The lenders of last resort doctrine must extend to the real sector if economies are to escape the pandemic relatively unscathed.
Jean-Édouard Colliard
Only a decade after the financial crisis, central banks were once again in the spotlight in the spring of 2020, when extraordinary measures were taken to support economies under lockdown: emergency rate cuts, large liquidity injections, purchase of a vast range of securities, dollar swap lines and repo facilities. What can such extraordinary measures achieve in such an unprecedented crisis?
The economic problem of managing a lockdown is both extraordinary in magnitude and simple in theory. Lockdown measures imply a near shutdown of many firms. If this shutdown only lasts for a couple of months and the impact of the crisis is temporary, then we need the same firms to reopen once the lockdown is over. Ideally, we would press the ‘pause’ button on the economy today, wait a couple of months and then press ‘play’, resuming our normal economic activities.
Stopping and resuming production is not complicated in itself, but it poses a huge financial challenge. In order to stay alive during the lockdown, firms must keep paying salaries, rents, suppliers, debts and taxes, while at the same time not being able to sell their products. This generates huge financing needs. In a world of perfect financial markets this would not be a problem, and all solvent firms would be able to use bank credit lines, issue some new debt or restructure.
In reality, of course, there are frictions that make it difficult for firms to find funding during a crisis. Investment funds suffer severe outflows and need to liquidate their positions. Banks are worried about their own liquidity position and are reluctant to increase lending. Companies expect to face liquidity issues and are less likely to give trade credit to their customers. If all economic agents simultaneously try to hoard cash, many solvent companies will fail and be liquidated during the epidemic, and thus won’t be able to resume production once it is over.
The problem described here is not completely new to the theory and practice of central banking: what is required is a ‘lender of last resort’, standing ready to lend to any solvent borrower – at a price and against good collateral. In this case, financial institutions do not take any liquidity risk by lending to a solvent borrower: if they need cash, they can use the loan as collateral and borrow from the lender of last resort.
Apart from interest rate cuts, most of the actions taken by central banks correspond with this logic. The European Central Bank (ECB), for instance, increased the scale of its targeted longer-term refinancing operations, lending up to €3tn ($3.6tn) to eurozone banks under the condition that this liquidity is used to finance the real economy. This makes banks able to lend without having to worry about becoming illiquid themselves.
While the lending of last resort idea dates back to the 19th century, it has never been used on such a massive scale. It is also an idea which is usually limited to supporting banks, not the entire economy. However, the Covid-19 crisis is not a financial crisis: it is non-financial firms that need liquidity, not banks. Thus, it seems that we need to extend the lending of last resort doctrine to the real sector. After the crisis, this will surely fuel new debates on whether central banks should use a central bank digital currency to extend credit to all economic agents directly, instead of using commercial banks as intermediaries.
The tools used by central banks are also in continuity with the past. The central banks have revived or expanded tools first used during the global financial crisis of 2007-2012, greatly helped by the fact that most of their staff had a direct experience of it. This precious institutional knowledge allowed central banks to move extremely quickly. Several of them have gone further than during the financial crisis already; for instance, concerning the type of assets they are ready to buy, such as the Federal Reserve which is now buying high-yield bond exchange traded funds.
So far, the Covid-19 pandemic has not morphed into a new financial crisis, probably in large part due to the extraordinary reaction of central banks. However, this reaction magnifies the governance challenge policy-makers are facing in the longer run. The independence enjoyed by central banks in developed economies is a delicate balance that used to be accompanied with a clear mandate centred on monetary policy. When central banks directly buy assets or support credit markets, their actions have direct distributional consequences and become politically charged. It is then no surprise that threats to central bank independence have been on the rise globally since the global financial crisis, and that major central banks like the Federal Reserve and the ECB are working on significant revisions to their monetary policy strategy.
More than a new economic theory, what central banks may need the most is a new political theory of how to best combine their huge power on the economy, democratic accountability and independence.
Jean-Édouard Colliard is associate professor of finance at HEC Paris.
