NCPA - National Center for Policy Analysis


May 6, 2008

Every day brings word of new write-downs and write-offs, and the Federal Reserve has rolled out a bewildering variety of stratagems, but the struggling economy is not responding positively.  What strategy or rule should the Fed be following to help the economy recover from recession, or curb what is now a spectacular inflation in commodity markets, asks Ronald McKinnon, a professor at Stanford University.

Fast backward 135 years to 1873, when the London capital market was the center of world finance under the gold standard.  Walter Bagehot, the eminent Victorian institutional economist and constitutional scholar, prescribed how the Bank of England should confront major financial crises.

Bagehot was worried about gold losses to foreigners that would cause domestic credit markets to seize up even more and, worse, weaken the pound in the foreign exchanges:

  • Now, foreigners are disinvesting from private U.S. financial assets, which itself worsens conditions in American markets.
  • Foreign central banks, are building up large dollar exchange reserves -- much of which are invested in U.S. Treasury bonds.
  • But U.S. Treasurys are the prime collateral for borrowing and lending in the multitrillion dollar U.S. interbank markets.
  • Thus there is a foreign "drain" of prime collateral from the already-impacted private U.S. markets.

Consequently, there is a strong case for raising the fed funds rate as much as is necessary to strengthen the dollar in the foreign exchanges -- as Bagehot would have it -- and to cooperate with foreign governments to halt and reverse the appreciations of their currencies against the dollar.

By slashing interest rates too much in 2007-2008, the Fed has accentuated the foreign drain and thus made the alleviation of the domestic drain more difficult.  Still, Bagehot would approve of other actions the Fed has taken to deal with the domestic drain by unblocking specific impacted domestic markets.   Yet these measures will be insufficient if the foreign drain continues.

Source: Ronald McKinnon, "Bagehot's Lessons for the Fed," Wall Street Journal, April 25, 2008.

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