Harold James: History provides little comfort

[The writer is professor of history and international affairs at the Woodrow Wilson School, Princeton University and Marie Curie professor of history at the European University Institute.]

The drama of the past days – the collapse of Lehman Brothers, the rapid purchase of Merrill Lynch, the weakness of AIG, the threats to other institutions – all have no real historical precedent.

It is impossible to find parallels for the extent of this week’s banking crisis since the Great Depression. But the implosions of the weekend do not even look like the American experience of depression, in which the country was swept by wave after wave of panic that wreaked widespread havoc by hitting small institutions exposed to local market conditions. Today’s crisis, by contrast, is right at the heart of the financial system, and threatens a complex pattern of credit guarantees and insurance backstops that were touted as making the financial system failsafe.

Bankers, like everyone else, like to suck on a comfort blanket. In the middle of any episode of banking weakness or financial turmoil their oft-repeated claim is that they have learnt the right lessons from the Great Depression. It became an article of faith that a catastrophe of that magnitude could not occur again.

In particular, in the 1930s, monetary policymaking was paralysed. Out of that story came a simple lesson that all policymakers have absorbed from Milton Friedman and Anna Schwartz’s monumental Monetary History of the United States, and from its central chapter on the Great Contraction. The policy recommendation is simple: central banks have a responsibility to not allow a bank collapse to be followed by a deflationary monetary contraction.

The US Federal Reserve, the European Central Bank and the Bank of England are currently doing much more than working out this lesson. They are providing massive amounts of liquidity and lending against an increasingly wide range of assets (now including equities). The central banks believe that they need to stop a chain reaction of financial sector collapses leading to a position when banks will no longer lend to anyone.

This lesson on liquidity is not the same as that drawn by Friedman and Schwartz. It is more activist and much older. It stems from the British experience of 19th century banking crises and it reached its most powerful exposition in Walter Bagehot’s Lombard Street.

Bagehot was the previous version of the bankers’ comfort blanket. The doctrine of liquidity provision depends on a clear separation of liquidity and solvency. Bagehot was completely lucid on this point: that the central bank’s responsibility lay in injecting temporary liquidity to deal with the problems of momentarily illiquid but not insolvent institutions. But if his doctrine was so effective as a remedy for crisis, why did the panics and collapses of the Great Depression occur?

The problem is that the Great Depression was quite different from Bagehot’s panics, as are our current problems. In the middle of a panic that does not arise suddenly, but follows from a valuation problem (such as the subprime crisis), when markets are no longer effectively communicating price signals, it is impossible to know what solvency means. Indeed, one peculiarity of Lehman’s bankruptcy filing is the statement of assets and liabilities, in which assets are still listed as being greater than the liabilities....

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