Monday, February 11, 2008

Life ain't easy for central bankers

The primary role of a central bank in a modern advanced economy is to set the price of money – the interest rate. Large commercial banks are generally compelled to hold a certain proportion of assets at the central bank and in return receive risk-free central bank money, the equivalent of large bundles of notes and coins.

What’s the big deal…? I ask.

All the major central banks are now beset by the issue of “moral hazard” – the concern that their actions in offsetting market turmoil might prompt investors to take even bigger risks in future, with potentially catastrophic consequences.

In a crisis, central banks have enormous firepower to drown financial institutions in cash. But if they throw money at a crisis, they face two risks.

First, they send the overnight interest rate tumbling because banks have too much cash and all try to lend it out. Inflation follows. Second, they send the signal they are always ready to bail out banks and encourage riskier practices in future.

Choose your devil. Easier said.

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