The UK Chancellor, Alistair Darling, has been busy repudiating the notion that the British government was planning to ‘print money’ to prevent deflation and stimulate the economy. He was reported in the Financial Times (January 9th, 2009) as saying :“Nobody is talking about printing money. There’s a debate to be had about what you do to support the economy as interest rates approach zero, as they are in the US. But for us that is an entirely hypothetical debate”.
This statement of the Chancellor either represents a major manifestation of profound ignorance about what central banks do and how monetary policy is conducted, or a deliberate denial of an obvious fact, perhaps because the words “printing money” have unfortunate Weimar or Zimbabwe connotations. Yet ‘printing money’ – that is, creating base money, either through the issuance of currency or by increasing the stock of commercial bank reserves held with the central bank – is what central banks do in a fiat money world. They do this not just in Zimbabwe, but also in the US, in the Eurozone and in the UK.
Even without the zero floor on the Bank of England’s official policy rate (Bank Rate) having been reached yet (it currently stands at 1.5 percent), the Bank of England has in fact be printing quite a lot of money. By no means enough in the period since September 2008, I would argue, but certainly quite a bit. This is clear from Charts 1 and 2 below, which show the behaviour of central bank money, also called base money or the monetary base, and its two components, currency (notes and coin held outside the Bank of England) and commercial bank reserves held with the Bank of England. Chart 2 also shows the behaviour of the monetary base, or narrow money, relative to a broad measure of money, M4, which includes sterling bank deposits held by the private sector and some close substitutes. The ratio of broad money to narrow money (here M4 to M0) is sometimes called the (base) money multiplier. Note that in Chart 2, both M0 and M4, but not the ratio of M4 to M0, are drawn on the log scale.
Until May 2006, UK monetary policy was unusual in that (a) there were no meaningful reserve requirements for banks (commercial banks only had to hold 0.25% of eligible reserves as non-interest-bearing reserves with the Bank of England under the Cash Ratio Deposit Scheme, an arrangement designed not for monetary policy purposes but to provide the Bank of England with another source of income) and (b) reserves in excess of this minimum required amount were subject to a financial penalty. Excess reserves did not earn interest at all until March 2005. From March 2005 until 18 May 2006 they earned Bank Rate minus 50 basis points. Since May 18, 2006, they earn Bank Rate.
You can see the effect of the May 2006 change in reserve arrangements clearly in Charts 1 and 2. The resulting increase in M0 reflected an increase in the demand for reserves by banks (holding constant everything except the interest rate on reserves). It was therefore not inflationary. The second rapid increase in reserves started in September 2008, when the UK banking system was on the edge of collapsing and, in the US, Lehman Brothers filed for bankruptcy protection on September 15, an event that triggered a state of cardiac arrest in most of the world’s money and capital markets. Again, this jump upwards in the stock of base money was driven by an increase in liquidity preference by banks. As long as the fear, risk-aversion, and partly irrational despondency that have the banks in their grip persist, the increase in M0 since September 2008 will not be inflationary. It reflects the central bank leveraging up to counteract the otherwise excessively rapid, sudden and destructive deleveraging of the commercial banks.
When fear and panic eventually desist, however, it is essential that the central bank stand ready to take back the injection of liquidity provided since September 2008. Indeed, as I hope and expect that the Bank of England will, during the rest of this year, engage in ‘printing money’ on a much larger scale than it has thus far , the need for an eventual massive contraction in the monetary base when the private financial sector rediscovers its poise and confidence, will be paramount if the UK is to avoid a major burst of inflation a few years down the road.
How does all this connect with quantitative and qualitative easing? In an earlier post I offered the following definitions:
Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase it is monetary liabilities (base money), holding constant the composition of its assets. Asset composition can be defined as the proportional shares of the different financial instruments held by the central bank in the total value of its assets. An almost equivalent definition would be that quantitative easing is an increase in the size of the balance sheet of the central bank through an increase in its monetary liabilities that holds constant the (average) liquidity and riskiness of its asset portfolio.
Qualitative easing is a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet (and the official policy rate and the rest of the list of usual suspects). The less liquid and more risky assets can be private securities as well as sovereign or sovereign-guaranteed instruments. All forms of risk, including credit risk (default risk) are included.
Let me expand on these two concepts with the help of the two central bank balance sheets in Tables 1 and 2.
Table 1 shows the balance sheet of a central bank that today’s besieged central bankers can only dream of. Apart from foreign exchange reserves (X), it has on the asset side of its balance sheet only sovereign debt instruments (T, for Treasury securities) or loans and similar claims on the private sector collateralised against sovereign debt instruments, L(T). On the liability side of its balance sheet it has base money, M0 (currency plus commercial bank reserves) and net worth, W.
This central bank can engage in quantitative easing but not in qualitative easing: even when it lends to the private sector, it requires government securities as collateral, so it engages only in default risk-free lending (more precisely, in lending subject to default risk no greater than the default risk of the sovereign). Quantitative easing would mean expanding the monetary base by buying government securities, or by engaging in an increased volume of lending (or in an increased amount of repos of government debt) to the private sector.
The purpose of the exercise would be, presumably, to lower the interest rate on government securities of maturities longer than overnight. Bank Rate – the official policy rate – sets the risk-free overnight nominal interest rate. Longer-term risk-free nominal interest rates can be influenced by the central bank through two mechanism. The first mechanism is expectations of future official policy rates – of future values of Bank Rate in the UK. If arbitrage is possible on a sufficient scale, confident expectations that the future official policy rate of the central bank over, say, a 3-month horizon, will be equal to its current level, say 1.5 percent, will drive the 3-month risk-free nominal rate to 1.5 percent also. Only the equilibrium risk premia and term premia consistent even with fully efficient financial markets would stand between the expected value of the central bank’s future policy rates over a three month horizon and the 3-month risk-free interest rate (those of you who wonder about a risk-premium with risk-free interest rates should recall that risk is defined in terms of real consumption, or the utility of real consumption, while what the central bank sets is the risk-free nominal interest rate).
In principle, the central bank can, by credibly committing itself to keep the official policy rate at its current level for the next 10 years, bring down the risk-free 1o-year nominal interest rate to something close to the current value of the official policy rate. This does, however, require that arbitrage is possible on a sufficient scale. This is a necessary condition for efficient markets. Events since August 2007 should have convinced even the most foaming-at-the-mouth true believers in the efficiency of financial markets, that they have been worshiping a false god. The idol has feet of clay and has now been toppled so convingly, that the last believers are being whisked away by men in white coats making soothing noises.
So, if expectations and the reality or threat of arbitrage does not drive future risk-free rates down to a suitably weighted average of future expected official policy rates, the central bank can lend the process a hand by purchasing risk-free securities of the relevant maturities whose yields exceed the average expected future official policy rate over the relevant horizon.
In the US, for instance, quantitative easing is not over until the nominal yield on all government securities of any and each maturity equals zero. But note that quantitative easing can, in principle, occur at any level of the official policy rate. It does not have to wait till the zero floor is reached. At the zero floor, of course, quantitative easing (and qualitative easing) are all the central bank can do.
Any central banker who argues, as some do, that “we set the overnight rate on reserves and we simply accommodate the demand for reserves at that (official policy) rate; therefore, until the official policy rate hits the zero floor there is no quantitative easing as a separate policy instrument” is delirious. This is because the demand for reserves depends not just on the official policy rate, but also on other interest rates and spreads (on public and private assets of different maturitities), some of which can be influenced by the central bank even when the official policy rate is kept constant. This is especially true during times when financial markets are illiquid and disorderly.
When markets are functioning properly, the central bank can really only set one nominal interest rate. When it pegs the risk-free overnight rate, it can influence longer-term risk-free rates only through expectations of its future policy rates. Term premia and default risk premia are not subject to monetary policy influence to any significant degree and liquidity premia are not a major factor. When markets are disorderly and illiquid, the arbitrage required for the expectations hypothesis to do its job cannot take place. There is a term structure of liquidity risk premia that can, in principle, be influenced by central bank liquidity injections (lending) at longer maturities. Liquidity premia and default risk premia are not independent, and central bank policy can even have a material influence on default risk.
All these factors also influence the demand for reserves and the stock of base money. A central bank can accommodate the demand for reserves at its official policy rate and influence that quantity demanded through the effect of its actions on other rates of returns and on market liquity at longer maturities and for a wide range of financial instruments.
Today’s central banks are, however, operating with a balance sheet more like the one shown in Table 2. The key difference is that on its asset side, the central bank now lends to banks (and perhaps to other private entities) against private collateral as well as against sovereign debt instruments; L(P) includes repos of private securities. The Bank of England was a late convert to this, but does now accept private debt instruments in repos and collateralised lending. The ECB always did, and so did the Fed, although it got out of the habit before August 2007.
In addition, the central bank can purchase private securities outright. This is the item P on the asset side of the balance sheet. The Fed does this on quite a large scale now, when it began to purchase commercial paper (CP) and Asset-Backed Commercial Paper (ABCP). If central banks make unsecured loans to private banks or other private sector entities, that too would be part of P.
The Fed’s proposed outright purchases of mortgage backed-securities issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae do not fall into this category, as Ginnie Mae is a government agency and both Fannie and Freddie are 100 percent government-owned. It is just a tiny bit silly to have one state entity (the Fed) acquire debt instruments issued or guaranteed by another state entity or state-owned entity. Much easier to slap a Federal guarantee directly on all these mortgage-backed instruments and leave the Fed to do monetary policy. But that would be too fiscally transparent and too easy. Neither the Bank of England nor the ECB have thus far acquired private securities outright or lent unsecured to the private sector.
There is also a potential addition on the liability side of the central bank’s balance sheet. Central banks can issue non-monetary liabilities, instruments effectively the same as Treasury Bills or Treasury Bonds – let’s call them central bank bills and central bank bonds. In many developing countries and emerging markets this is a common practice. Quite often the credit of the central bank is better than that of the government, and open market operations are conducted entirely through the purchase and sale of central bank bonds and bills. We may see this emerging market phenomenon in the the submerging market economies of the West before long.
The balance sheet of Table 2 permits us to discuss various ways of implementing qualitative easing, and combinations of quantitative and qualitative easing.
Qualitative easing means the central bank either making loans to the private sector that are not collateralised against sovereign debt instrument (L(P) increases) , or lending unsecured to the private sector or purchasing private securities outright (P increases), but without changing the quantity of base money ((M0) is constant). This means that these loans or purchases are either financed by the central bank selling sovereign debt instruments it holds (T falls), or by the central bank reducing the amount of lending secured against sovereign debt instruments (L(T) falls) , or the central bank increasing its issuance of central bank bills and bonds (N increases).
By expanding its acquisition of private instruments or by lending to the private sector either unsecured or secured against private collateral, the central bank can directly target the spreads of these private debt instruments and private lending over the expected average future official policy rate (as measured, say, by the OIS rate – the Overnight Indexed Swap rate). Clearly, even in fully efficient markets these spreads will be non-zero because of equilibrium term premia, equilibrium inflation risk premia and equilibrium default risk or credit risk premia. But the liquidity risk premia, and the fear-and-panic premia could be much reduced or even eliminated.
So I expect that our central banks will do quite a bit more quantitative and qualitative easing – expanding the size of their balance sheets, mainly by increasing the monetary base on the liability side, that is, by printing money, and on the asset side by increasing lending to the private sector secured against private securities (or unsecured) and increasing outright purchases of private securities.
The Fed is doing so already, and with gusto. It can do so without fear for its balance sheet, despite taking on a lot of private credit risk (default risk), because the Treasury explicitly guarantees the Fed’s outright purchases of private securities and other non-standard taking on of private default risk.
The Bank of England already has some credit risk on its balance sheet, through its repos of private securities. It has therefore engaged in qualitative easing. The sharp increase in the size of its monetary liabilities since September 2008 is evidence of considerable quantitative easing also. I expect it to increase the scale of its rediscounting of private securities and its repoing of private instruments during the coming year and beyond, until this crisis is over. I also expect it may have to lend outright and unsecured to banks and other private agents and that it will buy private securities outright and in volume before this is over.
Quantitative easing, through the acquisition of Treasury securities or through increased repos of Treasury securities and matching expansion of the monetary base, should be none of the Treasury’s business – it remains the province of the Monetary Policy Committee of the Bank of England. This is because the Bank of England does not take on any additonal credit risk other than that of the sovereign itself through these operations.
Qualitative easing or a combination of qualitative and quantitative easing does increase the credit risk the central bank is exposed to. Conceivably, the central bank could suffer a capital loss on its exposure to private securities that would be so large, that it could only restore its solvency without external assistance through monetary issuance of a magnitude that would threaten its price stability mandate. Indeed, if the exposure of the central bank were to foreign-currency-denominated securities, it might not be able to salvage its solvency through any amount of domestic currency issuance. In both these cases, the central bank (or its inflation mandate) would have to be rescued by the tax payer, through a non-inflationary recapitalisation by the Treasury. This means that qualitative easing, or any combination of qualitative and quantitative easing that increases the credit risk on the central bank’s balance sheet, should require the consent of the Treasury, and cannot be decided by the central bank alone.
I believe it would be best, operationally and to preserve central bank operational independence over monetary policy, if the Treasury were to set an upper limit to the amount of credit risk (by some metric) the central bank can take on, with the central bank being given the discretion to manage the composition and size of its balance sheet up to that limit.
Today, central banks and Treasuries appear to be conspiring to hide from the public the magnitude of the credit risk exposure they are taking on. In the UK, for instance, the SLS (the special liquidity scheme that swaps private securities like mortgage- backed securiteis for Treasury bills of less than one year maturity) is, as far as I can tell, neither on the balance sheet of the Bank of England nor on that of the Treasury. The Bank of England manages the facility as agent of the government, but does not carry the credit risk. Since the Treasury bills are of less than one year maturity, they are, for some obscure accounting reason, not counted as public debt in the UK. So I doubt they are recorded as Treasury liabilities – which of course they are. The assets, of course, are not counted either, but the liabilities are known and certain while the assets are illiquid, of unknown value and quite possibly dodgy. Accountability for the use of public resources is the first victim of a financial crisis.
I expect that we will see all three central bank, the Fed, the ECB and the Bank of England, continue to engage in qualitative and quantitative easing, expanding the size of their monetary liabilities (‘printing money’) to finance acquisitions of private securities and to increase the scale and scope of lending to the private sector, both unsecured and secured against private securities. The Fed clearly has the bit between its teeth and is hot to trot further and farther. The Bank of England has not yet engaged in either unsecured lending to the private sector on in outright purchases of private securities, but I anticipate we will see both types of interventions before long.
The ECB/Eurosystem is the most interesting case. It has historically repoed against a wider range of private securities that the other two central banks, and it accepts a similarly broad range of private securities as collateral at its discount window – the marginal lending facility.
It is also, however, the central bank that appears to be most anxious about credit risk on its balance sheet. And one can appreciate the reason for that. Who, after all, backs the ECB/Eurosystem fiscally? The US Department of the Treasury backs the Fed. HM Treasury backs the Bank of England. Do the national Treasuries of the 16 member states that make up the Eurozone back the ECB/Eurosystem if it needs aggregate recapitalisation? Do the national Treasuries of the 27 EU member states whose national central banks (NCBs) are the shareholders of the ECB back the ECB/Eurosystem fiscally? There is a sharing rule among the 16 NCBs that, together with the ECB, make up the Eurosystem. But this sharing rule concerns only the sharing of losses incurred in the conduct of the common monetary and liquidity management policy. It does not change the total amount of capital of the Eurosystem, only its distribution.
This glaring hole in the construction of the ECB/Eurosystem – the absence of a clear, credible fiscal back-up for the ECB/Eurosystem – must be plugged forthwith. The long-term solution is an independent supranational Eurozone fiscal authority with independent tax and borrowing powers. The interim solution is a Fund of, say, €3 trillion, created by the governments of the Eurozone member states, that can be accessed, with the consent of a qualified majority of the Eurogroup member states, to recapitalise the ECB/Eurosystem, should its capital be depleted to the point that its ability to fulfill its price stability mandate is under threat. This Eurofund fund could be administered by the European Commission, or even by the European Investment Bank. The 16 Eurozone governments could seed the Eurofund with national sovereign debt, in proportion to their countries’ share of the ECB’s existing capital (normalised by the share of the Eurozone member states in the total capital of the ECB). Alternatively, the Eurofund could issue Eurozone debt instruments (Eurozone Bonds) guaranteed jointly and severally by the Eurozone national governments. During normal times, the profits from the Eurofund would be paid out to the governments providing the guarantees. If the guarantee is joint and several, the Eurofund should be able to borrow more cheaply than the most creditworthy national government, provided national sovereign defaults are not perfectly positively correlated).
Without a credible fiscal back-up for the ECB/Eurosystem, there is a material risk that the current crisis will expose the limitations of a central bank construction that does not underpin the ability of the central bank to act as market maker of last resort with appropriate contingent fiscal support mechanism.
Let me be clear: there is no potential problem when a Eurozone NCB assists a private bank in its jurisdiction in a specific lender-of-last-resort operation. According to the Treaty, the NCB in question can only provide any financial support of this kind after the national Treasury involved has provided a comprehensive commitment to indemnify that NCB for any losses involved as a result of the lender-of-last-resort-operation. The problem arises when, as a result of ‘normal’ monetary policy or liquidity operations, the NCB (or even the ECB itself, were it to engage in such operations directly) incurs exposure to credit risk. The NCBs of the Eurosystem do so routinely. In the past, the credit risk involved – the probability of a joint default of the bank borrowing from the NCB and of the issuer of the collateral – was deemed small. That is no longer a safe assumption to make even in the case of repos of private securities. It certainly is not a safe assumption to make were the ECB to engage in unsecured lending or in direct purchases of private securities.
Unless a way is found soon to plug the fiscal black hole behind the ECB/Eurosystem, the ECB/Eurosystem may either have to take on excessive credit risk or it may have no choice but to abstain from participation in the next stage of quantitative and qualitative easing: direct unsecured lending by the central bank to the private sector and direct purchases of private securities by the central bank.