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In a classic bank run, for example, depositors rush to get their money out, even if they believe that the bank is fundamentally sound, because they know that the run itself can cause the institution to collapse.
Which is where public agencies like the Fed come in. We’ve known since the 19th century that such agencies can and should lend to cash-starved players during a financial panic, stopping the death spiral.
How much lending does it take to stop a panic? Often, not much at all. In fact, panics are often ended simply by the promise that cash will be provided if needed, with no need to actually write any checks.
Back in 2012 there was a runaway financial crisis in much of southern Europe. Countries like Spain saw their ability to borrow collapse and the interest rates on their debt soar. Yet these countries weren’t actually insolvent; Spain’s fiscal position was no worse than that of Britain, which was able to borrow at very low interest rates.
But Spain, which doesn’t have its own currency — it uses the euro — was the subject of a self-fulfilling panic attack, as investors fearing that it would run out of cash threatened to provoke the very outcome they feared. Britain, which can print its own money, was immune to such a crisis.
In July 2012, however, Mario Draghi, president of the European Central Bank — the Fed’s counterpart — promised to do “whatever it takes” to save the euro, which everyone interpreted as a commitment to lend money to crisis countries if necessary. And suddenly the crisis was over, even though the bank never did end up doing any lending.
Something similar happened here this past spring. For a few weeks in March and April, as investors panicked over the pandemic, America teetered on the edge of a major financial crisis. But the Fed, backstopped by the Treasury, stepped up with new programs offering to buy assets like corporate bonds and municipal debt. In the end, not much of the money was used — but the assurance that the money was there if needed stabilized the markets, and the crisis faded away.