Moral Hazard and Lending of Last Resort
Abstract
Nowadays, the idea that lending of last resort is necessarily conducive to moral hazard appears to be generally accepted. This chapter questions this received wisdom by tracking the evolution of monetary theory and practice over the very long term. While most economists have seen as inevitable the association between lending of last resort and moral hazard, others (especially Walter Bagehot) have claimed that the two may be separable if “constructive ambiguity” surrounds the conditions at which emergency liquidity may be accessed by banks. A brief overview of the practices adopted by monetary authorities over the centuries tends to confirm that the separability between lending of last resort and moral hazard may be attainable, but only through a correct design of banking regulation and liquidity-injecting operations.
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