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The ECB’s Battle Against Central Banking

We are live at Project Syndicate:

As I sat down to put the final touches on this column, I found that Paul de Grauwe had written the opening of it much better than I had:

Paul de Grauwe: When [the ECB] announced its programme of government bond buying, it made it known to the financial markets that it thoroughly dislikes it... [that it] was not fully committed... that it would stop the programme... that the stabilisation of the price of government bonds would only be temporary....

There is no sillier way to implement a bond purchase programme than the ECB way. By making it clear from the beginning that it does not trust its own programme, the ECB guaranteed its failure. By signalling that it distrusted the bonds it was buying, it also signalled to investors that they should distrust these too....

The people sitting around the table in Frankfurt continue to believe that financial stability is not part of their core business, and, to use the words of Trichet, that there is only one needle on the Frankfurt compass and that is inflation.... The result of this failure of the ECB to be a lender of last resort has been that a surrogate institution, the EFSF/ESM, had to be created that everybody knows will be ineffective. It has insufficient firepower and has an unworkable governance structure...

Indeed. From my perspective, the astonishing thing about the spectacle that the ECB is making of itself--its current claim that its proper mission is price stability and only price stability, not financial stability, certainly not being a lender of last resort, and certainly certainly no concern for the welfare of the workers and businesses that make up the economy--is its extraordinary divorce from the history of the central-banking tradition. Modern central banking has its start in the collapse of the British canal boom of the early 1820s, in the financial crisis and recession of 1825-6, and in the first time a central bank--the Bank of England--intervened in the interests of financial stability as the irrational overexuberance of the boom turned into the extravagant overpessimism of the bust.

As Walter Bagehot in his Lombard Street quoted Jeremiah Harman of the Court of the Bank of England, in the 1825-6 crisis:

We lent... by every possible means and in modes we had never adopted before; we took in stock on security, we purchased exchequer bills, we made advances on exchequer bills, we not only discounted outright, but we made advances on the deposit of bills or exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some cases over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power...

The charter of the Bank of England did not give it the legal authority to undertake such lender-of-last-resort financial stability operations. But the Bank undertook them anyway.

Half a generation later Britain’s Parliament discussed whether the modifications of the Bank’s charter should give it explicit power to conduct lender-of-last-resort operations. The answer Parliament reached was “no”: granting explicit power would undermine confidence in price stability, for already there was “difficulty restrain[ing] over-issue, depreciation, and fraud”; and granting explicit lender-of-last-resort powers to the Bank of England would mean that the “millennium of the paper-mongers would be at hand”. But the leaders of Parliament also believed that the absence of power to act as a lender-of-last-resort would not keep the Bank of England from doing so when dire necessity so commanded. As the then First Lord of the Treasury Sir Robert Peel wrote: “If it be necessary to assume a grave responsibility”--to exceed the limits that the Bank of England’s charter places upon it and act--”I dare say men will be willing to assume such a responsibility.”

Our current politico-economic institutions are built upon the wager that a decentralized monetary industrial market economy provides a superior social planning, coordination, and allocation mechanism to any other that we have yet had the wit to devise. But from the moment the Industrial Revolution was born part of our system has been a central law-giving authority that preserves trust that contracts will be fulfilled and promises kept--and the lender-of-last-resort role is part of that function.

That is what the ECB is now throwing away.