Central banks: a survival guide

Central banks are called lenders of last resort, for good reason. They have now duly become the last resort in a generalised panic in the core of the world's financial system on a scale not seen at least since the 1930s. Nobody trusts any credit, other than that of governments themselves.

In this situation, the rule is simple, clear and well-known ever since the days of Walter Bagehot. Central banks must lend freely against collateral of even borderline value. If the private sector will only lend to the government, the government must finance the private sector. It is as simple as that.

The world's central banks understand this very well. On Thursday they announced an emergency $180bn injection of dollar liquidity in the latest attempt to halt the panic. The US Federal Reserve is making available the extra funding to overnight and longer-term money markets. The European Central Bank, Bank of Japan, Bank of England, Bank of Canada and Swiss National Bank pledged to “take appropriate steps to address the ongoing pressures”.

Additional lending is very much what is needed in these difficult conditions. The additional lending also seems to have had some impact on markets. Spreads on short-term inter-bank lending, in particular, declined. But those on longer-term loans continued to rise in a sign that banks remained nervous about their peers' liquidity and solvency.

What are not needed, at least in the US right now, are still lower interest rates. Lower rates might even prove dangerous in that country. Further cuts now would risk a flight from the currency, which would make the job of rescuing the financial system even more difficult, not less. It should be remembered that the US is a debtor country, on an enormous scale. It also has an ongoing current account deficit to finance. Confidence of foreigners in the long-term value of its currency is not an optional extra. It is absolutely essential.

In any case, the crisis in the market is not due to the excessive cost of US government funds. With the federal funds rate at only 2 per cent, this is hardly the problem today. The danger is, instead, the disappearance of all private funding.

In essence, the world is witnessing an extreme shift in liquidity preference. People want to hold cash or securities only in the most secure and most accessible form, namely government liabilities. The government, which is the beneficiary of this shift in liquidity preference, must respond by engaging in a recycling operation on an enormous – indeed unlimited – scale. It must convince markets that sound businesses will not be allowed to disappear for lack of funding.

Such operations must be conducted on a global scale, with necessary swap arrangements among the world's principal central banks also being open-ended. It must now offer funds at relatively lengthy maturities, as well, or at least with a commitment to rolling funding over for as long as panic conditions last. This is not a time for niceties. When credit – or trust – has vanished, the only creditworthy institutions left on the planet – triple a rated big governments – have to act. Central banks are lenders of last resort because governments are insurers of last resort. This is, quite simply, what they exist to do.

Yet this is not, alas, all. It is increasingly likely that losses on bad assets are themselves going to de-capitalise the core of the US financial system to an unacceptable degree. But using the Federal Reserve at the behest of the government when semi-nationalising an insurer such as AIG may impose substantial losses on the US central bank. The peril is that the Federal Reserve will need to be recapitalised and that lawmakers may then impose unacceptable limits on its ability to act independently.

What are needed, instead, are emergency powers right now for the US government to recapitalise the financial system, perhaps by taking over bad assets. Precedents for such actions exist in other high-income countries, notably the handling of the Scandinavian banking crisis of the early 1990s and, albeit a smaller event, the savings and loans crisis in the US of the 1980s.

Such action will increase US government debt substantially, perhaps even by as much as 10 per cent of gross domestic product. Nobody knows the scale at present. The US government can, fortunately, afford this. Indeed, it cannot afford not to create the means to act in this way.

The follies of a generation of irresponsible financiers will fall on future generations of taxpayers. A price will have to be paid in fundamentally transformed and tightened financial regulation. But that is for another day. Today is about survival. Lenders of last resort must lend freely and they must do so right now.

Copyright The Financial Times Limited 2008