The lender of last resort and modern central banking: principles and reconstruction

Central banks are celebrated and castigated in broadly equal measure for the actions they have taken (or not taken) to stabilise the financial system and wider economy since crisis broke in 2007. For every paean of praise for their innovations in injecting liquidity, keeping markets open and supporting macroeconomic recovery, there is a chorus of reproof censuring central banks for breaching a crucial boundary between central banking and fiscal policy.

BIS No. 79

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By Paul Tucker, Harvard Kennedy School and Harvard Business School

Central banks are celebrated and castigated in broadly equal measure for the actions they have taken (or not taken) to stabilise the financial system and wider economy since crisis broke in 2007. For every paean of praise for their innovations in injecting liquidity, keeping markets open and supporting macroeconomic recovery, there is a chorus of reproof censuring central banks for breaching a crucial boundary between central banking and fiscal policy. Those criticisms are essentially about political economy, and as such amount to an important challenge to the legitimacy of today’s central banks. ¹

The terrain – and the object of the criticisms – covers three separable but linked areas: monetary policy, lender of last resort, and what has become known as “credit policy”. My focus here is lender of last resort (LOLR), where especially in the United States the atmosphere is probably most toxic, poisoning debates about central banking more generally. Once central banks are perceived as having overstepped the mark in bailing out bust institutions, critics look for overreach in their more overtly macroeconomic interventions too. That, more or less, is what has happened in the United States. ²

The relative neglect of LOLR in the core literature on central banking over the past twenty years is a tragedy – one that contributed to central banks losing their way and finding themselves struggling for breath when faced with a liquidity  crisis in 2007. That mainstream macroeconomics devoted so much effort to conceptualising the case for central bank independence and to articulating ever more sophisticated models of how monetary policy works while leaving out of those models the fragile banking system that called central banking into existence as a liquidity insurer in the first place warrants careful explanation – most probably by political scientists, sociologists and historians of ideas.

Of course, there wasn’t complete silence on LOLR. The technical academic literature advanced, ³ but was largely separate from policy debates, no doubt because LOLR was widely regarded as a relic of the past. With a few exceptions, prior to the crisis policy-oriented commentary was dominated, especially in the United States, by arguments for limiting or abolishing liquidity insurance and, indeed, central banking itself. ⁴  As such, rightly or wrongly, those who remained engaged with LOLR, including within the Federal Reserve system, are  often perceived to be politically partisan and, as such, pursuing a sectional interest. Nevertheless, that does not make a case for casting them and their arguments aside. Both they and events themselves have raised serious questions and challenges.

1. 2. My thanks for comments to Darrell Duffie, Dietrich Domanski and Geoffrey Wood; and to Steve Cecchetti for conversations on issues addressed here.
2. 3. See for example the film, “Money for nothing”.
3. 4. Via  the  work of,  for example, of Rochet and Tirole (1996); Holmström  and Tirole (1998);    Freixas, Giannini, Hoggarth and Soussa (2000); Freixas, Rochet and Parigi (2000, 2004); and Rochet and Vives (2004).
4. 5.  An exception  is  Laidler (2004),  for example  in “Central  banks as lenders of  last  resort:  trendy or passé?”.