Central bank balance sheets, revisited
Niall Ferguson and Andreas Schaab (Harvard) and Moritz Schularick (The Bonn Institute of Macroeconomics and Econometrics) have an interesting new study out detailing the history of central bank balance sheet expansions and contractions in “12 advanced economies since 1900.”
Mainstream economists tend to belittle the significance of this subject. Monetarists and Keynesians regard an elastic money supply, manipulated by central banks, as a desirable weapon to be used in smoothing out the business cycle. Some economists even go so far as to argue that with interest rates at record lows and inflation tepid, central banks should be directly monetising government infrastructure projects.
An expansion in base money will mean that a central bank’s balance sheet grows. It will be acquiring assets (mostly public debt, but some private as well – see the Fed’s purchases of mortgage-backed securities since 2008) which will of course be matched by equal dollar liabilities (or whichever currency it “prints” to buy said assets. All currency – whether the coins in your pocket or your online bank deposit – are liabilities of the issuing central bank).
Of the more established economic schools, Austrian economists are the only ones who are hostile to such ideas, on the grounds that such meddling will lead to inflation and moral hazard. When both government and large banks enjoy an “open bar” at the expense of everyone else, they grow disproportionately in relation to the parts of the economy that don’t enjoy first access to newly printed money. The impoverishing effects of high inflation hardly need spelling out.
This new study appears to offer some support for both positions. Contrary to a lot of Austrian, hard-money rhetoric in recent years, central bank asset purchases don’t look particularly significant when set against total credit levels over the last half century (page 10). A collapse in private credit post-2008 has been offset by a big rise in public debt – funded by central banks. This is why countries like the USA, UK and Japan are enjoying nice simulated recoveries, whereas nations without such money printing capabilities – the “Club Med” eurozone – continue to suffer depressions. It is also why inflation has remained fairly muted: the deflationary force of private credit contraction fighting the inflationary forces of government deficit spending and central bank money printing.
The authors note that central bank balance sheets (CBBS) did contract significantly over certain periods. But these contractions were relative to GDP, and seldom in nominal terms. In the US, the Fed’s balance sheet contracted steadily relative to GDP from the late 1940s until the late 60s, during the postwar boom. The same was true for other countries over roughly similar periods. So the concerns some have about how central banks are going to sell all the bonds they’ve bought post-2008 appear somewhat misplaced: most of these assets will never need to be sold in order for central banks to deleverage.
The fly in the ointment
All of this comes with a rather large caveat in the form of the final sentence of the study: “near-term inflation risks from CBBS expansion seem low, but the threat to long-run price stability is real when fiscal deficits are persistent and central bank independence is compromised.”
Fiscal deficits are certainly persistent in the US, UK and many other developed countries. They are likely to get worse owing to unaffordable welfare schemes (not to mention occasional, costly military adventures in far flung lands). So the question we have to ask ourselves is: has central bank independence been compromised?
The chart above (from page 12) offers hints. Note how the last year of expansion is entirely accounted for by the “Demand stabilization” category, with orange bars increasingly frequent during the last decade. Given that “Demand stabilization” involves artificially boosting government spending, the boundaries between it and “Government financing” don’t seem that clear-cut.
Consider the decision in November 2012 to reallocate the interest the Bank of England had earned on bonds bought via QE (then totaling £35bn) to HM Treasury. As the Telegraph’s Jeremy Warner argued, this crossed “the line into straight government financing.” And though the other two big QE nations – the US and Japan – also have the same tidy interest arrangement between their central banks and government, few believe in the latter’s case that the central bank is anything other than the pawn of a government that is desperate to boost exports and deal with a chronic debt problem.
Central bank independence has been compromised. Governments continue to go deeper into debt. As Jim Rogers says in this interesting (73 minute) interview, a lesson of history is that countries don’t generally recover from such situations without enduring a serious crisis first.
Though perhaps as PIMCO’s Paul McCulley argues, the “Big One” was in 2008, and we don’t have to worry about another one. He argues that thanks to central bank largesse we’re on the verge of exiting the post-crisis liquidity trap, and are currently enjoying “a once-in-a-lifetime revaluation of assets.”
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012