Lots of people think the euro area’s central banks will be handing back all the interest payments they receive on their QE bonds, providing a nice boost to the taxpayer. They won’t. Grim details here.
With QE purchases starting a few days ago, some thoughts on how QE works with a nice graph to explain.
Some new thoughts on the “can you make losses printing money” theme, this time with a Hans-Werner Sinn angle.
The situation in Greece continues to tick over. An explanation of the ECB’s decision tonight to cut off various Greek assets from its eligible collateral list.
It’s complicated. But it’s got nothing to do with technocratic ECB rules.
My thoughts on the ECB’s QE announcement. Perhaps a bit long, perhaps a bit disorganised ….
Everyone knows German savers are special, don’t they? Not so much it turns out. Read here.
Imagine you’re a smart young rich kid. You invent a money-printing machine. You use it to magic up money to buy $100 in assets. It turns out, though, you didn’t make a great investment and the assets end up being worth only $90.
Do you (a) Be grateful that you’re $90 better off or (b) Call up your Dad to tell him you need $10 to make up your losses?
The debate about potential ECB asset purchases continues to focus incessantly on the issues surrounding potential losses, with the ECB playing the role of the rich kid asking his Dad for an unnecessary bailout.
Take this from my old mate Hans Werner Sinn (via Constantin Gurdgiev).
Aaaand Sinn is baaack… pic.twitter.com/Udldwp8Xev
— Constantin Gurdgiev (@GTCost) October 2, 2014
Apparently tax-payers will have to make up for a shortfall of profits from the ECB if there are losses on ABS purchases. In saying the ECB will have reduced profits, Sinn focuses solely on losing the $10 and forgets about the $90 profit.
One could question whether money creation by the Eurosystem is really just pure profit. Doesn’t this expand the supply of liquidity to the banking system, increasing the amount of money on deposit with ECB and thus increase the interest payments it has to make to banks? Not now – the ECB currently charges banks to keep money on deposit with it so this factor now actually raises the profitability of money creation. (Interest on reserves is also not a necessary feature of a central bank operational framework – the Fed managed fine without it for years.)
I think there are two reasons there is so much confusion about these issues.
The first is the arcane way that central banks do their accounting. All money that is created is counted as a “liability” even if, like bank notes, it doesn’t actually ever impose a cost. Central bank capital measures based on subtracting reported liabilities from reported assets thus grossly underestimate the true financial value generated by central banks. (See here for a more detailed discussion).
Central bank profit and loss measures are calculated in line with this wholly uneconomic methodology. In the analogy above, the central bank would report a $10 loss because its assets had increased by $90 while its “liabilities” had increased by $100. Reporting a loss in these circumstances doesn’t actually make any economic sense but is sure to generate lots of hand-wringing from people who imagine something terrible has happened.
The second problem is the widespread failure to understand that central banks are fundamentally different from commercial banks. Central banks do not need to have assets greater than liabilities and cannot “go bust” due to losses on asset purchases. That said, most of the international policy community seems happy to perpetuate this myth.
For example, consider this Very Serious report from the BIS last year. It recommends that central banks should maintain positive capital, not because they need to, but because the public might be confused about this stuff and so it’s best not to get them too concerned. A quick flavour of the thinking:
we have no doubts about the central banks that are currently shouldering extraordinary financial risks. But our confidence is based on an understanding of the special character of central banks that may not be shared by markets and others.
So if financial markets believed central bankers needed to wear Hawaiian shirts, would it be best to ditch the suits and start drinking pina coladas at press conferences?
There may be another case where an international policy organisation recommends an incorrect policy solely because private investors believe strongly the incorrect policy must be followed, but I can’t think of one offhand.
These points are not intended as a recommendation for central banks to purchases whatever assets just take their fancy. There is an important opportunity cost here. For example, the money could be distributed to the public by providing each person with a fixed amount of money. So it’s important that the purchases are made in a fair and transparent way using market prices.
The other cost usually cited is that money creation may lead to inflation. But in the case of the ECB’s ABS purchases, this is a feature not a bug. The whole point of the programme is to raise inflation back to the ECB’s target level. The fact that the programme also fits with the ECB’s secondary goal of supporting the general economic goals of the EU is welcome but not crucial.
Anyway, expect lots more of this stuff over the next few months as the widespread lack of understanding of central bank balance sheets continues to see irrelevancies held up as crucial economic principles.
I was in Brussels on Monday to present my latest briefing paper to the European Paliament’s Economic and Monetary Affairs committee. The paper addresses issues related to inflation differentials in the euro area and argues that the ECB’s failure to meet its inflation target is significantly complicating the process of adjustment throughout the euro area.
After the briefing, I attended the committee’s “monetary dialogue” session with Mario Draghi. In this session, Draghi repeated a line that he has been using over the past few weeks about how monetary and fiscal policies cannot work unless countries implement a set of unspecified “structural reforms.” In light of these comments, I’ll repeat the last few paragraphs of my paper here.
As the ECB takes a more active role in battling the ongoing slump, Mario Draghi has intensified his rhetoric about structural reforms. The transcript of his September press conferences shows fifteen uses of this phrase. Draghi now says he has “concluded that there is no fiscal or monetary stimulus that will produce any effect without ambitious and important, strong, structural reforms.”
It is hard to find a logic (at least one based on macroeconomic theory as we know it) for this argument. It is certainly the case that potential output growth in the euro area is currently low and can be improved by various policy reforms. However, it is also true that there is currently a very large shortfall between aggregate demand and the current supply potential of the euro area economy, a shortfall summarised in an unemployment rate of over 11 percent. So there is room for fiscal and monetary stimulus to boost the economy, even without structural reforms. In addition, to the extent that we are worried about deflation, the initial impact of structural reforms that boosted the supply capacity of the euro area would be to further depress inflation.
My point here is not to argue against structural reforms. There are many such reforms that can have an important positive effect over the medium- and longer-run (though we know little about the magnitude of their potential impact). But it is important for the ECB to take responsibility for its crucial role in the shorter-term macroeconomic management of the euro area and ECB officials continually placing structural reforms at the heart of discussions of this issue is unhelpful.
Draghi has many very well-qualified economic advisers — one of the very best, Frank Smets, was sitting beside him at the monetary dialogue. Let’s hope they can pursuade him to abandon this unfortunate and unnecessary line of rhetoric.
The latest round of briefing papers for the Economic and Monetary Affairs committee’s monetary dialogue can be found here. Click on 14.07.2014. The papers discuss the strength of the euro and non-standard monetary policies. My paper is “The ECB and Non-Standard Policies: Too Little Too Late?” Click here for a version without the nasty “Draft” watermark. The paper contrasts the ECB’s approach to monetary policy in recent years with the that of the Federal Reserve. It also discusses the actions taken at the June Governing Council meeting and addresses issues relating to potential future asset purchase programmes. The abstract for the paper is as follows:
The ECB has been slower to cut interest rates and to consider asset purchase programmes than the other major central banks even though the euro area economy has performed worse than its comparators. This failure to act has not stemmed directly from the ECB’s price stability mandate. Indeed, by not acting sufficiently strongly, the ECB is now failing to meet its own definition of price stability. The measures introduced at the ECB’s June Governing Council meeting will have only a modest positive effect on the euro area economy. Large asset purchase programmes – of both sovereign bonds and private asset-backed securities – are overdue.