Wednesday, November 9

Clarifying What Is Meant By 'Lender of Last Resort'

As the European debt crisis continues to worsen there are growing calls for the European Central Bank to purchase ever greater quantities of Italian and other troubled sovereign debt. Berkeley Professor Brad DeLong recently wrote a widely discussed piece arguing that the ECB is failing in its central banking duty as 'Lender of last resort'. But is it?

Professor DeLong makes some good points, particularly about the importance of establishing credibility with the market. However, he fails to differentiate between a central bank serving as a lender of last resort to the banking system versus a lender of last resort to sovereign countries. So far as I know (central bank operations are often murky by design) the ECB has continued to serve as the former but has resisted becoming the latter. There is a big difference between the two so this is an important omission by Professor DeLong.

With respect to the European banks, the ECB has opened and accessed U.S. dollar swap lines with the New York Federal Reserve Bank while also providing certain "unlimited" lending facilities to European banks. In short, the ECB is in fact playing the role of 'Lender of last resort' to Europe's banks. However, as DeLong notes, the ECB has only purchased European sovereign debt in limited quantities. How come?

The Germans get blamed for the ECB's spendthrift ways, with the not-so-distant memories of the Weimar hyperinflation still weighing on Teutonic minds (or so the usual armchair-Freudian analysis goes). But there is some prima facie evidence for this hypothesis: even though the ECB has (so far) not chosen to crank up the printing press full-bore two German ECB board members have resigned in the past year. The most recent, Juergen Stark, publicly stated that his reason for quitting was the ECB's resumption of Italian and Spanish sovereign debt purchases.

While the ECB may continue to hold back for now I suspect that if things get extremely ugly it will in fact print a much greater quantity of money than it has to date to bail the Eurozone out of its debt problem. If this happens euro bulls beware.

The other alternative is for the proper lender of last resort to sovereign countries -- the IMF -- to step in. The IMF was in fact created precisely for situations like the current Eurozone debt crisis. Given this you might be wondering why the experts, in near unanimity, are instead pointing towards the ECB? The answer, in short, is because the ECB has a printing press and the IMF (for now) does not.

Other countries, such as China, do have the funds to bolster the IMF to bailout Europe. But they'll want something in return, such as a greater voting share on the IMF's Board. This is an unappealing prospect to the U.S. and (in particular) Europe, which has since the IMF's inception held a perennial lock on the top job at the Fund. And so in the minds of many that leaves only the ECB.

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