BERKELEY – When the European Central Bank announced its program of government-bond purchases, it let financial markets know that it thoroughly disliked the idea, was not fully committed to it, and would reverse the policy as soon as it could. Indeed, the ECB proclaimed its belief that the stabilization of government-bond prices brought about by such purchases would be only temporary.
It is difficult to think of a more self-defeating way to implement a bond-purchase program. By making it clear from the outset that it did not trust its own policy, the ECB practically guaranteed its failure. If it so evidently lacked confidence in the very bonds that it was buying, why should investors feel any differently?
The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Facility. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.
Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.
In his book Lombard Street, Walter Bagehot quoted Jeremiah Harman, the governor of the Bank of England in the 1825-1826 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 of 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 Bank of England’s charter 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 debated whether the modifications of the Bank’s charter should give it explicit power to conduct lender-of-last-resort operations. The answer was no: granting explicit power would undermine confidence in price stability, for already there was “difficulty restrain[ing] over-issue, depreciation, and fraud.” Indeed, 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 a codified authority to act as lender of last resort would not keep the Bank of England from doing so when necessity commanded. As First Lord of the Treasury Sir Robert Peel wrote: “If it be necessary to assume a grave responsibility, I dare say men will be willing to assume such a responsibility.”
Our current political and economic institutions rest upon the wager that a decentralized market provides a better social-planning, coordination, and capital-allocation mechanism than any other that we have yet been able to devise. But, since the dawn of the Industrial Revolution, part of that system has been a central financial authority that preserves trust that contracts will be fulfilled and promises kept. Time and again, the lender-of-last-resort role has been an indispensable part of that function.
That is what the ECB is now throwing away.