Of course, simply offering blank checks to the profligate is not a good solution either. But the current way the European Central Bank is acting may be the worst of all worlds. By buying government bonds while insisting it will soon stop, it is sending the message that bondholders had better sell quickly.
By contrast, if the bank made a promise to buy all the bonds that were offered to it ”” backed by its ability to print money ”” it might have to buy few bonds.
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.
Read it all.
Floyd Norris–It Shouldn’t Take a Panic to Spur Responsibility in the Eurozone Crisis
Of course, simply offering blank checks to the profligate is not a good solution either. But the current way the European Central Bank is acting may be the worst of all worlds. By buying government bonds while insisting it will soon stop, it is sending the message that bondholders had better sell quickly.
By contrast, if the bank made a promise to buy all the bonds that were offered to it ”” backed by its ability to print money ”” it might have to buy few bonds.
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.
Read it all.