States, Markets and the Instruments of Policy-making : Bankruptcy Law Vs. the Lender of Last Resort

Jerome Sgard (Sciences-Po (Paris))
Eric Brousseau (Université de Paris Ouest)

Abstract: We compare two generic instruments of crisis-management: bankruptcy law and the lender of last resort. They are generally not considered simultaneously either in the academic literature or in the policy-debate. Bankruptcy is a retail institution that is operated by a court, it works out-of-the-market, it is about the enforcement of the solvency constraint and the reallocation of individual property rights. Conversely, the LLR is a highly centralized act by a Central bank, it works for within the market (contractual rights are not suspended), it targets liquidity concerns and, in principle, it has not impact on the distribution of wealth. It is argued here that these two instruments are exclusive one to the other, yet complementary, though in good doctrine never supplementary. In other terms, the by-default doctrine is: first, that any actual instrument being mobilized in a context of crisis belongs to either one or the other of these two models; second, that at any point in time, a key strategic choice for crisis-managers is which one to choose and possibly when to switch to the other; and thirdly that they do not respond to the same diagnostic, hence they cannot be substitute. The two first sections of the paper develop this set of opposing patterns whereas the latter sections address two further issues that contribute to a more realistic view of crisis-management. One is how the socialization of losses affects these two generic instruments. Then is the rule of interaction between bankruptcy and the LLR, which is arguably one of the great sources of policy failure at time of crisis.

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