The global financial system may be caught in a downward spiral as market and funding illiquidity reinforce each other. The author of CEPR Policy Insight 22 presents a radical proposal that would break the feedback loop by not valuing illiquid assets at market prices under crisis conditions.

In a new CEPR Policy Insight, Javier Suarez proposes the creation of an Emergency Bank Debt Insurance Mechanism as an alternative to the massive lending of last resort operations undertaken by central banks since the start of the subprime crisis.

The current crisis is a modern form of a traditional banking crisis. The 125-year-old Bagehot's doctrine tells us how governments should react – lend to solvent but illiquid financial institutions. While easy to state, the doctrine is hard to apply. The key question to assess the future consequences of current central bank policy is whether the subprime mortgage crisis arises in the context of a moderate or a severe underlying moral hazard problem.

Inflation is rising. This column identifies three sources of inflation and argues that it is very important for central banks to tame inflation now, before we face a vicious cycle of rising inflation and expected inflation.

Many observers have argued that central banks should use monetary policy to prevent the rise of asset price bubbles. Recent research shows that monetary policy is too costly and too slow to serve such a role.

The final essay examines whether central bank actions have created moral hazard, encouraging asset managers to take on more risk than is in society’s interest; the answer is “no”.

The third essay in this 4-part series argues that central banks should have a direct role in financial supervision.

Inflation targeting proponents view central banks’ responsibilities as minimalist. But the subprime crisis shows that central banks cannot avoid taking responsibilities that include the prevention of bubbles and the supervision of all institutions that are in the business of creating credit and liquidity.

Last week's actions by the ECB, the Fed and the Bank of Japan were not particularly helpful – a classic example of trying to manage a credit crisis or liquidity squeeze using the tools suited to monetary policy-making in orderly markets. Monetary policy is easy; preventing or overcoming a financial crisis is hard; managing the exit from a credit squeeze without laying the foundations for the next credit and liquidity explosion is harder still. Central bankers should earn their keep by acting as market makers of last resort.