Endogenous Money and the Lender of Last Resort of International Liquidity

Abstract:The key to prevent financial crisis is to deal with the issue of the lender of last resort (LLR), and a network of swap lines among central banks may become the base infrastructure to provide the international liquidity.

In the modern financial system, money is largely generated endogenously, leading to the embedded possibility of financial crisis. In the time of intensified uncertainty, the deadly shrinking cycle may lead the enforced deleverage of the financial system into a self-fulfilling collapse. This is the time when only central bank could end the cycle by providing unlimited liquidity to the banks. By giving up the burden of “money convertibility” of golden standard, central banks gradually take up the duties of lender of last resort (LLR), which has substantially decreased the frequency and severity of financial crisis. However, due to the lack of an international lender of last resort (ILLR), many countries have encountered forex type of financial crisis since 1973 after Bretton Woods system collapsed. Build a network of swap lines among central banks of sovereign states could be a promising way to solve the problem. Under the principles of multilateralism, autonomy, transparency, gradualism and integration, this network, instead of any particular central bank or national institution, would be the basic infrastructure of ILLR.

The paper is organized as below. The first part discusses the endogeneity of money; the second part discusses central bank’s function as LLR and its relationship with financial crisis; and the third part discusses the necessity for central banks to build up a network of swap lines which functions as basic infrastructure of ILLR.

Endogenous Money and the Lender of Last Resort of International Liquidity