The Joye-z of central banking

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Chris Joye is on his discount window high horse again… See here

His lines of argument used to confuse me, so after his business spectator article I asked him – hey Chris, what’s the beef?

He told me that he wanted people to “call a spade a spade … And admit that without central bank liquidity support, more private banks would go broke”.

That much should be uncontroversial, as it is basically why central reserve systems were set up in the first place.

Now, the trick is figuring out when it is just liquidity that is the problem and when it is solvency.

An (easy) classic example for the USA is where, say, a bad cotton crop causes farmers to withdraw their precautionary savings — which leads to a credit crunch (remember that there were unit banking laws in the 19th C).

Prior to central liquidity support healthy but cash constrained firms went bust as a result (say, a boat builder despite a full order book, due the nature of their business). Banks went bust too, as the boat builders were unable to return the cotton farmer’s savings to the bank.

This is an easy case, but it demonstrates that there are cases when central liquidity support is welfare enhancing (after all, the rain will come again, and foreign demand for boats remain sound, so it is better not to pay the cost of adjustment).

Of course, in the GFC the decisions were a lot more difficult – and central banks clearly strayed into the grey area between monetary and fiscal policy. A lot of very sound companies obtained support – as well as a lot of bad ones.

For mine, the interesting question is how we discriminate between monetary policy issues (a temporary liquidity problem) and fiscal issues (a solvency problem). It is tempting to define the liquidity issues as those where the central bank makes a profit, but I think that is too cute.