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Lender of Last Resort

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Potency lost with each subsequent bailout.

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On Tuesday the Fed established a new lending facility further expanding the type of paper it would accept as collateral from banks. As Mr. Practical and Andrew Jeffery have pointed out – this is more about solvency than liquidity.

This new facility, together with a host of monetary and coordinated events among the major central banks constitutes classic Lender of Last Resort (LoLR) action.

One of the landmark studies of how the LoLR works can be found in Charlie Kindleberger's book Manias, Panics, and Crashes, which is a 300 year study of financial crises. Kindleberger was Prof. Emeritus of economics at MIT – an odd place for an economic historian. Into his old age he maintained a unique intellectual balance between the structure of financial markets and the psychology of market participants. In his final years we corresponded by mail and he would send letters he typed himself on an old manual typewriter. He would often say that human behavior is the only significant market constant, and he had centuries of data to prove it.

The LoLR is important because, to paraphrase Kindleberger, just as in a crowded theater where a fire breaks out, individuals will always try to save themselves first, and in doing so, guarantee that few – if any – get saved. The LoLR is not just the fire department – it is the fireman who throws himself onto the fire, in an effort to re-balance the integrity of the financial system.

Credit markets are rapidly de-leveraging and are caught in a vicious cycle of lower prices precipitating higher collateral requirements causing lower pricing, etc. This is a crisis of solvency and not liquidity. The Fed certainly has more tricks, but each new LoLR action typically has less and less effect. These LoLR actions must work and soon. Luckily they usually do work. However, when they fail, the lessons of history are sobering.
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