Edited by Christopher J. Green, Eric J. Pentecost and Tom Weyman-Jones
Chapter 9: Financial Crises from 1803 to 2009: The Crescendo of Moral Hazard
Forrest Capie and Geoffrey Wood1 INTRODUCTION Since late 2007 the banking systems of the world have been in turmoil. Despite this, there has been little discussion of the classic Lender of Last Resort (LoLR), essentially no consideration of whether the use of that technique could have prevented these banking difficulties leading to the recent sharp economic slowdown and severe recession in many countries, both developed and developing. Our aim in this chapter is to consider why this was; to discuss whether LoLR operations could have prevented or at least mitigated the consequences of what has been often called a worldwide financial crisis; and, if the answer is negative, what this implies for both the LoLR and the range of policy tools which are currently available for the preservation of financial stability. WHAT IS A FINANCIAL CRISIS? An implicit definition of a financial crisis was developed in parallel with the policy for how to deal with such episodes. The policy was what has become known as a lender of last resort operation, and, very soon after Francis Baring’s 1797 use of the term (in French) Henry Thornton (1802) provided a statement of what the LoLR was, why it was necessary, and how it should operate. This statement was an essentially complete description of the LoLR role as it worked up to the beginning of this century. His statement was made in a particular institutional context, and it is as well for the sake of subsequent clarity to set out what this...
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