Paul De Grauwe wrote a very interesting article on Vox a few days ago on ‘Fiscal implications of the ECB’s bond-buying programme’. The article tries to clear a few misconceptions about the treatment of a central bank balance sheet and its monetary operations and analyzes the results of a possible activation of the OMT program.
Although I agree with a large part of the article, there are a few points where I think that the authors are not entirely correct: The treatment of a government bond default and the inflation tax.
Bond Default
The article consolidates the government and the central bank into the public sector thus making any bonds held outright by the central bank as irrelevant from an accounting point of view since one part of the government owes a ‘debt’ to the other, which can be easily just canceled out. Even if the asset side of the central bank (CB) balance sheet is reduced substantially, the CB can still create liabilities (in the form of banknotes and bank reserves) without any need for an injection of capital by the Treasury (since its liabilities can only be exchanged for other central bank liabilities in a floating exchange rate regime).
Although the above is true, the article implies that government bonds are the only assets generating income for a central bank (in which case it is not a problem to cancel out bond coupon/principal payments with central bank profit remittance to the Treasury). In reality and especially in the case of the ECB, a central bank earns income on other assets as well such as short/long-term loans to commercial banks (MRO/LTROs in the ECB case) and it might also hold outright other interest bearing securities not issued by the government (such as MBS and covered bonds).
A default on bonds held on its balance sheet would lead to a reduction of capital and if the latter was not enough to the creation of a new asset containing ‘future profits’ on its balance sheet. As long as the central bank held negative (or not enough) capital, no profits would be returned to the Treasury. As a result, although the Treasury would not have to pay any interest payments on the defaulted bonds to the central bank, it would lose any ‘seignorage’ profit from the other income generating assets held by the latter. On a cash flow basis, the overall Treasury position would become negative with an increased ‘deficit’ which should be covered by new sources of funds (higher taxes or new borrowing).
An easy fix is to just assume that the central bank would acquire (on a yearly basis) any government debt necessary to finance this deficit. Nevertheless, this negates the initial proposition that the government can default on its bonds held by the central bank without any real financial consequences. The reality is that any future negative cash flows are a true cost for the Treasury and should be included in any accounting exercise.
Inflation Tax
The article concludes by repeating the (long-dead) money multiplier concept and stipulating that, due to the current crisis/liquidity trap, the money multiplier is zero which provides the central bank with enough room to pursue any program of monetary expansion (through outright purchases of government bonds) without any threat to price stability. The reality is that this way of thinking is deeply flawed:
- As acknowledged by all central banks (Fed, ECB, BIS) and their chief economists (Bindseil) the money multiplier framework does not really apply to modern central bank operations.
- Since the ECB provides a deposit facility at a certain spread over its target interbank rate, its operations are always sterilized since that facility provides a floor under which interbank rates cannot fall (since no bank would lend in the interbank market for a lower rate than the risk-free deposit rate at the central bank apart from cases of ‘repo specials’).
- The ECB can always use other mechanisms to sterilize its purchases such as fixed-term deposits (as it does already) or even debt certificates, thus negating any increase in the monetary base.
As a result, price stability is not really a constraint on any bond buying program by a central bank and any OMT activation does not risk run-away inflation today or in the future.
Economy View 
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17 Ιουνίου, 2013 στις 10:56
Ramanan
Also the important thing is the central bank has lost claims on foreigners. Imagine the Eurosystem holds $500bn of Spanish government bonds and Spain’s public debt runs into unsustainable territory. If the ECB lets Spain default this can no longer continue, the rest of the Euro Area’s international investment position deteriorates because Spain won’t be able to pay back.
De Grauwe is looking at the wrong thing.
17 Ιουνίου, 2013 στις 12:19
kkalev
Just to clarify the accounting part a bit:
OMT would mostly be implemented by NCBs. They ‘d acquire government bonds in the secondary market and credit commercial banks reserve accounts for their market value. The NIIP of the relevant countries would not change but the composition would, with the claim (and ownership of the security) moving from the private sector to the NCB.
In case of a (Spanish) default, the NIIP of each country would fall by the relevant amount while Spain’s NIIP would improve by the total amount defaulted on foreign holders. Each NCB would have to write-off the corresponding loss from its balance sheet and lower future profits (unless it already had reserves in place for that purpose).
As a result, other Euro countries would be harmed since both their foreign claims and future income from central bank operations would fall. The default should be treated as a de facto fiscal transfer (since an amount equal to the principal loss would be ‘transfered’ to Spain as forgone profits by other Euro area sovereigns).
18 Ιουνίου, 2013 στις 10:58
Mindkaiser
Although you raise some interesting points, I think we agree that the overall analysis of De Grauwe is on the right track. Just some thoughts:
1) Thinking outside of the box, the decision of a central bank to withhold the distribution of fixed income assets generated income when on negative on inadequate equity, is really a political one. There is no real solvency issue, since the future profitability of a central bank is always guaranteed. It could for example choose to return interest income from the MROs and LTRs to the treasuries, thus eliminating any «deficit», while at the same time cancel out the defaulted bond cash flows.
2) There are many economists out there still supporting the money multiplier concept (Krugman for example is one). In my personal view it’s outdated too, but the debate around it is far from settled. On the substance of the argument, you both seem to agree that inflation won’t be a problem in the current environment. Whether it be a liquidity trap setting, or a more structural/functional approach to modern central banking opperations.
18 Ιουνίου, 2013 στις 11:12
kkalev
1) Well, in order for the CB to balance its books in case it had negative equity it would have to create an asset such as ‘future profits’ on its balance sheet. I agree that it is mostly a political decision but still, it’s rather strange for the CB to distribute profits without first clearing that entry.
Furthermore, a CB profit is guaranteed but not infinite, especially if it operates under an inflation targeting regime. Citi’s Buiter has done some relevant calculations in papers regarding the ECB and SMP/OMT.
2) The basic argument is that under a regime of Interest on Reserves, excess reserves do not carry an opportunity cost and thus are not a threat to price stability as a driver of credit expansion. Furthermore, the idea that reserves drive deposit creation (instead of loans creating deposits and reserves being provided at a certain cost by the central bank) is quite clearly wrong. Bindseil does an excellent job in describing the process in great detail.
18 Ιουνίου, 2013 στις 17:04
Mindkaiser
1) You might find this interesting:
Hall – Reis – Maintaining Central-Bank Solvency under New-Style Central
Banking
2) I don’t disagree that the money multiplier argument isn’t solid. I’m just claiming that this debate is far from over and quite controversial.