The Fed’s AIG Loan/Takeover: Another New Deal Legacy

by Liberty and Power

My idea of the ratchet effect in the growth of government, which I first described in detail in an article published in 1985 and employed extensively in my 1987 book Crisis and Leviathan, has received a degree of acceptance among scholars. One aspect of my model, however, has received relatively little notice, although I have always regarded it as especially important. That is the notion that episodes of crisis and abrupt growth of government leave legacies after the crisis has passed, and these legacies, which may be institutional or ideological, sometimes lie dormant for long periods before they exert effects on the course of events.

I thought immediately of this idea today as I read the Washington Post’s report of the Fed’s loan/takeover of the insurance giant AIG. Having heard preliminary discussions of the possibility of such a takeover, I had wondered about the government’s authority for such an action. The Post’s report answered my question as follows: “The Fed is using the emergency authority it was granted during the Great Depression. By law, the Fed can lend money to any individual, partnership or corporation in unusual and exigent circumstances, when the borrower cannot access funds in other ways. The power had not been exercised until March, when the Fed used it to rescue Bear Stearns.” I confess that I had not known about this particular Fed authority until today.

So, here we are in the year 2008, witnessing the use of a power that had lain dormant in the government’s arsenal for more than 70 years, a power whose existence, I am confident, few people were aware of. Beware, all ye who would endow the state with amplified powers. It may refrain from using those powers for a very long time. Yet, there they lie, sleeping peacefully, but capable of being awakened and used with highly consequential (and, as in this case, extremely unfortunate) effect.

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Oscar Chamberlain - 9/23/2008

I am not very familiar with national bank charters in the post Civil War era. You may have a point about the burdens placed upon banks by these charters. But while these provisions may have had an impact on those boom and bust cycles, the cycles began before a national banking system was created.

The cycle of panics started in the antebellum period. While the second Bank of the US did serve a regulatory function from 1817 to around 1835, the bulk of that power stemmed from its being the largest bank and the only one with a multi-state presence. It did not stem from the imposition of charter requirements.

Between 1837 and the Civil War, different states did have different requirements for charters. These usually required a minimum deposit of specie, specified liability in case of collapse, and established some sort of examination system. Some states only allowed banking if the law was approved in a popular referendum. A few states even banned banking.

While I should have conditioned my blanket statement that banks were unregulated, I don't think this comes close to the regulated system that you describe. So I suppose my follow up question is, if you are right, why did Panics increase in impact before the establishment of national banks in 1863?

Steven Horwitz - 9/21/2008

Oscar,

The US economy of the 19th century was hardly "unregulated," and especially so in the banking sector. Those booms and busts you note were largely caused by a number of burdensome regulations on the federally-chartered banks that made it prohibitively costly to issue currency in times of high demand, as well as long-standing prohibitions on branch banking that even well into the 20th century made US banks very under-diversified, prone to failure, and unable to move resources nationwide in a timely manner.

Blaming the 19th century panics and depressions on unregulated markets is simply ignorant of the actual workings of the banking and financial markets of that era. You can say the regulations weren't the issue if you want (I disagree), but referring to the system as "unregulated" or suggesting that intervention took place because people didn't like the results of an "unregulated" system is simply wrong on the facts.

Oscar Chamberlain - 9/19/2008

Given where the economy is this week some sort of intervention was necessary. Whether this was the way to do it can be debated, but nothing was not an option, given the current structure of the system.

And remember, regulation was ratcheted back in the early 90s with the bi-partisan repeal of Glass Steagall. It was the dubious assumption that markets are self regulating in a manner consistent with the maintenance of a strong economy that led a lot of conservatives to support that repeal. And of course it was the comparative lack of regulation and oversight which helped lead to the ratcheting of power that you correctly describe.

PS As to the comparative effectiveness of unregulated markets and a strong economy, one simply needs to look at the 19th century US. There were boom and bust cycles in which the impact of the busts kept increasing even as the percentage of the population that had some degree of self-sufficiency declined.

The result was ever more painful depressions.

Intervention and regulation has increased because a majority of people did not like what an unregulated economy did. Has that intervention and regulation always been wise? Of course not. But not to have done so would have been to deny the will of a pretty large and pretty consistent majority.

Jonathan Andrew Goff - 9/18/2008

Robert,
Thanks for the good post. This is something that has had me worried for some time. Here's my take:

http://selenianboondocks.com/2008/09/the-ratchet-effect/

Pretty much the same as yours but figured my readers could use the concept as well.

~Jon