Lender of last resort in a monetary union

• Main Author: Gylfi Magnússon
• Format: Article
• Language: English
• Published: University of Iceland 2014-12-01
• Series: Stjórnmál og Stjórnsýsla
• Subjects: Þrautalánveitandi; myntbandalag; fjármálakrísa.
• Online Access: http://www.irpa.is/article/view/1612
• ISSN: 1670-6803; 1670-679X

The theory of optimal currency areas was developed during the 1960’s and 1970’s. At that time the international financial system was very different from the current system, banking systems were smaller and the flow of funds across borders limited. Developments in the Eurozone in recent years have shown that when the theory was developed and the decision made to adopt the euro some of the drawbacks of a common currency were not foreseen and important issues were not addressed. This includes the role of a common central bank as a lender of last resort to national governments. In addition, few foresaw how many closely linked financial systems could create problems that are unsolvable without the cooperation of several governments. An adequate framework for dealing with such problems was thus not put in place. The possibility that macro-economic shocks could originate in the financial system was mainly ignored. During the current crisis it has been necessary to address all these issues. It took four years to find a politically viable solution. This involves the redefinition of the role of the European Central Bank, making it a lender of last resort to national governments. This policy change buys time to deal with many fundamental imbalances within the Eurozone but does not in and of itself solve the underlying problems. The delay in implementing this policy was however very costly.