Central bank policy: who wins?

A few days ago, I mentioned in passing the idea that there is an experiment going on at the moment with central banks policy: it seems unlikely that the FED, the ECB and the Bank of England are all right in their reactions to the crunch. Larry Elliott focussed on the rates part of the puzzle, weighing up the pros and cons of the different levels of rates in USD, EUR and GBP versus the inflationary environment.

The other part of this puzzle is collateral, or more precisely what collateral is eligible at the window. Here too policy differs: the ECB for instance is remarkably generous in the range of collateral it permits banks to post at the window. Indeed posting RMBS as collateral with the ECB is basically keeping the Spanish banking system afloat (i.e. liquid) at the moment. Similarly the collateral eligible at the FED's new TAF is rather widely defined, and the Bank of England perhaps belatedly has extended the range of admissible collateral recently.

As Willem Buiter points out, central banks have a duty to provide liquidity to the market in times of stress. He says furthermore (although the emphasis is mine):

There is no moral hazards as long as central banks provide the liquidity against properly priced collateral, which is in addition subject to the usual 'liquidity haircuts' on this fair valuation.

Right now I think it is reasonable to doubt if this collateral is properly priced. Certainly the idea that a bank can take a bunch of mortgages, package it up as RMBS, and repo it with the central bank without market scrutiny of any kind is bizarre. If this paper has never traded, why does the bank feel comfortable that it is worth par?

The wide range of eligible collateral and lack of scrutiny in valuation of that collateral has succeeded in liquifying the banking system. It was probably the right short term policy reaction. But as the situation improves central banks will need to wean the market off the crack cocaine of cheap liquidity with no questions asked about collateral value. How (if?) they do this may prove as significant as the path of rates for the final outcome.