It’s recently been argued that central banks working as a lender of last resort makes no sense under a fiat money system. Being insolvent and being illiquid is virtually the same thing when the central bank can just print money. It’s not exactly clear why this should be the case. There is a finite number of dollars out there in the world, manipulatable by the Fed. When a banking panic sets in, and the value of assets is completely confused, credit lines seize up and illiquidity sets in — no one will lend to anyone else. That said, there are still institutions which, if given credit, can apply it to good use and pay their creditor back. As Felix Salmon points out, this is exactly what happened to Morgan Stanley in 2008. At one point, they owed the Fed $107 billion! Though they did pay this back, due to the extremely cheap rate at which the Fed was lending, MS made over $76 million dollars on the deal. This is acting as a lender of last resort, shooting huge amounts of money into the system to bolster banks and prevent complete collapse of the financial system and credit markets.
There are two questions that emerge from this. First, is there any real distinction between an illiquid and an insolvent company? After all, you just need to invest in US Treasuries to make an income, and in fact given that Morgan was loaned $107 billion at near-zero rates and only made about $76 million shows a tiny rate of return — hardly great evidence of solvency. At a certain point, if leant money at ~0% interest and given an investing opportunity that returns more (say, a US T bill) it’s essentially impossible not to make money. If the US govt leant me $100 billion dollars and charged me almost no interest, I could make some money too. Of course, the Fed could’ve listened to the founder of central banking Bagehot’s famous words, “lend freely, at a penalty rate.” But given that the banks were barely able to eke out a profit even at the absurdly cheap rates the Fed gave, it’s entirely possible that penalty rates would have wrecked the banking system completely. As Stephen Williams points out, lending freely and charging a penalty rate is kind of a contradiction in terms.
If that’s the case, the second question is: how can we solve general liquidity crises without rewarding the same bankers who in part created it? How can we avoid moral hazard? The real issue here is that we treat the banks as the only medium for solving liquidity crises. This makes a kind of sense, as they seize up and don’t lend to each other or anyone else. However, what the Fed is often doing when solving liquidity crises is managing expectations — will the money supply shrink? Will assets that we thought were safe stay valuable? Will NGDP grow? But expectations can be managed by means other than safeguarding banks. Because it’s the entire economy that’s uncertain, more direct means would be preferable.
For example, the U.S. might institute a minimum guaranteed income for all citizens as its form of welfare, subject to certain conditions (seeking work, scaling up when finding a job, etc). Even Hayek was in favor of minimum income! And to avoid bailing out the banks, the Fed could have control over the amount given every month. When a recession hits, the Fed would target NGDP by raising minimum income, directly raising the monetary supply and roughly fixing the liquidity crisis. Debt overhang is avoided; aggregate demand can stay roughly stable. And because liquidity crises raise the value of the dollar (by increasing demand for cash), this wouldn’t have to cause inflation if it’s aimed at propping up the growth in NGDP. In one fell swoop you can stabilize AD and avoid bailing out the banks.
Update: As Felix Salmon points out, Bloomberg’s assertion that the Fed leant these loans at below market rates is actually pretty unsubstantiated. The Fed claims that it usually leant at above market rates — a penalty rate. The point is that there’s a huge amount that just isn’t disclosed, and Bloomberg read things as being pretty bad. This doesn’t discount from the main argument here though, that giving money to the bank might not be the best way to solve a liquidity crisis while also avoiding moral hazard.