came into possession of additional gold.”  That is, the gold standard is not “true” unless it imposes a 100 percent gold marginal reserve requirement on central bank liabilities.  This is a highly idiosyncratic understanding of a true gold standard.  Peel’s Act of 1844 did impose a 100 percent marginal gold reserve requirement on expansion on the Bank of England’s note-issues, but the Bank could still provide additional credit by expanding its deposit liabilities.  Indeed the Bank is generally understood to have acted as a lender of last resort during the Baring Crisis in 1890, while Peel’s Act was still in place.

A 100 percent gold marginal reserve requirement on all central bank liabilities would constrain last-resort lending.  But imposing such a rule on the central bank is not required to have a true gold standard, and indeed having a central bank is not even required.  A gold standard, again, is generically defined by gold serving as the medium of redemption and medium of account, not by any reserve requirement imposed on a central bank. The United States was on the classical gold standard without a central bank from 1879 to 1914.  During that period, private clearinghouse associations acted as lenders of last resort to their member banks (Timberlake 1984).  So a central bank is not even necessary to have a lender of last resort.

Eichengreen (2011) argues that “confidence problems are intrinsic to fractional-reserve banking and why an economy with a modern banking system needs a lender of last resort.”  But as noted in Section 6 above, confidence problems are minimal if no legal restrictions prevent banks from adequately capitalizing and diversifying themselves.

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