The challenges of the lender of last resort role

Summary:

– The existence of a lender of last resort would reduce the cost of the debt crisis for eurozone countries.

– Paul de Grauwe demonstrates that a liquidity crisis turns into a solvency crisis if a state does not have free rein over its monetary policy.

– He therefore recommends that the European Central Bank act as lender of last resort when a European country is hit by a liquidity crisis.

The lender of last resort lends the necessary funds to an institution that has no other financing options (see previous article on our website). The lender of last resort is the body that supports and absorbs debts when an institution can no longer find funds on the financial markets. When faced with significant financial difficulties, a government, company, or household may find itself in default because it can no longer meet its commitments. While households and companies can go bankrupt, this solution is much more delicate for a government, as it involves the non-repayment of private and public debt, as well as a loss of credibility with investors. Thus, an over-indebted state finds itself facing a growing increase in its financing costs, which hinders its growth and generates a snowball effect. There is only one solution to get out of this situation: to have time to restructure its economy! The lender of last resort makes it possible to avoid facing creditors.

In the banking sector, this responsibility falls to governments. But in the case of governments, who in Europe supports a country in financial difficulty?

Today, the main lender of last resort on the planet is the International Monetary Fund. With the aim of ensuring the stability of the international system, the fund supports states in difficulty that wish to benefit from an aid package. However, IMF loans come with conditions known as structural adjustment conditions, which have been identified as a factor that aggravated the Asian crisis (Stiglitz, The Great Disillusionment) [1]. Obtaining an IMF loan is a bad sign for a country in difficulty. In the case of European countries facing financing difficulties, this type of loan is combined with loans from the European Financial Stability Facility (EFSF). This mechanism allows Europe to maintain its leadership in supporting countries in the eurozone while ensuring that it has an international institution at its side to guarantee the implementation of the necessary structural reforms.

However, this solution, which is negotiated and renegotiated on a case-by-case basis according to fluctuations in the cost of debt financing for the countries concerned, does not provide a sustainable solution. Indeed, unfavorable economic growth, rising financing costs, or the maturity of sovereign bonds regularly plunge countries in difficulty into a new crisis. The lack of an automatic stabilization mechanism, combined with the impossibility of obtaining sufficient time to implement reforms, ultimately puts additional pressure on European countries in difficulty. However, overly generous lending conditions for countries in difficulty could slow down the pace of reforms needed to return to balanced growth prospects [2].

De Grauwe: the PDR as a response to a liquidity crisis to prevent a solvency crisis among European countries.

Economist Paul de Grauwe is known for his contributions on the mimetic effects of traders in finance, the Taylor rule, and his criticism of general equilibrium models. His article « Self-fulfilling crises in the Eurozone: An empirical test » (2013), written with Yuemei Ji, demonstrates the emergence of self-fulfilling fiscal crises within the eurozone. Given the increased vulnerability of European countries to this type of crisis, he recommends giving the European Central Bank the role of lender of last resort for states in difficulty. The authors study the reaction of two types of countries to a liquidity shock, i.e., an inability to meet short-term commitments due to cash flow difficulties [3].

The first case relates to a country that issues its sovereign debt in its national currency and controls its central bank. Faced with a liquidity shock, this type of country can issue national currency via its central bank and repay its creditors. Given the long-term solvency of the government in question, it can repay the central bank for the funds it has committed. Thus, a financial investor can be certain that a government that controls its monetary policy has the capacity to meet its maturing obligations, even in the event of a liquidity or cash flow shock.

Conversely, a country that does not control its monetary policy may see the liquidity crisis turn into a solvency crisis. Thus, a eurozone member state facing a liquidity crisis will find itself unable to meet its bond maturities due to prohibitive interest rates. Rational financial investors who are aware of a country’s inability to cope with a liquidity crisis will decide to leave the country if there is a potential risk of a liquidity crisis. This will result in an increase in outflows from the economy [4], which will further exacerbate the government’s budgetary difficulties and could lead to insolvency.

Indeed, as with a company or a bank, increased financial pressure forces the state to divest itself of viable assets or to take severe austerity measures that threaten long-term growth and the return to budgetary balance in the medium term. Through this mechanism, the liquidity crisis turns into a solvency crisis. The emergence of this snowball effect is self-fulfilling for states that do not have their own monetary policy, because the simple loss of investor confidence leads to capital flight, which causes a liquidity crisis leading to a solvency crisis.

Thus, intrinsically, the eurozone, which is in a better debt situation than the United States or the United Kingdom, finds itself, according to Paul de Grauwe, in a more delicate economic situation than these two areas. In the absence of a lender of last resort, eurozone countries facing this fragility have only one solution in the current system to escape this spiral: restore investor confidence by improving the economic fundamentals of the economy. This generally translates into austerity policies to meet financial commitments and improve the government’s budgetary situation.

Paul De Grauwe and Yuemei Ji propose an alternative solution: allowing the European Central Bank to provide liquidity to governments facing a liquidity crisis. The mere presence of this guarantee would prevent capital flight by investors and thus reduce both the likelihood of a liquidity shock and its transformation into a solvency shock.

The limitations of this solution:

This attractive solution nevertheless presents several risks and limitations that hinder its adoption by Eurozone member states.

The first limitation is associated with the theory of moral hazard. The existence of a lender of last resort creates behavioral incentives that are detrimental to the economic system. Indeed, the presence of a lender of last resort with the capacity to support a state in difficulty may slow down the implementation of reforms necessary to restore budgetary balance.

The second limitation is both political and economic. In order not to threaten the stability of the entire economic zone, it is necessary that the state calling on the lender of last resort be facing a liquidity crisis and remain solvent in order to be able to repay the aid provided in the medium to long term. However, it is difficult to assess a state’s situation in the face of a crisis and therefore to know whether it is facing a liquidity and solvency shock. The decision by members of the zone to support or not to support a state in difficulty could also have political consequences.

Finally, the implementation of a loan of last resort by the central bank implies an increase in the money supply in circulation in the economy. However, this increase in the money supply [5] may lead to an increase in inflation expectations within the European monetary zone, which runs counter to the mandate of the European Central Bank.

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