Someone needs to take over the excess debt if creditors are to maximize payback (and minimize losses) and debtors are to offload as much debt as possible. This is what the central banks are doing—the Bank of England, the Federal Reserve, increasingly the Bank of Japan, and, following the policy shift by its president Mario Draghi, the ECB. But such intervention does not change the reality that creditors, savers, and taxpayers are likely to lose money—through significant inflation, outright bankruptcy, or increased taxation—because an impaired asset remains impaired regardless of the balance sheet on which it sits.
The two largest central banks in the world saw their balance sheets grow dramatically during the crisis. Their assets have been deteriorating in quality and lengthening significantly in maturity. Five years into the financial crisis, the U.S. and most European governments rely on funding from their own central banks. In 2011, the Fed has printed enough money to purchase roughly 60 percent of the Treasury notes issued over the same period. During the first months of so-called Operation Twist in late 2011 (see below), the Fed acquired about 90 percent of the gross new bond supply of U.S. Treasuries with a maturity of 20 years to 30 years. The Fed now owns 27 percent of all U.S. Treasuries. If it keeps buying at the current rate, it will own 60 percent of outstanding debt by the end of 2015. Without these massive central-bank purchases, the U.S. government would have to pay significantly higher interest rates for long-dated bonds. Goldman Sachs estimates that 40 bp to 50 bp has been shaved off five-year bonds.
In Europe, Target2 complicates the situation. Target2 is the mechanism by which the euro zone central banks provide each other with short-term financing. Unimportant before 2007, it has become a vehicle for the Deutsche Bundesbank’s financing of the periphery’s financial systems—reflecting the euro zone trade imbalances and some capital flight from the periphery. About €300 billion was withdrawn from bank accounts in Spain, Portugal, Italy, and Greece from August 2011 through July 2012. Over the same period, the seven nations of the euro zone core (including Germany and France) showed a corresponding net increase. In July 2012 alone, the capital outflow from Spanish bank accounts amounted to 5 percent of total deposits. In practice, Spain has already been bailed out by the ECB: the funding of the country’s banks by main refinancing operations (MRO) and longer-term refinancing operations (LTRO) reached €400 billion in July. If the euro survives and the quality of collateral improves, the ECB will be right to call the open €700 billion Target2 receivables of the Bundesbank “non-issue.” If there is a debt restructuring or even a breakup of the euro zone, then this would become a problem for the German taxpayer.
Compared with their GDP, Europe, the U.S., and Japan have significantly grown their central-bank balance sheets. New measures by the ECB and the Fed will lead to even faster expansion. A deeper look at the development of these balance sheets reveals the issues. (See Exhibit 2.)
On September 6, 2012, the ECB announced that it would buy unlimited quantities of European periphery government bonds in order “to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area.” This amounts to direct funding of governments, something prohibited by law. The ECB says that the measure is only directed at restoring confidence in the euro zone and reducing risk premiums associated with the fear of a potential breakup (such as being paid back in a post-breakup currency). ECB support is conditional on the receiving country asking for official EU support and accepting the remedial measures (mostly austerity) defined by the EU. Spain and Italy are trying to avoid asking for official support but may well need to do so in the near future. Once such support is forthcoming, the Greek experience suggests that governments receiving support will seek to ameliorate the measures—banking on the ECB being unable to withdraw its support for fear of destabilizing the markets. So we expect the ECB to continue expanding its balance sheet— the only credible approach to ensure euro zone survival in the short and medium term.European Central Bank press conference by Mario Draghi on September 6, 2012; transcript available.
The Fed surprised the markets on September 13 by announcing a program of unlimited asset purchases, mostly of mortgage-backed securities. It plans to inject up to $85 billion each month “to help the economy to grow quickly enough to generate new jobs and reduce the unemployment rate.” This will continue as long as the “outlook for the labor market does not improve substantially.”16 The announcement was applauded by the markets, especially because of chairman Ben Bernanke’s express goal of driving up stock and real estate prices.
The central banks, particularly in Europe, continue to buy securities and extend loans against ever more doubtful collateral. Exhibit 3 shows the composition of the Fed and ECB balance sheets over time.
The ECB’s balance sheet has expanded from €1.2 trillion to more than €3.0 trillion in an attempt to address deteriorating bank and government funding—sucking up assets of doubtful quality in the process. It has acquired €200 billion in sovereign bonds in the periphery of Europe through its Securities Markets Program plus another €100 billion in residential mortgages and public-sector loans through its Covered Bonds Purchase Program. To address rapidly worsening bank-funding conditions, the ECB relaxed the conditions for its LTRO. It halved the required reserve ratios and widened the range of assets accepted as collateral while allowing longer maturities. LTROs thereby expanded by a factor of seven, reached one-third of the ECB’s total assets, and became backed by (relatively) less lower-quality collateral.
The Fed’s balance sheet has grown even more dramatically. It was $900 billion at the beginning of the financial crisis, and it reached almost $3.0 trillion by mid-2012. When interest rates could not be reduced any further, the Fed launched quantitative easing (QE) and acquired mortgage-backed securities and U.S. Treasuries. While QE1 and QE2 were limited to $600 billion each, the recently announced QE3—also nicknamed “QE Infinity” or “QEternity”—has no maximum limit in magnitude or duration. Through Operation Twist, the Fed has replaced short-dated Treasuries with long-dated Treasuries, thereby extending the average maturity. In order to reduce its balance sheet again to a “normal” level, the Fed can no longer simply let bonds retire; it will have to find buyers. And these outright sales would face the problem of market expectations, since the market would most likely price in a fully normalized balance sheet—leading to markedly higher interest rates.