EKIP– Expert Club for Economics and Politics A Different Opinion
Central bank intervention in financial markets distorts the supply and demand of various asset classes, which has repercussions on the productive structure of the economy and the consumption and saving behavior of individuals. Eliminating the risk premium is only part of the central bank's portfolio of vices.
Ivan Georgiev
In the article for EKIP The Hidden Cost of the ECB’s Contribution to the Debt Crisis, Stoyan Hristov makes a brilliant presentation of the consequences of operating as a lender of last resort. Stoyan examines the activities of the central bank in the context of the debt crisis, characterized by the increase in government debt, the making of relatively riskier investments and the deterioration of the quality of the monetary unit. What deserves additional attention is the relationship between moral hazard and the level of the interest rate.
As is known, the prime interest rate represents the exchange ratio between present and future goods. Since we live in a world of uncertainty and transaction costs, when lending funds, several more components are added to the prime interest rate. One of them is the risk premium, which is an insurance against the possibility of default on the loan obligation (financial instrument). Despite the improvement of forecasting models and risk control methods, credit default, and accordingly "bad" credit, cannot be predicted with perfect accuracy. Risk is an invariable phenomenon accompanying lending, and it plays an important role in the allocation of funds over time. It puts pressure on lenders to select their borrowers and deters the use of resources by unsuitable borrowers. In other words, the level of the risk premium has an economic role in the use of limited funds over time and between competing individuals with different goals.
But while risk is an inevitable part of human activity, the same is not true of the risk premium. In a world where the central bank has demonstrated a willingness to help institutions with liquidity changes, the risk premium is (almost) eliminated and the interest rate is artificially low. When the central bank indicates that it will act as the buyer of last resort for certain debt assets, the probability of default on them is eliminated. This leads to a decline in the yield on these assets, but not a decline in demand for them. The central bank's "favorite" assets have an advantage over discriminated assets because they have been made perpetually liquid (i.e., there will always be a buyer for them).
Central bank intervention in financial markets leads to distortions in the supply and demand of different asset classes, which has its impact on the production structure of the economy and the consumption and saving behavior of individuals. Eliminating the risk premium is only part of the portfolio of central bank vices. Others are – the initiation of credit expansion, the bail-out (rescue) of financial institutions and the monetization of government debt. All this leads to the deterioration of the signaling function of the interest rate and the balance between savings and investment, an increase in government indebtedness and a continuously growing unemployment.
