This Is How Independent Central Banks Are

July 26 2016

While ECB-chairman Mario Draghi firmly continues buying up bonds (but for now decided to keep rates where they are and not increase the pool of eligible assets by relaxing the boundaries of its purchase program), an important question arises. Can a central bank go bankrupt? Central banks can certainly become insolvent or, in other words, have a negative equity with the value of their liabilities surpassing the value of their assets. Better yet, it is very likely that the coming years central bank will have to take enormous losses on its bond positions and that they will get into solvency troubles. The solution differs. In the meanwhile, central banks finance governments to an increasing degree.

The Obvious

We can of course talk about the fact that central banks repress interest rates to such an extent and buy government bonds in such quantities that governments are able to finance themselves against negative rates. We can talk about the fact that the only reason that periphery countries in the Eurozone, such as Italy and Spain, did not go bankrupt merely thanks to Mario Draghi’s “whatever it takes.” We can talk about how absurd it is that the central bank buys corporate bonds and favors a select group of companies to the detriment of small and mid-size companies and start-ups. We can talk about the fact that the European Central Bank (ECB) directly benefits “old giants” such as Volkswagen and Deutsche Bahn at the expense of the rest and helps them with cheap financing. We can talk about the fact that, despite desperate attempts of the ECB, the consumer price index does not care about the alleged omnipotence of the Italian tsar that rules over our money. We can talk about the fact that the objectives of a modern central bank, a twisted idea about price stability and “full employment,” is for starters a bizarre notion.

But that is exactly what I do not want to talk about today.

The Less Obvious

Perhaps you did not notice.

Wikipedia says that Bridgewater Associates of famed investor Ray Dalio (and his “all-weather” strategy which put 25% into gold) is the biggest hedge fund in the world, with assets under management (AUM) exceeding $80 billion dollar. Unfortunately, this information is incorrect. The biggest hedge fund in the world is the Federal Reserve, with almost $4,500 billion dollar under management. On a modest second place follows the Bank of Japan, with approximately $4,000 billion dollar under management. On the third place comes our Italian rock star hedge fund manager (pun intended), Mario Draghi, with about $3,500 billion dollar of assets under management.

This comparison should stun every reader. The role of central banks in our economy is out of whack and blown out of proportion. And all this is not without its consequences.

Because who are the shareholders of these three giant hedge funds?

You could have guessed it by now: governments.

Although the Dutch central bank happens to act a bit mysterious about this undeniable fact. “Is De Nederlandsche Bank (DNB) owned by the government?”, we can read on its website. The first sentence that follows is: “As central bank, DNB is completely independent of the government.” In the last two sentences, however, it admits to the question: “The Dutch government is the only shareholder. That means for instance that any profits DNB generates will be to the benefit of the State.”

“Benefit” is a big word.

The worst is yet to come: did they put up the money in these giant hedge funds? The answer is a definite “no.” They did not even accumulate their initial investment by taxing us “fairly.” No, central banks buy investments with deposits which they create out of thin air. Then they hand over the shares in these investments to the government. Simple as that.

Increasingly central banks forecast profits, so governments can take these profits into account in their annual budgets.

The Netherlands is no exception to this rule. The forecasted distribution of profits of DNB is included shamelessly in the annual budget proposal. According to DNB, profits amount every year to about €600 million euro (which is a little bit disappointing return on, let’s say, €140 billion: +0.43%).

But should it be like this?

Apparently, the Dutch government views central bank profits as government revenue: either a tax, a duty, or a return on some government-owned asset. We can be highly critical of any of these three notions.

Never mind what the state of affairs in other European countries would be.

Curiously, DNB is less secretive about what it invests in. The answer to this question can also be found on the website of DNB: “For one part, capital includes gold. For the other part, the capital is invested. DNB, for instance, invests in dollars and euro’s. DNB also invests in stock markets. As such, DNB earns interest and dividends.” The founders of the Federal Reserve would turn over in their graves (the Fed was initially limited to buying “real bills”, short-term commercial paper).

For some reason, DNB does not view gold as an investment. Because their capital “includes gold”, but the rest of its capital “is invested” (literally cited from their website). I can only guess as to what DNB considers gold if it is not an investment (an international currency, will they really?).

Anyhow, it is clear that central banks are investing in increasingly risky assets.

Which makes it possible, or even likely, that central banks will become insolvent when they take losses on their holdings, in other words, that their equity will be negative.

The Federal Reserve does not care. A few years ago, Ben Bernanke made sure legislation was passed to exempt the Fed from normal accounting laws. The Federal Reserve can have negative equity indefinitely, and nothing will happen.

At the other side of the ocean, central banks are not so lucky. Negative equity will in most cases mean the government has to re-capitalize the central bank, just like it re-capitalized commercial banks in the 2008 crisis.

For that reason, DNB has decided to reserve the coming years a large share of its profits for possible losses down the line. It is literally building a buffer, in case it suffers losses on its deteriorating asset base.

The Irony of Low Interest Rates

The call of politicians for an “independent central bank” is loudest when everything is fine. While the European Central Bank (ECB) manipulates interest rates downward and interest payments, despite the staggering debt, decrease, every politician shouts that the independence of the central bank should be protected at all cost.

But this rhetoric is also cyclical.

As soon as rates rise and the ECB either (a) cannot intervene because inflation is already (way) too high or (b) deliberately chooses not to intervene, no politician will talk about defending central bank independence. They will most likely complain, with direct and indirect threats to the chairman of that moment.

And who elects a central bank president again?

Right: the minister of Finance.

Did you have any illusions left about the idea of central bank independence?


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