"In the next few days the situation would grow much worse, and the interconnected nature of the relationships among the nation's financial institutions would only enable the contagion to spread."
The question I pose is which set of circumstances is the author of this passage describing? Was it in March 2008 immediately after the problems were discovered at Bear Stearns and the Federal Reserve rushed to the rescue? Was it during September 2008 that month that saw the meltdown of Fannie Mae and Freddie Mac followed by Lehman Brothers, followed by AIG and Wachovia? Was it in November 2008 as Citigroup approached failure? Or was it during an earlier financial crisis, maybe during the 1980s when Continental Illinois was bailed out by the Federal Reserve and then the FDIC.
The passage is actually from a book by Robert F. Bruner and Sean D. Carr of the University of Virginia: The Panic of 1907: Lessons Learned from the Market's Perfect Storm. Having listened to Timothy "Chicken Little" Geithner and Hank "I'm prepared to do anything" Paulson tell us how the troubles they faced during 2008 were absolutely unprecedented in nature, this may be surprising. But this passage actually describes the financial crisis that preceded the creation of the Federal Reserve and led to its creation.
During the Panic of 1907 there were discussions of bailouts. However, these were bailouts by private parties that were contemplated, not governments. JP Morgan (the man, not the financial institution) and the private, voluntary clearinghouses were the 'lenders of last resort' back then. They considered giving a bailout to a large troubled financial institution: Knickerbocker Trust Company. The clearinghouse committee denied a loan through an intermediary bank on behalf of Knickerbocker. JP Morgan commissioned an assessment of the trust companies to determine which should be supported and which should be allowed to fail. He had two bankers, one of whom was Benjamin Strong who later would become the first President of the New York Fed, examine Knickerbocker. If they determined Knickerbocker was sound, Morgan committed to finding money for it. Ultimately they determined that it was not solvent and that there were other more sound institutions that were better candidates for funding. Knickerbocker was allowed to fail (see Bruner and Carr pages 72 to 76, 84, 87).
It is useful to think about what happened in this pre-Federal Reserve crisis. The impetus was on these private financial players to assess the soundness of Knickerbocker, as well as any collateral that might have been available and determine if they wanted to put up their own money to save it. They knew about the possible adverse consequences of letting Knickerbocker fail and they had an interest in assuring that the financial system did not collapse. Yet they decided to not provide any funding to Knickerbocker.
Contrast the situation in 1907 with the most recent crisis and the alignment of interests. The three bailout agencies (the Federal Reserve, Treasury Department and the FDIC) were all dealing with public funds involving handing out other people's money, so of course it is easier to make the decision to hand out public funds than one's own funds. They felt they had to do "something" and could not just let these financial institutions that were on the brink of failure simply collapse. They had what former FDIC Chairman Bill Seidman called the "not on my watch" mentality. They wanted to avoid a large failure on their watch at all costs, with Lehman Brothers being the singular exception. These policymakers probably recognized the possibility that there were moral hazard costs to such bailouts, but those costs would come home to roost in the future, on someone else's watch. They acted in their own self-interest rather than the public's interest in effectively using public funds.
This description of the reality of the response of public officials contrasts with what was anticipated when the Federal Reserve was under development. From the comments of Senator Claude Swanson, Democrat of Virginia, who was President Wilson's point person in securing passage of the Federal Reserve Act (51 Cong Rec 428, 430 – 432— December 8, 1913):
"The benefits which will accrue from these regional, or, as named in this bill, Federal reserve banks are great and many. The reserves of this Nation, which are needed in times of financial distress and stringency, will be held by those who have a public responsibility for their just and proper use, and not as now, by those who have such responsibility and no purpose of public benefit in their use…I am satisfied that the Federal reserve board when constituted will wisely, faithfully, fearlessly, and patriotically discharge the duties conferred upon them to the benefit of the whole of the country and without favoritism to any…I believe the present President of the United States, animated by only lofty and noble principles in all of his work, will select as members of this Federal reserve board men fully equipped, men with noble purposes and whose administration of their office will redound to the great betterment of this Nation."