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As noted above, financial panics and the de-leveraging that often occur after them can wreak havoc on the real economy by decreasing the volume of loans, insurance contracts, and other beneficial financial products. That, in turn, can cause firms to reduce output and employment. Lenders of last resort try to stop panics and de-leveraging by adding liquidity to the financial system and/or attempting to restore investor confidence. They add liquidity by increasing the money supply, reducing interest rates, and making loans to worthy borrowers who find themselves shut off from their normal sources of external finance. They try to restore investor confidence by making upbeat statements about the overall health of the economy and/or financial system and by implementing policies that investors are likely to find beneficial. During the darkest days of 1933, for example, the U.S. federal government restored confidence in the banking system through strong executive leadership and by creating the Federal Deposit Insurance Corporation.
In a single day, October 19, 1987, the S&P fell by 20 percent. What caused such a rapid decline? Why did the panic not result in de-leveraging or recession?
According to a short history of the event by Mark Carlson (“A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response”),http://www.federalreserve.gov/Pubs/feds/2007/200713/200713pap.pdf “During the years prior to the crash, equity markets had been posting strong gains. . . . There had been an influx of new investors. . . . Equities were also boosted by some favorable tax treatments given to the financing of corporate buyouts. . . . The macroeconomic outlook during the months leading up to the crash had become somewhat less certain. . . . Interest rates were rising globally. . . . A growing U.S. trade deficit and decline in the value of the dollar were leading to concerns about inflation and the need for higher interest rates in the U.S. as well.” On the day of the crash, investors learned that deficits were higher than expected and that the favorable tax rules might change. As prices dropped, “record margin calls” were made, fueling further selling. The panic did not proceed further because Federal Reserve Chairman Alan Greenspan restored confidence in the stock market by promising to make large loans to banks exposed to brokers hurt by the steep decline in stock prices. Specifically, the Fed made it known that “The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
The most common form of lender of last resort today is the government central bank, like the European Central Bank (ECB) or the Federal Reserve. The International Monetary Fund (IMF) sometimes tries to act as a sort of international lender of last resort, but it has been largely unsuccessful in that role. In the past, wealthy individuals like J. P. Morgan and private entities like bank clearinghouses tried to act as lenders of last resort, with mixed success. Most individuals did not have enough wealth or influence to thwart a panic, and bank clearinghouses were at most regional in nature.