There’s still a widespread belief that the federal government will bail out large financial firms if there’s another crisis. Curbing the Federal Reserve’s ability to spread money around would be a great way to lower the chances of future bailouts.

So it’s encouraging to learn that Senators Elizabeth Warren (D-Mass.) and David Vitter (R-La.) have joined forces in an effort to “further curb” the Fed’s ability to make so-called emergency loans.

But if the Senators really want to end bailouts, they won’t just curb the Fed’s emergency lending, they’ll get rid of it altogether. In the words of Richmond Fed President Jeffrey Lacker:

In its 100-year history, many of the Federal Reserve’s actions in the name of financial stability have come through emergency lending once financial crises are underway. It is not obvious that the Fed should be involved in emergency lending, however, since expectations of such lending can increase the likelihood of crises. Arguments in favor of this role often misread history. Instead, history and experience suggest that the Fed’s balance sheet activities should be restricted to the conduct of monetary policy.

The best contribution the Senators can make is to lead the charge to revoke the Fed’s emergency lending authority and close the discount window.

To merely restrict the Fed’s emergency lending leaves intact the notion that the Fed should bail out firms in emergencies, and that’s the whole problem. Just altering the rules again – the 2010 Dodd-Frank bill was the latest example – will not fix the problem.

It’s unclear exactly what Warren and Vitter will come up with. But Bloomberg News reports:

They are seeking to define more clearly when a bank is solvent, and thus eligible for funding, limit the length of time a firm can borrow and set penalty rates of interest on emergency loans.

This set of changes is grounded in the classic prescription for a lender of last resort – a scheme that the Fed has never really followed. The idea, based largely on the work of 19th century economist Walter Bagehot, amounts to the following two objectives:

1. A central bank should prevent panic-induced contractions of the economy-wide stock of money; and,

2. During a crisis, the central bank should provide short-term loans to all solvent institutions, on good collateral, at a high rate of interest.

It would be great if legislation could actually make the Fed stick to these terms, but some practical problems make it very unlikely any bill could do so. The only (potentially) clear components of this prescription are the interest rate and the time frame, but these are relatively minor compared to insolvency.

It would be very easy, for instance, to force the Fed to make emergency loans at a rate 3 percentage points higher than the prime rate of interest for no more than 30 days. Financial firms would most likely balk, and the final rules would probably end up just as convoluted as all the other banking regulations we have, but the concept is relatively clear: Higher rates of interest for loans that can’t exceed a brief time-period.

The real trick, though, is to lend only to solvent firms. And developing a clear – much less objective – definition of solvency is virtually impossible. One difficult issue deals with exactly how banks’ assets should be valued.

If bank assets are marked to market during a crisis, insolvency would likely be widespread. In this scenario, we would end up no better off than we are now, with the Fed authorized to make emergency loans available to broad groups of firms.

If, on the other hand, bank assets are not marked to market during the crisis, nearly all financial institutions will appear sound on paper. This option implies we don’t need emergency loans at all; we only need regulators to exempt firms from statutory capital requirements.

Regardless, the political temptation in a crisis will be to extend and expand “emergency” assistance of every kind, and we already know the Fed is no exception to this rule. Our central bank has a long history of failing to adhere to any aspect of the classic prescription for a lender of last resort.

And their track record really isn’t that surprising. It’s often overlooked, but even Bagehot offered his ideas as a second-best solution. He rightly viewed central banking as an undesirable, destabilizing force.

As monetary expert George Selgin noted, Bagehot’s policy prescription was:

a first aid to what was, in his view, a fundamentally unhealthy arrangement, the healthy alternative to which was free banking, with numerous banks issuing their own notes and maintaining their own reserves, as in the pre-1845 Scottish banking system.

In Bagehot’s judgment, society would have been better off if private markets had been allowed to function freely rather than set up a central bank to come to the rescue. In the U.S., prior to the Fed taking over, private clearinghouses did function (quite well) as last resort lenders issuing their own emergency notes.

In fact, this idea was expanded in 1908 and allowed private banks to successfully navigate a crisis without a government-backed lender of last resort.

The 1908 Aldrich-Vreeland Act, a temporary reform measure, helped banks stem a panic in 1914 (after the Federal Reserve Act had passed but before the Fed was up and running).

The 1908 Act allowed private banks to issue emergency currencies, and more than 2,000 banks throughout the US issued nearly $375 million in their own notes, successfully ending the panic.

It is impossible to know for sure, but the Federal Reserve may not have been created in 1913 had these events unfolded closer to 1908.

Regardless, since we’re stuck (for now) with the Federal Reserve, we need a central bank that is not conducive to bailouts. And there simply is no clear economic rationale for allowing the Fed to make emergency loans in the first place.

Throughout its history, the bulk of the Fed’s emergency lending has been counter to the very principles that define the lender of last resort concept. In those few instances where the Fed effectively fulfilled its lending function, it stuck to providing liquidity to the entire market rather than allocating credit to specific firms.

So the historical record clearly shows that the Fed can provide market-wide liquidity without lending to individual firms.

If members of Congress are serious about ending bailouts, they’ll revoke the Fed’s emergency lending authority and close the discount window. The Fed doesn’t need either one.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.