Question

What it is the Bagehot's Rule? Did the Central Bank of Us applied this rule in 1930's? Could the Great Depression of 1930's be avoided or less severe?

Answer 1

Answer:

Bagehot's Rule:

Bagehot's rules are considered the most effective guidelines for central bankers in times of panic. In his famous book "Lombard Street," Bagehot proposed a course of action for the Bank of England in response to banking crises.

Bagehot was not an advocate of central banking, but given the role taken on by the Bank of England as a central banker, he believed that the bank should act as the lender of last resort in times of panic. Bagehot had four rules for a lender of last resort:

1. The central bank should lend freely to solvent banks. As long as they are backed by sound collateral, there should be no limit on the loan amounts.

2.The central bank should only provide last-resort loans at a high rate of interest. This penalty rate serves as a self-selection mechanism so only the banks that are truly in need of funds seek them.

3. The central bank should only lend to illiquid but fundamentally solvent institutions. During a crisis, the central banker is under pressure because many banks are short on liquidity. However, the central bank should only make loans that it expects to be repaid in the future.

4.The central bank should announce its policies before any crisis takes place. This creates an expectation that the central bank will help to stabilize the banking system in future financial crises.

Great Depression:

It is sensible to begin an investigation of the Great Depression with an analysis of the world’s most powerful economy, the USA. During the 1920s America became the vital engine for sustained recovery from the effects of the Great War and for the maintenance of international economic stability. Following a rapid recovery from the post-war slump of 1920–1, Americans enjoyed until the end of the decade a great consumer boom, which was heavily dependent upon the automobile and the building sectors. High levels of investment, significant productivity advances, stable prices, full employment, tranquil labour relations, high wages, and high company profits combined to create the perfect conditions for a stock-market boom. Many contemporaries believed that a new age of cooperative capitalism had dawned in sharp contrast to the weak economies of class-ridden Europe (Barber, 1985).

America was linked to the rest of the world through international trade as the world’s leading exporter and second, behind the UK, as an importer. Furthermore, after 1918 America replaced Britain as the world’s leading international lender. The First World War imposed an onerous and potentially destabilizing indebtedness on many of the world’s economies. Massive war debts accumulated by Britain and France were owed to both the US government and to US private citizens. Britain and France sought punitive damages from Germany in the form of reparations. But the post-war network of inter-government indebtedness eventually involved 28 countries, with Germany the most heavily in debt and the US owed 40 per cent of total receipts (Wolf, 2010, this issue).