Modern central banks have already moved far beyond what was once considered the proper role for a central bank as a “lender of last resort.” Now Keynesians and MMTers (modern monetary theorists) want to take things even further.
By Fabrizio Ferrari
As the COVID-19 pandemic and the consequent freezing of economic activity take place, many economists are hoping for central bankers and monetary policy to take the lead and steer the economy. However, this cannot possibly be the solution—the shock being mainly a supply one rather than a demand one. Moreover, a fiery debate is taking place within the euro-zone about the European Central Bank’s role, specifically its (unduly disputed) nature as a full-fledged lender of last resort (LoLR).
There are two main stripes amongst those economists, politicians, and journalists asserting the incompleteness and inadequacy of the ECB’s mandate to act as a full-fledged LoLR: the first group comprises many Keynesians and post-Keynesians, while the second features MMTers and monetary nationalists.
Keynesians and Post-Keynesians.
The first vein of criticisms raised against the ECB’s toolbox stems from a paper published by Belgian economist Paul De Grauwe in 2013 (already circulating as a working paper back in 2011). The argument proposed by the Belgian economist goes as follows: even after the technical introduction of OMT (outright monetary transactions) in September 2012, the ECB cannot be considered a full-fledged lender of last resort, because in the case of a sovereign bond crisis it would not guarantee unlimited purchasing of member states’ government bonds on the secondary market. In other words, De Grauwe contends that—in a financial crisis—a full-fledged LoLR (within a fractional reserve system) should not only prevent bank runs (granting liquidity to illiquid but still solvent commercial banks), but also make sure that governments can access liquidity at low interest rates on financial markets—even (if needed) via unlimited injection of high-powered money into the economy.
However, this argument is patently flawed for at least two reasons.
First, the classical theory about central banks and their role as LoLR (formulated by Henry Thornton and Walter Bagehot in the nineteenth century) does not contemplate any kind of interaction between central banks and governments at all. Being the LoLR only entitles one to decide, during a financial crisis, whether a commercial bank is illiquid (and hence worth saving) or insolvent (and hence no longer useful to the economic system). Governments, on the other hand, need to fund their expenditures either through taxation or borrowing; either way, this is a fiscal policy concern—never ever a monetary policy one. That’s why, indeed, such ideas as helicopter money and deficit monetisation (MMT) are deeply perverted—paving the way for socialism—and contrary to economic theory: they are, as Hayek put it, the most detrimental potential outcome of “the unholy marriage between monetary and fiscal policy, long clandestine but formally consecrated with the victory of ‘Keynesian’ economics.” – F.A. Hayek, Denationalisation of Money: The Argument Refined (London: The Institute of Economic Affairs, 1990), p. 117.
Second, this interpretation of the LoLR’s role would entail clear conflicts of interests within the euro-zone. In fact, were the ECB to grant unlimited backing to the demand for the government bonds of a member state (say, Italy), it would cause huge imbalances in the price formation mechanism—preventing correct risk assessment and causing distortions in asset pricing (i.e., Cantillon effects). In fact, this member state could access credit at an artificially lowered interest rate at the expense of other member states that would be financing themselves at relatively higher interest rates. Moreover, the fact of ensuring relatively lower interest rates on a member state’s government bonds would force risk-averse investors—in pursuit of higher yields (consistent with their risk and intertemporal preferences and with the natural formation of interest rates)—to perform riskier investments, thus artificially dragging down yields and also increasing the prices of riskier bonds—hence causing malinvestment and bubbles.
MMTers and Monetary Nationalists
The second vein of criticism raised against the ECB as an alleged imperfect LoLR is that of the MMTers and monetary nationalists. Here the idea is that a full-fledged LoLR should carry out outright deficit monetisation—granting governments high-powered money to be directly spent either on purchasing goods and services or on transfers to citizens (i.e., helicopter money).
Again, this second argument is flawed for two reasons.
First, were central banks to grow the monetary base via direct purchases of goods and services instead of purchases of bonds (the so-called open market operations), they would lose their power to control the newly issued monetary base. In this economically absurd scenario, central banks, issuing a liability (i.e., monetary base) without acquiring a corresponding asset, would intuitively debase the issued currency—which would be circulating in greater amount while being “backed” by an unvaried amount of assets—and would lose the ability to withdraw that currency by way of asset selling. Therefore, the only possible outcome would be CPI (Consumer Price Index) inflation (instead of the capital goods and asset inflation that we have been experiencing because of various QEs) unless the involved government were to credibly promise to withdraw the excess currency—by way of fiscal surpluses (i.e., taxation greater than government spending). In other words, even in the perverted and distorted MMT framework, debt monetisation would cause inflation unless it were accompanied by a credible promise of fiscal austerity.
Second, there is no central bank in the Western world performing the LoLR role as MMTers and monetary nationalists conceive of it. In this regard, the ECB operates exactly in the same legal framework (article 21.1 of the ECB Statute, Article 123.1 of the Treaty on the Functioning of EU) as the Fed does (Federal Reserve Act, Section 14, Article 2, bullet point b, number 1). Both are legally prohibited from monetising government deficits, just like any other Western central bank.
First, it is untrue that providing liquidity to governments and / or low interest rates on government bonds is a duty of a full-fledged LoLR. Rather, the classical economic theory has always labeled central banks as “LoLR” only, and simply, in so far as they guaranteed operational continuity of a fractional reserve banking system.
Second, the ECB performs its role as a full-fledged LoLR exactly as every other Western central bank does and consistently with the European institutional and political framework, which features a confederal monetary policy but several national fiscal policies, thus requiring checks and balances so as to avoid moral hazards and surreptitious transfers within the monetary union.
Author: Fabrizio Ferrari is a graduate student in economics.