The euro lacks a government banker, not a lender of last resort

In his novel, The Jungle, the American muckraking author Upton Sinclair wrote about the horrendous work and sanitary conditions in the Chicago meat packing industry of the early 20th century. It is sometimes said Sinclair aimed for the heart but hit the stomach. That is because he aimed for progressive social and economic change but instead prompted the founding of the Food and Drug Administration.

The same problem of aiming for the heart and hitting the stomach confounds current discussions of the euro zone’s problems. What the euro lacks is a government banker, not a lender of last resort as is widely claimed.

The euro has a lender of last resort in the European Central Bank (ECB) which has dutifully performed that function. Lenders of last resort provide liquidity in financial panics, which is exactly what the ECB did in the financial crisis of 2008-09 and has continued doing via its Lombard lending facility. According to Bagehot’s rule, lenders of last resort should lend without limit, to solvent firms, against good collateral – though Bagehot also recommended lending at high rates whereas today’s practice is (sensibly) to lend at low rates.

The euro lacks a government banker, like the Federal Reserve or Bank of England, which helps finance budget deficits and keeps rates low on government debt. This explains why the U.S. and U.K. can borrow at low rates and remain solvent, whereas Spain, which has a roughly similar deficit and debt profile, is under speculative attack.

The lack of a government banker reflects the euro’s neoliberal birthmark. Neoliberalism aims to diminish the role of the state and enhance the power of the market, and this goal is reflected in neoliberal monetary theory which guided the euro’s design. The theory argues central banks should control inflation, but there should be complete separation between the central bank and government finances.

By adopting this theory, the euro’s architects intentionally changed the monetary/fiscal balance. Whereas previous national monetary systems ensured “fiscal dominance” as central banks served governments, the euro instituted “central bank dominance” by stripping governments of access to central bank help managing public finances. This was done by creating a “detached” central bank that is prohibited from buying government debt. This is fundamentally different from an “independent” central bank which distances its decision making from government, but is allowed to purchase government debt. The Federal Reserve and the Bank of England are both independent but they are not detached. The ECB is detached by design.

The consequences are enormous. Prior national banking systems made governments masters of the bond market. The euro’s architecture makes bond markets master of national governments, and that is the problem.

The solution is to create a European Public Finance Authority (EPFA) that issues collectively guaranteed debt on behalf of euro zone governments which the ECB is allowed to buy. That would enable the ECB to manage governments’ interest rate via open market operations, as does the Federal Reserve and Bank of England. Proceeds from EPFA debt issues would be distributed to countries on a per capita basis so that national governments would control all spending decisions. Country liability for EPFA debt would also be on a per capita basis, and EPFA decision-making would be governed by member countries with voting rights again granted on a per capita basis. That would render EPFA democratic.

The critical feature is EPFA’s power to issue debt would be used immediately to finance the roll-over of existing debt at lower rates, and it would also be used on a permanent basis to finance current and future budget deficits. EPFA would therefore be a solution to both the current crisis and the euro’s design flaw regarding absence of a government banker.

The great psychoanalyst Sigmund Freud claimed everything we say has psychic sense. That holds for economics too. Characterizing the problem as lack of a lender of last resort obscures the euro’s fundamental neoliberal design problem regarding lack of a government banker and subservience of fiscal policy. That is a structural flaw which creates financial fragility and permanent budgetary pressure that shrinks social democratic policy space. Failure to frame the problem accurately blocks identification of the proper resolution, so that policy reform - the intended solution - misses the mark and hits the stomach instead of the heart.

This article was posted in the FT Economists’ Forum on December 9, 2011 at

Copyright Thomas I. Palley

Leave a Reply

You must be logged in to post a comment.