Monday, November 28, 2011

Interest Rates and a Lender of Last Resort

A few days ago Joe Weisenthal at Business Insider posted a chart of the day article, "The Infection of Europe Is Now Complete." He is responding to a German government bond issue that failed to draw the anticipated number of buyer/lenders. Weisenthal thinks this especially remarkable given Germany's assumed status as a relatively safe haven in Europe.

Then he concludes with this:
Seeing Germany not catch this flight-to-quality bid is a major break in the pattern. And when it's combined with the lack of interest at the auction, then it hits you: Germany is more like Greece than the U.S. in the sense that neither it nor Greece has a central bank as a lender of last resort.
Given Weisenthal's economic and political biases, I assume he is here implying that the American banking system should get the nod over the European system because our central bank, the Federal Reserve, not only has a mandate to keep prices stable, but also is charged with maintaining financial stability by serving as a lender of last resort. Having a lender of last resort soothes fears some might have about a house made up of too many too-highly-leveraged financial cards.

There is another way to look at the situation. In the first place, it is not clear that the European Central Bank (ECB) is not acting, at least informally, as a lender of last resort. On the other hand, if the lack of demand for German bonds is due to a perception that the ECB is not a lender of last resort, this just means that interest rates should be higher than they are both here and abroad.

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