David Warsh links to an interesting letter sent by the British Academy Forum on why economists did not predict the financial crisis. They write,

A generation of bankers and financiers deceived themselves and those who thought that they were the pace-making engineers of advanced economies.

Read the whole thing.

Warsh himself writes,

To halt a “run,” explained [Walter] Bagehot, whether on a bank, a stock market or, for that matter, on paper claims to wheat, coal, land or any other set of illiquid assets, all that was necessary was that, in moments of acute distress, the government should ease up on its monetary policy and indicate its willingness to lend money to those who wanted cash. Not just anybody, of course; sound collateral would be required. Not too easily available, either; the government would want to charge something more than was taken to be the going rate. Above all, not too frequently; a market that expects to be bailed out by a lender of last resort may take unwarranted risks.

“Lend freely but at a penalty” became the mantra

Re-read the phrases “sound collateral” and “penalty.” Bernanke and Paulson forgot about those.

In fact, I would suggest that in our current financial crisis, there were plenty of institutions willing to lend to banks at a penalty rate on the basis of sound collateral. In that sense, we did not need the Fed and the Treasury to be lenders of last resort.

The problem was that banks were so highly leveraged and had charged such small risk premiums for risky assets that the only way they could survive was by having someone lend to them on the basis of unsound collateral (“toxic assets”) or not charge a penalty rate, or both. In other words, to survive they needed a bailout, not a liquidity backstop. And that is what Bernanke and Paulson gave them.

Let me reiterate the profit test. If you “lend freely but at a penalty” in a liquidity crisis, then you make a profit. If you bail out leveraged firms that made bad bets, then you take a loss. If you take a loss, then what you mostly did was transfer money from ordinary taxpayers to the managers and shareholders of unsound banks.

And then you pat yourself on the back, claiming that you averted another Great Depression.