Can a Lender-of-Last Resort Stabilize Financial Markets? Lessons from the Founding of the Fed
40 Pages Posted: 13 Oct 2008
Date Written: July 1, 2008
The sub-prime mortgage crisis raises serious questions about the role of a lender-of-last resort in containing the spread of a financial crisis. We use the founding of the Federal Reserve as a historical experiment to provide some insight into whether a lender-of-last resort can stabilize financial markets. Following the Panic of 1907, Congress passed two measures that established a lender-of-last resort in the United States: (1) the Aldrich-Vreeland Act of 1908 which authorized certain banks to issue emergency currency during a financial crisis and (2) the Federal Reserve Act of 1913 which established a central bank. We employ a new identification strategy to isolate the effects of the introduction of a lender-of-last resort from other macroeconomic shocks such as World War I, the closing of financial markets in 1914, and the abandonment of the gold standard. We compare the standard deviation of stock returns and short-term interest rates over time across the months of September and October, the two months of the year when financial markets were most vulnerable to a crash because of financial stringency from the harvest season, with the rest of the year during the period 1870-1925. Stock volatility in the post-1907 period (June 1908-1925) was more than 40 percent lower in the months of September and October compared to the period (1870- May 1908). We also find that the volatility of the call loan rate declined nearly 70 percent in September and October following the monetary regime change. The introduction of a lender-of-last resort dramatically reduced financial market volatility in the United States.
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