ECB Sparks Fight for Bagehot’s Legacy as Greek Crisis Tests Role

Walter Bagehot
English economist and journalist Walter Bagehot (1826 - 1877). Source: Hulton Archive/Getty Images

If only present-day central bankers could ask Walter Bagehot what to do about Greece.

The 19th century English economist formulated the golden rule of central banking, that in a financial panic the monetary authority should lend “quickly, freely, readily, at a high rate, to all that bring good securities.” Yet in the current crisis, the European Central Bank has struggled to make that dictum count.

Instead, facing a Greek government that for months has seemed poised to declare bankruptcy and drag its banks down with it, the ECB has had to drip-feed, and then freeze, funding, even amid a classic run on deposits. The tension is spurring a debate on whether the ECB, in its application of strict solvency and collateral rules, is getting its interpretation of Bagehot right.

“Bagehot is supposed to have said that you should never lend to insolvent institutions, but what he actually means is that you should lend to an institution that’s got collateral,” Charles Goodhart, a professor at the London School of Economics, said at a conference in Frankfurt Thursday. Given the difficulty of valuing that Greek collateral, “I’m jolly glad I’m not having to do it,” he said.

Euro Uncertainty

Since the government under Prime Minister Alexis Tsipras came to power in January, bringing uncertainty over Greece’s place in the euro with it, a slow-motion bank run that eventually led to capital controls has sharpened divisions about the ECB’s role. Those on both sides sparred at Thursday’s star-studded conference on central-bank history hosted by the Bundesbank.

One school of thought contends the ECB must keep funds flowing, as a true “lender of last resort” no matter what the political turmoil, because that’s what central banks are for. The other, mindful of central banks’ status as unelected bodies that essentially put public money at risk, says they should be very cautious indeed when bailing out the bankrupt.

“A central bank needs to draw the line,” said Marvin Goodfriend, professor of economics at Carnegie Mellon University in Pittsburgh. At some point there’s the possibility that the ECB’s Emergency Liquidity Assistance “will have to be collectivized, so that’s a decision that has to be made. Based on the Federal Reserve’s experience of being drawn, over the long sweep of history, ever more deeply into credit policy actions, that’s more problematic.”

German Warnings

Amongst practitioners, the narrow-mandate camp includes Jens Weidmann, president of Germany’s Bundesbank. A member of the ECB’s Governing Council, he has repeatedly warned against pushing the ECB’s lending to Greek banks too far, against too-weak collateral.

“Ever-growing expectations with regard to the contribution of central banks and the increased role they actually play are more a curse than a blessing,” Weidmann told the conference attendees. Regarding Greece, “in the event that further short-term assistance is thought to be desirable or necessary, it is up to fiscal policymakers to provide ad hoc financial support,” he said.

The ECB froze the level of ELA it approves for Greek banks at 88.6 billion euros ($99 billion) at the end of June, after Tsipras announced a referendum on the terms of the country’s bailout and walked away from negotiations. The ECB’s tightening of policy since then has won it a barrage of criticism from European academics like Charles Wyplosz in Geneva and Paul De Grauwe at the London School of Economics.

New Proposals

“Since the Greek government is insolvent, the Greek banks that have Greek bonds on their balance sheets are equally insolvent, and as a result the ECB cannot provide liquidity support -- this is the narrative,” De Grauwe said Thursday. “The decision not to provide liquidity to the banks means that the value of these assets that they hold is going to collapse even further.”

There may be a way out. On Thursday the Greek government submitted fresh reform proposals to its creditors, raising hopes the country will be able to agree a new bailout and stay in the euro.

If European leaders signal a deal will be reached at a summit on Sunday, the ECB could for now increase its aid to the country’s lenders, allowing them to re-open after two weeks of closure.

Yet the tussle over how to follow Bagehot keeps stumbling over the lopsided nature of Europe’s monetary union -- a problem the Englishman, who died in 1877, didn’t face. Without a fiscal and political union to match the single currency, the central bank can never be a real lender of last resort, according to Benjamin Friedman, professor of economics at Harvard University.

“The euro experiment is a very bizarre experiment,” he said. “Those who were central in constructing this experiment were optimistic that, in time, the monetary union would create the momentum, the pressures, the needs for governments to fill in along with it. Maybe the optimism of the creators of this system was misplaced.”

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