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If the ECB really cared about financial stability, it would greatly increase bank reserve requirements while providing unlimited liquidity (at asset-appropriate discounts) at the weekly refinancing operations, and it would use open-market operations for market-making of last resort.

I would argue that reserve requirements should be increased to 100 % of insured deposits and wholly abandon open market operations (except in sovereign bonds, which it should buy at par whenever issued). This would enable the central bank to impose appropriate margin requirements on all lending which receives liquidity from the central bank. Margin requirements which can, ultimately, go all the way to 100 %, cutting off central bank liquidity to that particular loan type altogether.

Further, and more interestingly, this would allow the central bank to discriminate between different loan types, both in terms of funding cost and margin requirements. It could, for instance, cut the balls off someone trying to short its currency or blow a real estate bubble, while leaving revolving business credit unchanged.

The central bank might then actually become a useful instrument for industrial and macroeconomic planning.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon May 9th, 2011 at 04:17:03 PM EST

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