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:

  1. 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.
  2. 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’).
  3. 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.

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