I often receive e-mails with questions, comments and references. Frequently, I respond to these e-mails, but recently I received a few questions that might be of interest to a majority of our subscribers. How do central banks expand their balance sheets? What happens when the ECB buys all (government) bonds and countries go into default? Will the public burden the losses? What will the role of the IMF be? How long will government bonds remain on central bank balance sheets? Is the Federal Reserve a private entity with banks as shareholders? Who receives the profits the Federal Reserve and European Central Bank earn? Have central bank profits risen since 2008? Are central banks consciously pushing for a cashless society? What is the future role of digital coins, or “cryptocurrencies,” in the banking system? And, to close, how high is the probability that gold will be a monetary anchor in the future? Keep reading if you are interested in the answer to one (or various) of these readers’ questions.
Often I assume as given certain knowledge on the technical procedures of central banks. Yet, nothing could be further from the truth. This “curse of knowledge”, as we call it in psychology, is sometimes unavoidable.
Central banks do two things when they expand their balance sheet: they create a liability, a deposit, and use this deposit to buy an asset (for instance: a government bond). Even though I describe this operation as two separate actions, in fact it is a single action that is executed in one stroke. Central banks buy bonds from other financial intermediaries, which hold a bank account at the central bank, and pay by adding the purchase amount to the account balance of the financial intermediary. It is a mere accounting adjustment.
A consequence is that the amount of “bank reserves” now has increased. Bank reserves are the deposits that commercial banks hold at the central bank and paper currency. Because the central bank in fact pays with “bank reserves,” and as central banks have increased their asset purchases considerably, the amount of bank reserves has increased exponentially.
The central bank creates means of payment out of thin air and uses these means of payment generously. At the same time, a central bank does not experience the same “negative feedback mechanism” that commercial banks experience.
Is there a limit to the expansion of a central bank balance sheet? The answer is yes. First, these are voluntary transactions. If a bank is not willing to sell its government bonds, then central banks can do whatever they want, but nothing will happen. The central bank can bid a higher price (and remember, interest rates are the inverse of a bond price), but it cannot force anyone to sell. Second, the central bank cannot buy more financial assets than the ones that exist, apart from the restrictions that the central bank imposes on itself. And I explained before that with every next asset purchase, the central banks hurts price formation and discovery to a greater and greater extent.
This question is perhaps a paradox. When the ECB buys all government bonds, countries can strictly taken not go bankrupt anymore. This under the assumption that no budget deficit exists and that these countries do not try to finance these deficits would the ECB buying any new issues of bonds.
Today, however, the ECB is on a course to have on its balance sheet 17% of all outstanding government bonds in the eurozone. What happens when the ECB balance sheet, which consists mostly of government debt (on a balance sheet with total assets of 3500 billion euro’s to be precise), when countries go bankrupt now?
In that case, the ECB has a big problem. Better said, this will lead to a negative equity and an insolvent ECB. The Federal Reserve, at the time under Ben Bernanke, thought of a way out: a law that allows the Fed to operate with negative equity indefinitely. In the case of the ECB, such a chapter might lead to a loss of confidence in the euro. A change in law, akin to the changes made in the US, would be likely and a recapitalization by European governments a possibility.
On a side note, some analysts argue that the ECB has a big problem when interest rates rise, because the ECB will have to take losses on its positions. With rising interest rates, bond prices go down. This, however, is not correct, since the ECB – different from an investment fund – does not value its investment “mark to market” (against market prices).
The answer is, unfortunately, as always: yes. The ECB finances euro-governments and allows them to run large budget deficits. Never were governments as indebted as today. With regard to the enormous public debt burden, there are two ways out: huge losses on bonds (which in great part are in possession of the middle class through pension funds) or inflation. In the former case, the ECB puts an end to its expansionary monetary policy (balance sheet expansion, massive purchases of government bonds). In the latter case, the ECB does not put an end to its expansionary monetary policy until it owns all outstanding government debt. Inflation is the result. Inflation is a tax on everyone, but most of all a tax which is unreasonable since nobody knows who suffers the burden of the tax beforehand to the largest degree.
The International Monetary Fund (IMF) was founded in 1945 during the conclusion of the Bretton Woods-agreements. Bretton Woods meant a return to a (pseudo) gold standard, after many governments abandoned the gold standard to finance the Second World War. Under a gold standard, it is difficult to run large budget deficits and finance public debt through the printing press, because the central bank is not able to buy or monetize all the debt (something which is completely possible nowadays). The IMF was a gesture, a compensation, to adopt the Bretton Woods gold standard; governments could count on the IMF as a “lender of last resort.”
The IMF received gold and foreign exchange reserves (dollars backed by gold) by its members. Only after 1969 the SDR was introduced. Initially, a SDR was promise for payment in gold (0.888671 grams to be precise – equal to a dollar at the time). Nowadays, it is a promise of payment in various currencies (the US dollar, the euro, the British pound sterling, the Chinese renminbi, and the Japanese yen).
As long as central banks play along, the role of the IMF in the developed world will be limited. But as soon as interest rates rise and central banks restrict monetary policy, the domino’s start falling. And as soon as the domino’s start falling, there is precious little the IMF can do. They might want to keep the “illusion of control,” and be involved with possible debt reductions (in other words, defaults) as the alleged financial firefighters of the world. But the IMF remains a sideshow.
In principle, until maturity. That, however, might take a while, since central banks in modern times buy long-dated government debt. Nevertheless, as long as the government bonds the central bank buys have a fixed duration, these bonds will reach maturity and disappear from the central bank balance sheet. To give an example, the balance sheet of the Federal Reserve is currently shrinking.
In theory, governments could issue bonds with an infinite duration and a 0% coupon interest rate. And, in theory, central banks could buy these bonds. This is a de facto bankruptcy. The loss is shouldered, indirectly, by the holders of the currency in the form of inflation.
Conspiracy theories may not be left out. Better yet, “Black Swan” author Nassim Taleb wrote that it is as irrational to deny all conspiracy theories as to accept them. And he has a point. But the idea that the Fed is a private entity, with bankers as private shareholders getting rich over the backs of the American people, is a popular myth.
Before the Fed was founded in 1913, with one of its principal objectives being to soften seasonal fluctuations in bank credit and thus interbank interest rates, the question that was quickly raised was: who should direct this bank of banks? The government? Bankers? A board of businessmen and farmers?
The final solution was quite complex. Commercial banks are, by law (the Federal Reserve Act), obliged to buy shares in the Federal Reserve of its state. Every commercial bank has one vote and is allowed to vote for directors and the president of their local Fed. Just to give you an idea, there are many banks in the US; the New York Fed has several thousand members who represent several thousand votes.
The board that decides on monetary policy, the Federal Open Market Committee (FOMC), consists of the president of the New York Fed, four presidents of four other local Fed’s according to a rotation scheme, and seven board members that are appointed by the US president, including the chairman of the Fed, nowadays Janet Yellen. On a brief side note, Trump can and will elect several new board members, because the term of these board members is expiring.
All profits of the Fed and the ECB go to their respective governments. In the case of the ECB, we have to remark that, for instance, the Dutch National Bank (DNB) merely executes ECB policy in the Netherlands and therefore owns merely Dutch government bonds. The profits that DNB earns on these bonds, is paid out to the Dutch government.
Worse yet, the Dutch government actually includes in the public budget the payments that the DNB expect to generate from the bonds that it buys by creating means of payment out of thin air. That is what “central bank independence” means, as far as anybody still believed that.
The Fed, just to complete the story, does pay a 6% dividend to its shareholders, which are banks. Because commercial banks are obliged to buy shares in their local Fed, and this investment is “dead capital”, i.e., they cannot invest it anywhere else, they receive an “interest” over their non-marketable shares. 6% might be a lot today, but in the 70’s with high inflation it was a meager return.
The largest hedge fund in the world is Bridgewater Associates, with about $80 billion in assets under management. The Fed manages fifty times that amount. The ECB somewhat less than that, but still comes close with $3,700 billion under management. That the profits of these central banks flow back to governments, is worrying.
The profits that central banks generate have, thanks to the gigantic expansion of their balance sheets, risen enormously. Never did the ECB and Fed generate as much money as today. The Dutch government can currently count on about €600 million euro a year.
My answer: this is very likely to be the case. I have actually written on multiple occasions about the introduction of a Gesell-rule.
Academics like to talk about the “lower zero bound” in monetary policy, which is an expensive word for the idea that it is very difficult to impose negative interest rates (rates lower than zero). Central banks can, without any doubt, charge negative interest rates on deposits that banks maintain with them. But paper currency has a hypothetical zero percent interest rate (hypothetical because in the real world you incur some costs for the transport, custody and insurance of large amounts of paper currency). If a central banks charges negative interest rates on deposits, then there will be a tendency to convert these deposits (with negative interest rates) into paper bills (with a zero percent interest rate).
To make a long story short, by banning the use of cash money, this “zero lower bound” disappears and the central banker is able to make its dream come true: a world in which capital is no longer scarce (after all, you get money to borrow). That they realize that this is only a temporary illusion with a very nasty end, is a matter of time.
But a central banker who desires full control over monetary policy and wants to make negative interest rates workable, benefits without doubt from a cashless society.
Without getting into too much detail (much can be said about digital coins), my expectation is that clearing houses will disappear and blockchain-technology will take over their function. And banks have discovered this, too. That is why we are seeing a surge in investment and experiments which we have read about in the papers lately.
Not very likely. No central banker, no government has an incentive to have a currency anchored by gold. A peg with gold limits their possibilities to run budget deficits, increase public debt, and finance all kinds of projects with easy and cheap credit. Laymen would benefit from a gold standard, but they know nothing about it. A politician with a gold standard as his main election promise, will fail to win over many souls. Something which might, of course, change in the future.
My advice is to not wait for the future and buy your own gold, instead of waiting for politicians to get elected on a gold standard campaign promise.