Daniel L. Thornton On The Federal Reserve’s Response To The Collapse Of Lehman Brothers

In Memoriam Daniel L. Thornton

Editor’s Note: On April 15, 2024, Professor Daniel L. Thornton and I agreed to conduct a three question interview in a written format. Sadly, Professor Thornton passed away on May 4, 2024 having only had the time to submit an answer to the first of our three questions. A prolific writer and advocate of accessible economics education, the passing of Professor Thornton serves as a reminder of one of the great tragedies of the human condition: those of us lucky enough to find our passions are gifted so little time in this world to pursue them.

This unfinished interview is one of, if not the, last media appearances scheduled by Professor Thornton. I have made the decision to publish it so that one of his final contributions to social scientific discourse is not lost to history.

Please join us in remembering Professor Thornton and consider viewing his bio page to learn more about his research, writing, and time in public service.

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Question: You’ve suggested that the Federal Reserve’s monetary policy decisions leading up to and following the collapse of Lehman Brothers were suboptimal. What could have been done better?

Answer: What the Bernanke Fed did was make loans to banks and a variety of other financial institutions that the Fed considered to be credit constrained. One problem with this approach is the Fed was deciding who was the most in need of credit. Hence, the Fed was attempting to allocate credit, which it should never do. The Fed’s job is to supply the needed credit and let the market do the allocation of the credit the Fed supplies.

The Fed’s biggest failure is it did not increase the supply of credit to the market because it sterilized all of its lending dollar-for-dollar. Specifically, for every X-dollars of loans it made it sold X-dollars of Treasuries. Consequently, the amount of credit it supplied the market was unchanged. In a paper I published in 2009, I noted during financial crises what central banks need to do is flood the market with liquidity. The 19 th Century businessman and journalist, Walter Bagehot pointed this out suggesting that in times of financial crises the Bank of England should lend freely on good collateral and at a penalty rate. Bagehot’s requirements of “good collateral and at a penalty rate” were due to the fact that the English central bank, the Bank of England, was a private bank. Strictly speaking these requirements appear to be unnecessary for modern central banks. Allen and Gale, Understanding Financial Crises concur with Bagehot, market liquidity is the key to ending and preventing financial crises.

Before the collapse of Lehman Brothers the Fed sterilized and, hence, failed to increase the supply of any additional credit to the credit market. That the Fed didn’t follow Bagehot’s dictum is evidenced by the fact that total reserves were unchanged over the period. Ironically in his two books, The Courage to Act, (see pp. 45, 144, 148, and 268) and 21 st Century Monetary Policy, (see p. 121), and elsewhere, Ben Bernanke repeatedly claimed that the Fed followed Bagehot dictum before Lehman’s failure.

The Fed did follow Bagehot’s and Allen and Gale’s advice after Lehman failure. But it did so in spite of Chairman Bernanke’s effort not to. Specifically, Bernanke had the Treasury issue more Treasuries than it needed to and deposit the proceeds from these sales into a special “supplementary financing account” at the Fed. This operation has the same effect as selling Treasuries—it absorbs liquidity from the market. From Lehman’s bankruptcy to the week ending October 29, 2008 this account peaked at $559 billion. Given the Fed’s lending and its bond buying program, commonly called “qualitative easing” (QE). Total reserves increased by $270 billion by October 2008. They would have increased by $829 billion had Bernanke not induced the Treasury to deposit $559 billion into its supplementary financing account. The account balance declined to $200 by the week ending February 18, 2009, where it remained until late September 2009 before declining to essentially zero by year’s end.

In spite of the Fed’s effort to sterilize its lending, total reserves increased from $45.8 billion in August 2008 to $860.2 billion in January 2009. The Fed was finally doing what it should have been doing since the financial crisis began in August 2007. It was doing what Bagehot and Allen and Gale suggested. It is important to note that the supply of credit increased significantly in spite of Chairman Bernanke’s best effort to prevent this from happening.

I published a paper in 2021 where I argued that providing liquidity as Bagehot and Allen and Gale recommend worked just as Bagehot predicted it would. I show that the financial crisis began on August 9, 2007, when the French bank and financial services company BNP Paribus failed to redeem three of its investment funds and that both the financial crisis and the recession ended in June 2009. For more information on this see my Cato Policy Analysis No 783.

Published May 21, 2024