Floyd Norris on the Arcana Imperii of Central Banking: Central Banks Have the Power to Do Things They Have No Power to Do Department
If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security — on what is then commonly pledged and easily convertible — the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.
— Walter Bagehot, “Lombard Street,” 1873
For well over a century it was taken for granted that the first job of central banks was to stem panics. It was, as the phrase went, to be a lender of last resort.
As Europe’s financial situation has gotten worse and worse, the European Central Bank has moved grudgingly….
Implicit in the German prescription is the message that the sinners who spent and borrowed too much deserve to be punished. They can regain competitiveness with structural reforms — which Germany will happily help to devise — over a sustained period…. Implicitly, Germany is threatening that countries which do not do as they should will be forced out of the euro zone and left to fend for themselves. It is a threat that led Greek and Italian politicians to cede power, but will it persuade most of the people to go along with unpopular changes? If they rebel, and in the end Germany does pull the plug, Germany will be among the big losers….
There is a real risk of moral hazard in central bank bailouts. The theory offered by Bagehot in the 19th century called for banks to make loans on securities that are of high quality and will be liquid when the panic passes, but not on low-quality securities. Telling the good from the bad during a panic is not always easy. But we have until now assumed that a central bank would find bonds issued by its own government to be good paper, and investors could act accordingly. It may be true that the European Central Bank lacks specific legal authority to perform as a central bank should in a crisis. But there is nothing new to that. Brad DeLong, an economist at the University of California, Berkeley, points to comments made in 1844 by Sir Robert Peel, then Britain’s prime minister, explaining why he had not sought specific legislation to authorize the bank to step in during a panic:
“My confidence is unshaken that we have taken all the precautions which legislation can prudently take against a recurrence of a pecuniary crisis,” he wrote in a letter. “It may occur in spite of our precautions; and if it does and if it be necessary to assume a grave responsibility, I dare say men will be found willing to assume such a responsibility.”
In Europe, it is high time for such men, or women, to be found.