According to Thomas Mayer, the former chief economist of Deutsche Bank, the implications of an ever-growing central-bank balance sheet are significant—and unclear. The central banks have supplanted private credit in an effort to restore trust, thereby helping creditors avoid losses. Draghi’s plan to rescue the euro is no different. By accepting doubtful collateral, the central banks now directly or indirectly own doubtful assets. Greek banks have no more assets acceptable to the ECB as collateral, while the collateral quality of Spanish banks has been gradually deteriorating.
Having bailed out the creditors, the central banks now have to find ways of helping the debtors without incurring losses themselves. The obvious approach is to lower the cost of money—which is why the central banks have reduced interest rates and pursued quantitative easing. Just as in Japan after the bubble burst in the early 1990s, central banks today are lowering the financing costs for debtors in order to avoid crystallizing any losses. In Japan, this strategy created “zombie banks”—one of the reasons that Japan became trapped in a prolonged period of economic stagnation. The Bank for International Settlements says that the Western world is repeating the mistakes of the Japanese government, only this time the central banks run the risk of becoming zombies themselves. Thomas Mayer points out that “it remains unclear how we can move from the central bank money regime towards a more sustainable regime based on traditional money and hedge credit relations. So far there has been no example of a successful exit from zero interest cum non-standard monetary policy regimes.”
With a significant debt overhang and a number of Western economies facing insolvency, any additional central-bank intervention merely offers creditors an opportunity to dump assets. In theory, they could lower the interest rate for all these loans to zero while extending them to perpetuity. No one would ever go bankrupt. Indeed, there was a proposal that went beyond the “evergreening” of outstanding debt, arguing that the central banks should simply “retire the debt” (that is, write off the asset and forgive the debtor—which, in the case of quantitative easing, means the government). This proposal is seductive. Given the relationship between governments and central banks, the government is essentially only paying interest to itself anyway. For this idea to work, supporters argue that it requires a balanced budget in order to secure public and market trust. Otherwise it would be seen as direct central-bank funding of government debt, which in 1920s Germany led to hyperinflation.
Could this work? Many see the risk of inflation as negligible since printing the money to buy the assets in the first place has not yet led to inflation. Moreover, if done over time rather than in a single step, the central bank could still reduce the monetary base by selling assets, thereby preventing any inflation. For the multinational ECB, such an approach implies a redistribution of wealth among countries, notably from the north to the south, posing an additional hurdle not faced by the Fed or the Bank of England.
So is this the secret formula for implementing a debt restructuring without hurting anybody? Is this “Back to Mesopotamia” in the twenty-first century? Goethe’s Faust turns out to be eerily prophetic. (See “Inflation in Goethe’s Faust Part Two,” below.)
In the play’s famous first part, Faust makes a deal with the devil (Mephistopheles) to exchange his soul for unlimited knowledge and worldly pleasures. In the tragedy’s second part, Faust seeks redemption by expanding his horizon and seeking to shape society as an entrepreneur and statesman. Goethe incorporated his personal experiences, developed during ten years as chief adviser to the Duke of Saxe-Weimar-Eisenach, where he led the Ministry of Finance. The Duchy was heavily indebted. Goethe’s primary concern resonates today: how to reduce the state deficit while stimulating the economy.
In the first act of part two, Mephistopheles, working as jester to the court of the bankrupt Holy Roman Empire, makes this discovery:
“Where in this world does not some lack appear? / Here this, there that, but money’s lacking here.”
He persuades the emperor to replace gold with paper money in order to encourage spending and economic recovery. The court is initially excited by the stimulatory effects of printing money. Mephistopheles praises its advantages:
“Nor gold nor pearls are half as handy as such paper. / Then a man knows what he has. / There is no need of higgling or exchanging; / In love and wine one can at will be ranging.”
Initially, the Holy Roman Empire is able to repay all its debt, and the economy flourishes. But when inflation kicks in, paper money loses its value, and the empire descends into chaos. As this unfolds, only the Fool does not use his new (and temporary) wealth for private amusement:
FOOL. Five thousand crowns are mine? How unexpected!
MEPHISTOPHELES. Two-legged wineskin, are you resurrected?
FOOL. That happens oft but like this never yet.
MEPHISTOPHELES. You are so glad you’re breaking out in sweat.
FOOL. Is that the same as cash? Look, are you sure?
MEPHISTOPHELES. What throat and belly want it will procure.
FOOL. And cattle can I buy and house and land?
MEPHISTOPHELES. Of course! Just bid and they will be at hand.
FOOL: Castle with wood, chase, fish-brook?
MEPHISTOPHELES. On my word! I’d like to see you as a stern Milord!
FOOL. Tonight a landed owner I shall sit!
MEPHISTOPHELES, solus. Who still will have a doubt of our fool’s wit?
Exhibit 3 illustrates the magnitude of the problem with the structure of central bank balance sheets, both in terms of quantum and quality. Additionally, not only is government debt too high but so are debt levels in most sectors of the economy. Addressing the sovereign debt issue only resolves part of the problem—unless the governments shoulder substantial private-sector debt as well, which requires selling it to their central banks.
Are the central banks’ balance sheets prepared for such massive debt forgiveness? Exhibit 4 shows the ECB and Fed balance sheets. The ECB carries capital that is able to absorb debt retirements of about €500 billion. If larger losses were to occur, the ECB will either have to carry forward negative capital or the national central banks (and ultimately the highly indebted governments) will have to inject fresh capital.
On paper, the Fed has a rather limited loss-absorption capacity. But a change of accounting standards in 2011 created an almost infinite loss-absorption capacity by introducing the new liability position: interest on Federal Reserve notes due to the U.S. Treasury. Losses (such as those from selling bonds below their original purchasing price) will not show up on the Fed’s balance sheet as a reduction in capital but as capital participation from the U.S. Treasury. The Fed usually sends most of its profits to the Treasury on a weekly basis, but it will simply postpone remittances if the new line item becomes negative. In other words, the Fed can simply set off any potential loss against future gains from seigniorage (the profits earned from the issuance of base money). The present value of future seigniorage by far exceeds the conventional loss-absorption capacity of central banks; indeed, it would increase by an estimated $1.8 trillion! Similarly, the ECB would have an enormous additional loss-absorption capacity outside of today’s balance sheet. Citi economists estimate the present value of future seigniorage for the euro system to be at least €2.0 trillion.
As bond purchasing programs are ongoing, there is no end in sight yet. At the same time, the likelihood of defaults on central banks’ balance sheets becomes greater. Although their loss-absorption capacity seems almost infinite, it does not appear credible that this scenario would lead to a pain-free resolution:
Monetary Overhang. The expansion of the monetary base and balance sheet of the central banks has not yet led to inflation. The obvious reason for this is the deflationary impact of debt deleveraging in the West, which has led the velocity of money to drop to all-time lows. Any debt restructuring involving forgiveness by the central bank could drive the velocity of money back to the long-term average. As Charles I. Plosser, chairman and CEO of the Federal Reserve Bank of Philadelphia, pointed out, this would lead to significant inflation unless the central bank reduces its balance sheet by selling assets to the market. The magnitude of the required adjustment would be huge: the Federal Reserve would have to reduce its balance sheet and, therefore, the monetary base by $1.8 trillion to sterilize inflationary pressure. Failure to do so would drive up the price level in the U.S. by almost 300 percent. After the debt restructuring, the remaining Fed assets would be about $1.2 trillion. There would only be no risk of inflation from such debt forgiveness by the central bank if the velocity of money were to remain historically low.Charles I. Plosser, Federal Reserve Bank of Philadelphia, “Exit,” speech at the Shadow Open Market Committee, New York, March 25, 2011.John P. Hussman, “Sixteen Cents: Pushing the Unstable Limits of Monetary Policy,” Weekly Market Comment, January 24, 2011
Trust. In a fiat monetary system (where money is not backed by a real asset such as gold), public trust in the value of money is particularly important. As Ludwig von Mises described nearly 100 years ago, holders of money need to believe that the money will be valuable tomorrow before being willing to accept it today. Or as Jens Weidman, president of the Deutsche Bundesbank recently put it: “If a central bank can potentially create unlimited money from nothing, how can it ensure that money is sufficiently scarce to retain its value?” Should this trust erode, an ensuing flight into real assets could precipitate significant inflation.See, for example, “The Economic Consequences of Cheap Money” in Ludwig von Mises, The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression, 2006, and Murray N. Rothbard, “The Austrian Theory of Money,” Mises Daily on January 3, 2012.“Central Bank Action Is Work of the Devil, says Germany’s Jens Weidmann,” The Telegraph, September 18, 2012.
The health of the economy and the monetary system seems to rest on zombie central banks. The long-term effects of the various measures to date are still unclear, and the ensuing cleanup will remain a significant future challenge. In a recent speech, Plosser observed: “We are unlikely to see much benefit to growth or to employment from further asset purchases. Conveying the idea that such action will have a substantive impact on labor markets and the speed of the recovery risks the Fed’s credibility.”