There is a passage in Bolingbroke, an eighteenth century British sage much admired by John Adams, which expresses nicely a precept of statecraft relevant to the financial crisis. The problem illuminated concerns the respective roles, in threatened insolvencies, of shareholders, creditors, and governments (which must be prepared to act “in the last resort” when the entire financial system is threatened).
Bolingbroke is describing the proper British strategy in response to the danger that a single great power should dominate the European continent, and he sets forth what would today be termed by political scientists “an offshore balancing strategy.” Bolingbroke says: Britain should look upon “the powers of the continent, to whom we incline, like the two first lines, the principes and hastati of a Roman army: and on ourselves like the triarii, that are not to charge with these legions on every occasion but to be ready for the conflict whenever . . . necessary.” Never commit the whole, says Mr. B, unless the whole is at stake (pp. 56-57).
The shareholders are the principes, the creditors and bondholders the hastati, and the government’s lender of last resort function is the triarii. The idea is to let the first two lines bear the brunt of the fighting in the first and second instances, carefully husbanding one’s strategic reserve.
My view is that Paulson and Bernanke committed the triarii way too early, when the general equity averages were only down 20%. Probably this stemmed from their misunderstanding of the situation as a liquidity rather than solvency crisis. They also seemed to be unaware that there was a relevant ordering among different stakeholders—that is, they failed to distinguish adequately among the principes, the hastati, and the triarii in their generalship. Quite apart from various tactical blunders and obnoxious threats, the strategic concept was unsound.
It is interesting to think about the “last resort” function across a variety of fields. It is important not only in central banking but also (as with Bolingbroke) in military strategy. The concept plays an important role in theories of the just war. Someone could do a dissertation comparing the last resort function across these various domains. That would make a good book. Good luck finding a job!
Q&A with David Einhorn
6 hours ago