Finance

Will The ECB Act As Lender Of Last Resort?

During financial crises, central banks often act as lenders of last resort. They step in and lend money to banks that are fundamentally sound, but are in trouble because of panic-driven bank runs.

By acting as a backstop for the financial system, central banks can short-circuit the fear loop that perpetuates financial crises.

Right now, one of the most important questions in the global economy is whether the European Central Bank is willing to act as a lender of last resort (sometimes abbreviated as LOLR) — not for banks, but for governments.

Will the ECB act as a backstop for Europe by by buying bonds of solvent European governments (namely Italy)?

The ECB has been buying some Italian bonds on the open market. But it hasn't yet offered a full backstop. So far, the central bank's leaders have refused to come out and say something along the lines of, "We believe Italy is solvent, and as long as Italy adheres to responsible fiscal policies, we will buy up as much Italian debt as necessary to keep Italy's borrowing costs from spiraling out of control."

The ECB says it is prohibited by law from doing this. And some argue that the bank shouldn't do so in any case, because the promise of a backstop would create an incentive for countries to borrow too much money, and because it could drive up inflation.

But with the interest rate on Italian bonds above 7 percent (crazy high), and a euro-zone bailout fund that's not nearly big enough to save Italy, calls for the ECB to act as a lender of last resort seem louder than ever.