Replacing Humpty Dumpty: the new role of central bank credit targets.

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton University Press, 2009).

George A. Akerlof is the Daniel E. Koshland St. Distinguished Professor of Economics at the University of California, Berkeley, and was awarded the 2001 Nobel Prize in Economics.

Robert J. Shiller is the Arthur M. Okun Professor of Economics at Yale University. This article is adapted from their book,

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The Fed has a way other than open market operations to prevent economic crises--which is what it was set up to do long ago. We here present an alternative view of central bank power that has more to do with systemic effects, and with animal spirits as well. When the Fed was initially set up in 1913, in imitation of European central banks, direct lending by the Federal Reserve banks in times of crisis--in times of special need for liquidity--was thought to be its major tool. The Fed was supposed to be dealing with systemic effects--the contagion of failure from one business to another.

Throughout the nineteenth century there were periodic banking panics. The depositors would literally line up in front of their bank, fearful that those ahead of them in line would be the last to make their withdrawals and that the bank would then be out of money. Such runs on banks were contagious. Word that one bank had failed its obligations led depositors at other banks to line up as well. Even banks that were solvent prior to the crisis could have a hard time meeting their obligations. Indeed when everyone was withdrawing their deposits out of fear, there might not be enough currency to meet their demands.

For the public, the banking panic of 1907 was the last straw. Once again the same pattern had repeated itself. The financial crisis appears to have gone out of control with the suspension of currency payments by New York's Knickerbocker Trust in October 1907. The bank run spread from there. Banks in the interior, outside New York, held deposits at large New York banks, including Knickerbocker. They counted on using these deposits when there was a demand for currency by their own depositors. After the Knickerbocker suspension, there was a run on all the banks, both in the interior, where the depositors actually lined up, and in New York, where the interior banks were trying to cash in their deposits. The resulting disruption of commerce caused a sharp reduction in the country's economic output. From 1907 to 1908 real output declined by 11 percent.

Nelson Aldrich, the prominent Republican senator from Rhode Island and father-in-law of John D. Rockefeller Jr., was appointed chairman of a National Monetary Commission. He went to Europe for almost two years to study central banking. On his return, Aldrich sequestered himself in deep secrecy for a week with four of New York's leading bankers at the Jekyll Island Club, off the coast of Georgia. There they hatched the plan that, duly amended, became the basis for the Federal Reserve System. It was designed to cure the problem of flight from deposits into currency. The Fed was empowered to provide credit (hence the discount window) and also cash for banks that were in temporary need, especially in times of panic. When the Fed was founded in 1913, this provision of a "flexible currency" was considered its major innovation. It was the lender of last resort, providing credit when no one else would.

Note that the original motivation for providing this elastic currency via the Fed was to deal with confidence and its opposite, panics. These issues were frequently discussed in connection with proposals for monetary reform after the panic of 1907. In 1911, as Nelson Aldrich continued to press his case for a U.S. institution modeled after a central bank, a Washington Post editorial summed up the situation: "We need first of all some centralizing organization, so that an impending crisis may be met and repulsed with combined power--instead of every bank or every local bank association scurrying to cover for itself, thereby precipitating or intensifying the panic. This happened in 1907, when the demoralizing factor consisted precisely of the banks' lack of confidence in one another." The actual implementation of the Federal Reserve System--after it had been talked about for years--took place in anticipation of yet another possible panic. Representative Carter Glass of Virginia declared early in 1913 that "There are symptoms that should not go unobserved.... It would be the height of folly for us to defer action until it is forced upon us by the imminence of panic." From its inception the Fed was seen as an agency that would take decisive action at those moments when confidence might be collapsing.

THE CHANGING NATURE OF THE PROBLEM

The Fed and subsequently the Federal Deposit Insurance Corporation were the clever solutions to liquidity problems that could give rise to bank panics. Indeed, for some time now, bank panics and liquidity crises have seemed a thing of the past, so much so that most economists, until very recently, have viewed them as a solved problem.

Four lines of defense prevent the failure of normal depository institutions from causing a systemic crisis. First, they are supervised--although, as we know all too well, that supervision is not foolproof. Second, such institutions are guaranteed liquidity in the event of panic (but not in the event of insolvency) at the Fed's discount window. Third, individual depositors are insured by the FDIC for amounts up to $250,000, according to current limits. Finally, if all three of these lines of defense have failed, the FDIC has the power to take the bank into resolution. Indeed, this insolvency function of the FDIC may be the most important government tool for limiting and preventing bank panic, because it can resolve the bank (that is, it can take over the bank's assets and sell them) slowly, according to its own schedule.

But not all institutions of credit are covered by this careful overlapping system of defense. Over the course of the twentieth century, and especially in recent years, a new shadow banking system has grown up. These so-called non-bank banks are the investment banks, bank holding companies, and hedge funds. Functionally these do just what a "bank" does. They take out loans with short maturities--a great deal of it typically borrowed from banks or from bank holding companies--and then they invest that money.

And there can be a "run" on these institutions just as there can be a run on traditional banks. In the same way that nineteenth-century bank depositors fled into currency in times of panic, every short-term lender may want to be the first in line not to renew its loans to investment banks, bank holding companies, and hedge funds.

Furthermore, such a flight to safety can occur systemically, as everyone rushes for the door at once. The lenders' apprehension of a demand by their own depositors may make them especially skittish. This reduces the funds available to the non-bank banks. It also raises the rates that they must pay for the funds they are able to borrow. They may have been fully solvent before the flight to liquidity began, but in a liquidity crisis they may not be able to afford the higher rates required for continued borrowing.

BEAR STEARNS AND LONG-TERM CAPITAL MANAGEMENT

The interactions between the Fed and Bear Steams in 2008, and between the Fed and Long-Term Capital Management in 1998, are illustrative of the Fed's concern about the shadow banking system and the possibility that failures there would...