Trade-off Between Plague and Cholera: The Role of Central Banks in Financial Crises.

Once a taboo, now commonplace: Central banks have become the eternal saviours of last resort. When is a rescue necessary, when is it not? Discussion between Bundesbank President Joachim Nagel and IfW-Kiel President Moritz Schularick.




6. FEBRUARY 2024


"Before the 2008 financial crisis, many believed in the efficiency of the financial markets, that the risks would balance out, and enshrined many things that later turned out not to be good. We only looked at the rating and not at the structure... We only learnt painfully afterwards what it means when the system proves to be inefficient, when you as a central bank have to choose between plague and cholera."
Joachim Nagel, January 30, 2024

Financial crises and bank bailouts are nothing new. This is one of the main insights reached by Moritz Schularick and co-authors in the study ‘The Safety Net: Central Bank Balance Sheets and Financial Crises, 1587-2020’. On the contrary, the last 400 years have seen no shortage of financial crises in which central banks have had to intervene as lenders of last resort. What lessons can be learnt from this historical analysis for today’s central bank policy? We discussed this at length last week with Joachim Nagel, President of the Deutsche Bundesbank, and Moritz Schularick, author of the study and President of the Kiel Institute for the World Economy.

The Presentation of the Study presented as Introduction by Thomas Fricke

The study suggests that, over time, the provision of liquidity during financial turmoil has successfully stabilised the economy. At the same time, however, they have increased the probability of future boom-bust episodes. This is because banks that feel safe to take more risks (moral hazard)[1].

In view of the massive excess liquidity in the financial system since the pandemic, the question of the trade-off between rescue and increased risk appetite seems more relevant than ever. According to Joachim Nagel, the reason for the increased central bank activity is that the financial system has changed fundamentally in recent years: Financial markets have become much larger, the speed has increased significantly and financial crises have also become more frequent. At the same time, according to Nagel, the security and liquidity requirements for banks have also increased, which helped, for example, to deal with the crisis at the beginning of 2023 (Credit Suisse).

The 2008 financial crisis also led to a paradigm shift in central banking. While the market-liberal paradigm that prevailed at the time saw efficient financial markets absorbing risks and thus rendering central bank intervention obsolete, the crisis exposed the systemic vulnerability of the financial system.

"Do we have to run ever faster just to stand still? By the central bank wanting to take risks out of the system, but at the same time inviting new risks to be taken. In the end, we are where we were before and the crisis still happens."
Moritz Schularick, January 30, 2024

Moritz Schularick also agreed that financial market conditions had changed significantly. Although the dilemma between rescue and more risk had always existed, it had become more important in recent years. In recent centuries, there has been a systematic development of central banks providing liquidity in crises. With Covid, things have moved even faster: there are large purchase programmes that can be (re)activated if necessary and market participants are aware of this. Which in turn changes the rules of the game. Could central banks create more risk by extending the safety net?

Nagel’s answer was that in extreme situations, there is no choice but to act. That it is a choice between plague and cholera. However, it is clear that the marginal benefit of interventions is diminishing. This means that you have to do more and more to get a certain reaction. This is because market participants are seeing how central banks work and are adapting their business practices to some extent. As a result, the scale of interventions is growing. According to Nagel, the important question is whether central banks could withdraw from the market. A question that the Bundesbank President answers with a clear ‘yes’: in order to maintain price and financial stability as a public good, the balance sheet total must be reduced in calm times.

Moritz Schularick agreed with Joachim Nagel that central banks should intervene in crises. This is exactly what the study shows: interventions do help! However, it is important to look at the big banks after the crisis because they are decisive in macroprudential terms. What you see in crises is that the big banks trigger systemic crises with their lending and are rewarded from the crisis by becoming even bigger.

When asked about the distributional effects of interventions along the lines of ‘profits are privatised, losses are socialised’, Joachim Nagel defended the policy of the central banks.

"Sometimes it's a trade-off between plague and cholera, but I still think that the intervention over the last 15 years was the right one. Because without the intervention of the central banks, the bill would have been even more expensive for everyone."
Joachim Nagel, January 30, 2024

Schularick followed up with an appeal to look at the costs not in terms of fiscal costs, but in terms of lost output costs (GDP growth), which would have much greater macroeconomic welfare effects.

So what conclusion can be drawn – should central banks intervene and how? Both panellists agreed that intervention should be made in crises in order to mitigate the negative effects of systemic financial crises and stabilise the system. Because risks do not balance themselves out in the free play of market forces. This makes it all the more important to keep a close eye on the major players to avoid future crises as far as possible.

Watch the whole discussion here (in German)



More than a decade after the financial crisis there still seems to be something seriously wrong with the financial system. Financial markets still tend to periodically misprice risk and contribute to boom and bust cycles. A better financial system needs to discourage short-termism and speculative activity, curtail systemic risk and distribute wealth more broadly.