These various episodes were dress rehearsals for the Fed’s maximalist responses to the global financial crisis of 2007-09 and the covid crash of 2020. Read more of this package What’s wrong with the banks How deep is the rot in America’s banking industry? For markets Silicon Valley Bank’s demise signals a painful new phase What the loss of Silicon Valley Bank means for Silicon Valley Ultimately, though, it would stop the chain reaction. The Fed was willing to let a few dominoes fall. Even if each episode was different, the basic principles were consistent. In 1998 they helped to unwind a hedge fund. In 1987 they pumped liquidity into the banking system after a stockmarket crash. In 1984 they guaranteed uninsured deposits. In 1974 they auctioned off a failed bank. In 1970 they snuffed out trouble that originated outside the banking system. On each occasion officials expanded their playbook. But starting in the 1970s, when inflation soared and growth softened, the financial system came under stress.
In the decades after the Great Depression, the Fed seemed to have put an end to bank runs. Getting the balance right is what is fiendishly difficult. This has remained the general lolr template ever since: authorities both provide support and impose limits. To limit moral hazard, other tools such as deposit-rate caps constrained banks. Power was concentrated at the Fed’s centre, while the federal government introduced deposit insurance. Only in the aftermath of that crisis did America establish a true lolr framework. But broken into regional fiefdoms, it was too timid in response to the Great Depression. The government responded by creating the Federal Reserve system in 1913. There were eight American banking panics in the half-century between 18, each delivering heavy blows to the economy. The clearest evidence of the need for a financial backstop of some variety comes from the pre- lolr years. How to prevent panics without sowing new dangers is perhaps the central question faced by financial regulators. Banks will hold on to fewer liquid, low-yielding assets, piling instead into higher-risk lines of business. Foreknowledge of central-bank intervention may induce bad behaviour. Nearly as old as Bagehot’s writing is the obvious objection to lolr: that of moral hazard.
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