Of course, simply offering blank checks to the profligate is not a good solution either. But the current way the European Central Bank is acting may be the worst of all worlds. By buying government bonds while insisting it will soon stop, it is sending the message that bondholders had better sell quickly.

By contrast, if the bank made a promise to buy all the bonds that were offered to it — backed by its ability to print money — it might have to buy few bonds.

There is a real risk of moral hazard in central bank bailouts. The theory offered by Bagehot in the 19th century called for banks to make loans on securities that are of high quality and will be liquid when the panic passes, but not on low-quality securities. Telling the good from the bad during a panic is not always easy.

But we have until now assumed that a central bank would find bonds issued by its own government to be good paper, and investors could act accordingly.

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Filed under: * Economics, Politics • Economy • Consumer/consumer spending • Corporations/Corporate Life • Credit Markets • Currency Markets • Euro • European Central Bank • The Banking System/Sector • The Credit Freeze Crisis of Fall 2008/The Recession of 2007-- • Foreign Relations • Politics in General • * International News & Commentary • Europe • --European Sovereign Debt Crisis of 2010

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