The United States as an ILLR during the Great Panic of2008-2009

The attitude is “don’t show me anything east of a [New York] 212-area code.” If you lend to [those banks], it could be a career-ending experience.

Anonymous banker (The Financial Times, 2007)

In a way, we [Europe] became the thirteenth Federal Reserve district.

Anonymous European central banker (The Globalist, 2013)

I guess I’m worried about this for all of the considerations that President Hoenig and President Lacker have just been talking about. I don’t know where we draw the lines.

Charles Plosser, Federal Reserve Bank President, Philadelphia (FOMC 2008i)

By the early 1980s, the central bank currency swap network that the Fed so brilliantly developed to protect the dollar and the stability of the Bretton Woods monetary system in the 1960s had faded into obscurity. While the Treasury’s Exchange Stabilization Fund (ESF) rose to prominence by extending bailouts to a developing world rife with financial crises during the late twentieth century, the financial seas in the world’s wealthiest economies were remarkably calm during those decades. A system of official emergency credit lines between advanced industrial central banks was no longer needed to stabilize their currencies. International financial liberalization opened up new sources of private credit for governments and floating exchange rates made balance of payments crises in developed economies seem a thing of the past. Accordingly, in the fourth quarter of 1998, the Fed announced that

owing to the formation of the European Central Bank and in light of fifteen years of disuse, the bilateral swap arrangements of the Federal Reserve . . . were jointly deemed no longer necessary in view of the well-established present-day arrangements for international monetary cooperation. Accordingly, the respective parties to the arrangements mutually agreed to allow them to lapse.[1]

Central bank swaps had fallen out of fashion. They seemed a relic of a bygone era when financial crises were not just relegated to developing and emerging economies. Yet, only a decade after their fall from favor, central bank currency swaps would once again become all the rage.

In late 2007, the Federal Reserve was compelled to reach back into its bag of tricks and dust off the old technique. What began as a housing crisis related to concerns over the rising number of foreclosures in the US real estate market quickly matured into a full-blown, five-alarm global financial crisis in 2008 as global dollar funding markets seized up. In the midst of the storm, the Fed willingly acted as an ILLR by establishing new swap arrangements with 14 foreign central banks. It also provided billions of dollars in liquidity directly to dozens of foreign banks with US affiliates through several additional domestic liquidity facilities. So, what explains the Fed’s decision to act as an ILLR and provide an unprecedented amount of liquidity to the global economy during the Great Panic of 2008? And why did the Fed act as an ILLR on behalf of a select group of foreign economies while it passed on helping others facing similar circumstances?

While select foreign economies no doubt benefited greatly from the Fed’s decision to provide dollar liquidity to foreign jurisdictions during the global financial crisis, their interests were not the target of the actions. Consistent with my argument in chapter 5, here I show that the goal of protecting US national financial interests was the primary motivation behind the Fed’s efforts. More precisely, I explain that the international dimensions of the crisis threatened US financial stability in two key ways. First, systemically important US banks and money market funds were directly exposed to foreign financial institutions that were blocked from frozen dollar-funding markets. Thus, without an international lender of last resort (ILLR), the US financial system was facing an existential threat from a wave of potential foreign defaults. Moreover, the International

Monetary Fund (IMF) was incapable of providing the volume of liquidity that the global financial system needed. Once again, Fund resources were too limited. Second, the seizure of global credit markets was severely impairing the transmission of the Fed’s interest-rate cuts to the real economy. Only by providing dollars to a global economy desperate for liquidity could the Fed ensure that the US economy got the stimulus it desired by cutting rates to historically low levels. In support of the argument, this chapter presents a variety of evidence, including case-study analysis of the financial risks facing the US economy from foreign sources, statistical analysis of the Fed’s swap line selection, and chronological process tracing drawing from a review of Federal Open Market Committee (FOMC) transcripts during the crisis.

  • [1] . Treasury and Federal Reserve 1998, p. 9.
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