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.)