Last Tuesday, just a few hours after the terrorist attacks, the Federal Reserve issued a terse press release: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.”
On Thursday, the Fed announces a $50 billion swap arrangement with the European Central Bank to help international banks short of cash after the attacks. Many other banks were borrowing from the Fed because check clearing and interbank transactions had been severely disrupted by the attacks. Wire services report the New York Fed was also operating from a backup site across the river in New Jersey.
What is going on here? Why is the normally placid Federal Reserve swarming like a kicked anthill? Simply put, the Fed is stepping into its role as the ensurer of the nation’s financial system.
References to the Fed as an ensurer do not appear in any economics textbook. Besides, it is spelled “insurer,” not “ensurer,” and if anyone insures the banking system, it has to be the Federal Deposit Insurance Corporation.
No, I don’t refer to deposit insurance. And yes, I mean to say ensure. The Fed was created to ensure that our nation’s financial system not be undermined by panic or by illiquidity caused by any disruption of the payments system.
“Panic?” you query. Think of the isolated gas stations selling, and customers buying, $5-a-gallon gas on Tuesday evening. The Fed wants to avoid similar actions by banks or consumers; no forced sales of bank assets for quick cash, no lines of depositors as in “It’s a Wonderful Life.”
What is “illiquidity?” It is the lack of available cash. What is “a disruption of the payments system?” It might be a bank whose customers have deposited millions in checks drawn on banks elsewhere in the country. Now the bank cannot physically present these checks to the banks on which they were drawn because check clearing across the country depends on nightly courier planes. All planes have been grounded for three days.
Perhaps a St. Paul bank bought foreign currency from a New York bank one day or one hour before the planes hit. Normally, foreign exchange would have to be delivered in two or three business days. But the selling bank was located in the north tower, its files are now part of the inches of gray ash coating lower Manhattan, its computers are part of a five-story pile of rubble, and hundreds of the firm’s employees still are not accounted for.
Perhaps a farm credit co-op needs funds to disburse to a farmer who already is pouring concrete for a new hog facility. What if the underwriter of Agribank’s most recent bond issue counts a number of dead and missing from its employee list?
Perhaps some Eau Claire customer of a multinational insurance firm headquartered in Golden Valley wants to cash in a $300,000 variable annuity. But no one is answering the phones at the company where the annuity was actually placed since 9:45 Tuesday morning.
Think about the names of all the tenant firms that streamed across the bottom of your television screen in the past week. Think about the companies that occupied those buildings, still tenuously standing, that ring the WTC complex. Most such firms paid or received millions, in some cases billions, of dollars each day. Many of the country’s electronic payments passed through computers and switchboards in the WTC towers themselves.
The Federal Reserve and other central banks are simply stating, clearly and firmly, that as stock and other financial markets shudder back into life, there’s no firm that needs to fear problems because of a lack of liquidity.
The Fed controls the money supply. It exists to create more money instantaneously and lend it to banks through its discount “window.” It now is saying that it will do so promptly, and in such quantities that no bank or business will grind to a halt for lack of credit.
Has the Fed done this before? Yes, many times, though perhaps not in reaction to so large a disaster. It pushed tons of physical currency to Florida banks in 1992 after Hurricane Andrew destroyed bank branch buildings and thousands of families needed cash to buy chain saws, drinking water and plywood. It did so, on a much smaller scale, after the 1997 flooding in Grand Forks. It did so in 1987, when stock markets plunged just weeks after Alan Greenspan took over from Paul Volcker. It did so after Pearl Harbor.
Unfortunately, there have also been times when it did not supply needed liquidity. It should have acted vigorously when the stock market crashed in late 1929. Instead, it stood by and let the money supply fall by 50 percent in 15 months. The depth of the Great Depression was due largely to Fed bungling.
Is there a risk that some discount window loans will turn bad? Might the Fed be forced to write them off? Yes, there is a small risk, but far less than the danger of the entire economy grinding to a halt because no one has money to pay anyone else. A good analogy would be the oiling of a steam locomotive. It doesn’t hurt if a little oil drips onto the ground. That is far better than having the whole ponderous mechanism seize up and refuse to move.
Besides, the most immediate consequence of Fed alacrity is confidence. The more people are sure that the Fed stands ready to lend, the less it will have to do so. To paraphrase Napoleon, in central banking, as in war, “morale is to all other factors as four is to one.”
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.