Whenever it comes to supporting ailing financial sectors, central banks routinely quote the nineteenth-century Bagehot dictum: 'lend freely to solvent institutions against good collateral'.
This might sound sensible, but in fact it is a narrowly conservative strategy. At the time, the then-governor of the Bank of England commented that, when a serious crisis occurred, this formula would be too cautious. To prevent a systemic crisis, a central bank should be ready to lend to any systemically-important institution regardless of collateral. It would have to risk losing money and be ready to go outside its formal mandate.
This is the kind of boldness that the US Federal Reserve demonstrated in 2008. The Fed stepped in when the political system showed itself incapable of reacting effectively. Bloomberg, using freedom-of-information material, has added up all the various lending and guarantees given by the Fed, and the total is an astonishing $US7.77 trillion, equal to more than half a year's US GDP.
The Fed lent to banks whose solvency was doubtful, but it didn't confine itself to banks: it lent hugely to institutions such as AIG, outside its supervision or its jurisdiction, and which had done unforgivably foolish things. It bought private-sector sub-prime mortgages that were shunned by the markets. It expanded its balance sheet three-fold and took on interest-rate risk with its bond purchases. It risked being sucked into a vortex of budget financing by buying government debt. It gave a guarantee to the money market, the key player in the much-reviled shadow financial sector.
It withstood endless mindless criticism that its quantitative easing operations were 'printing money'. It put up with the criticism that it was saving financial fat-cats whose misjudgments had created to mess, while 'Main Street' suffered. It risked the ire of politicians, with one presidential candidate calling its policies 'almost treasonous'.
Contrast this with the situation in Europe.
The European Central Bank has the opportunity to play a key role in pulling the world back from crisis. It seems well on the way to fumbling this opportunity through timidity. It was slow to see the problem, raising interest rates as recently as July; it stood in the way of Greek debt rescheduling, which would probably have nipped the crisis in the bud if implemented in early 2010; and it is now twiddling its thumbs in the hope that someone else will save the situation.
Of course others need to play their part in getting these economies in order. But austerity is not enough. It is equally clear that doubts about sovereign debt will feed on themselves unless a circuit-breaker can instill some confidence that Italy, Spain and France are still good credit risks. Only the ECB can do this. Yet it remains hobbled by doctrinal debates and obfuscation about the details of its mandate.
How can there be doubt about its legal ability to help? It has already purchased large amounts of government debt (including around US$50 billion of Greek debt). Now it could do something to support economies which, unlike Greece, have good prospects of sustainability.
The trance-like drift towards economic disaster reminds one European economist of the descent into World War I: the British and Germans were close (in fact, they had a royal family in common) and had no good reason to sacrifice the flower of their youth in mass slaughter. And yet events unrolled in ways that brought this result, without anyone feeling responsible for standing in the way or devising means to avoid this terrible outcome. This is the thought which should be on the minds of the ECB board, not a legalistic debate about the extent of its mandate.