Thursday, 17 November 2011

Last Resort

A lender of last resort, as Walter Bagehot taught us, is the central bank function of providing unlimited liquidity to commercial banks at a penal interest rate in exchange for good quality paper.  Those who today advocate the ECB acting as a lender of last resort to Eurozone governments are misusing the terminology and thus misunderstanding the function of the central bank.

It is true that a central bank has a function of acting  as treasurer to a government (or the state) providing unlimited liquidity to fund public expenditure if and when it might be necessary.  However this traditional function has been limited over time by the myth of central bank independence and by legislative limits such as the debt ceiling in the US, or the Italian prohibition on lending money to the government (in 1980 Beniamino Andreatta introduced such a prohibition which reduced Italian inflation at the cost of paving the way to the accumulation of Italy's large public debt.) 

Angela Merkel and general German opposition to ECB purchase of government bonds should be contrasted not by appealing for a non-existent role of lender of last resort but to the traditional function of the Bank acting as treasurer to the state. There is nothing in the EU treaties that forbids this; the problem is that there is no state.  What needs to be resolved are distribution problems  across the member states.

Willem Buiter  refers to such a possible ECB role as "quasi fiscal abuse" of the ECB.  Be that as it may it is a much less expensive alternative than a generalised, large-scale default of the larger part of the Euro area.

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