Blog Post

Blogs review: QE and central bank solvency (continued)

What’s at stake: Our previous review suggested reasons for believing that central bank financial strength was a non-issue, even within the particular institutional set-up of the euro area. Yet central banks tend to display a strong aversion to financial weakness. And as this week ECB’s decision (that QE risks won’t be fully mutualized) illustrates, this aversion is even higher within in a currency union. In this review, we explore potential reasons for this aversion.

By: Date: January 26, 2015 Topic: European Macroeconomics & Governance

What’s at stake: Our previous review suggested reasons for believing that central bank financial strength was a non-issue, even within the particular institutional set-up of the euro area. Yet central banks tend to display a strong aversion to financial weakness. And as this week ECB’s decision (that QE risks won’t be fully mutualized) illustrates, this aversion is even higher within in a currency union. In this review, we explore potential reasons for this aversion.

Central Banks aversion to negative equity

The Economist writes that under European QE each of the 19 national central banks, which together with the ECB constitute the Eurosystem, will buy the bonds of its own government and bear any risk of losses on it.

The BIS notes that up until the passage of the Dodd-Frank Act in 2010, Section 13(3) of the Federal Reserve Act provided the Federal Reserve with the authority to lend to individual non-depository financial institutions (such as AIG, but more generally also to individuals, partnerships and corporations) in “unusual and exigent circumstances”, subject to a qualified majority of Board members voting to do so. With the passage of the Dodd-Frank Act, that independent authority has been curtailed. Such lending is now required to be in a manner “consistent with sound management practices” that protects taxpayers from losses, and subject to the authorization of the Treasury Secretary. According to records of the Congressional debate, the motivation for the restriction was to limit the ability of the Federal Reserve to put taxpayer money at risk through emergency lending.

In its 2010 Convergence Report, the ECB writes that “any situation should be avoided whereby for a prolonged period of time an NCB’s net equity is below the level of its statutory capital or is even negative, including where losses beyond the level of capital and the reserves are carried over […] the event of an NCB’s net equity becoming less than its statutory capital or even negative would require that the respective Member State provides the NCB with an appropriate amount of capital at least up to the level of the statutory capital within a reasonable period of time so as to comply with the principle of financial independence.”

Recapitalization through base money issuance, inflation and signals

Peter Stella writes that losses for a central bank become an immediate problem when they interfere with the conduct of monetary policy. As losses either lead to an injection of reserve money or portend future cash injections if they’re unrealized, they have either an immediate impact on domestic liquidity or influence expectations about future monetary growth.

Willem Buiter writes that it should be obvious that the central bank can make the nominal present discounted value of current and future seigniorage pretty much anything it wants it to be. While a central bank can always recapitalize itself through the issuance of base money, doing so may not be optimal or even acceptable, even though it is feasible: self-recapitalization through seigniorage may generate undesirably high rates of inflation. Marco Del Negro and Christopher A. Sims write that whether a can manages to recapitalize through base money issuance and respect its policy objectives depends on the policy rule, the demand for its non-interest-bearing liabilities, and the size of the initial net worth gap.

Source: Willem Buiter

Jaime Caruana writes that the problem is that not everyone appreciates that a central bank’s accounting equity can be negative without any reason for alarm bells to ring. Markets may instead react badly in the false belief that losses imply a loss of policy effectiveness. Politicians may also object, if they leap to the conclusion that bad decisions have been made at the taxpayer’s expense, or that the central bank now depends on the government for a rescue. Such harmful self-fulfilling prophecies are in nobody’s interest.

Economists at the Czech National Bank write that the link from CB financial strength to inflation is far from straightforward. There are historical examples of countries where central bank financial weakness has led to clear problems, but there are also central banks that have successfully delivered price stability for many years irrespective of their negative equity. Economists at the Bank of Thailand write that four central banks which are commonly referred as successful central banks with weak financial status are Czech National Bank (CNB), Central Bank of Chile (CBC), Bank of Israel (BOI) and Bank of Mexico (BOM). Mojmír Hampl writes that the Czech National Bank has indeed lived for years with negative equity of up to some 5% of gross domestic product without experiencing any ill effects on its reputation or operation. The Slovak central bank adopted the euro comfortably with an uncovered loss and is still functioning happily within the euro area.

QE and fiscal transfers redux (on Paul de Grauwe)

Monetary Realism writes that the standard central bank strategy for QE includes the assumption that it is temporary – that there will be an exit sometime down the road, anticipating the prospect that central banks will be returning policy interest rates to more normal positive levels. Given that goal and expectation, QE related excess reserves (and related liability forms) will have to pay a positive rate of interest in order to support a policy rate structure above the zero bound – until the completion of QE exit. QE related liabilities must pay a positive interest rate as floor support if the central bank’s policy rate is set sufficiently above zero.

Monetary Realism writes that De Grauwe has overlooked the fiscal effect linked to the charge for any future interest expenses on the ECB liabilities that were created as the result of QE purchases of bonds that have now defaulted. This is relevant considering the real possibility that the world may return to more positive interest rates at some future point. In that case, under De Grauwe’s proposed treatment, any Eurozone country that has defaulted on bonds will have escaped its respective share of ECB liability costs for which it has been responsible by direct QE association. Such a country will have obtained perpetual free funding courtesy of the ECB and its remaining capital holders. That is an unambiguous fiscal transfer that De Grauwe has either not recognized or assumed away.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article More by this author
 

Blog Post

It’s hard to live in the city: Berlin’s rent freeze and the economics of rent control

A proposal in Berlin to ban increases in rent for the next five years sparked intense debate in Germany. Similar policies to the Mietendeckel are currently being discussed in London and NYC. All three proposals reflect and raise similar concerns – the increase in per-capita incomes is not keeping pace with increases in rents, but will a cap do more harm than good? We review recent views on the matter.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: July 8, 2019
Read article More on this topic More by this author
 

Blog Post

The breakdown of the covered interest rate parity condition

A textbook condition of international finance breaks down. Economic research identifies the interplay between divergent monetary policies and new financial regulation as the source of the puzzle, and generates concerns about unintended consequences for financing conditions and financial stability.

By: Konstantinos Efstathiou Topic: Finance & Financial Regulation Date: July 1, 2019
Read article More on this topic More by this author
 

Blog Post

The June Eurogroup meeting: Reflections on BICC

The Eurogroup met on June 13th to discuss the deepening of the economic and monetary union (EMU) and prepare the discussions for the Euro Summit. From the meeting came two main deliverables: an agreement over a budgetary instrument for competitiveness and convergence and the reform of the European Stability Mechanism (ESM) treaty texts. We review economists’ first impressions.

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 24, 2019
Read article More on this topic More by this author
 

Blog Post

The campaign against ‘nonsense’ output gaps

A campaign against “nonsense” consensus output gaps has been launched on social media. It has triggered responses focusing on the implications of output gaps for fiscal policy under EU rules, especially for Italy. But the debate about the reliability of output-gap estimates is more wide-ranging.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: June 17, 2019
Read article More on this topic More by this author
 

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 11, 2019
Read article More on this topic More by this author
 

Blog Post

The 'seven' ceiling: China's yuan in trade talks

Investors and the public have been looking at the renminbi with caution after the Trump administration threatened to increase duties on countries that intervene in the markets to devalue/undervalue their currency relative to the dollar. The fear is that China could weaponise its currency following the further increase in tariffs imposed by the United States in early May. What is the likelihood of this happening and what would be the consequences for the existing tensions with the United States, as well as for the global economy?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 3, 2019
Read article More on this topic More by this author
 

Blog Post

The next ECB president

On May 28th, EU heads of state and government will start the nomination process for the next ECB president. Leaving names of possible candidates aside, this review tries to isolate the arguments about what qualifications the new president should have and what challenges he or she is likely to face.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 27, 2019
Read article More on this topic More by this author
 

Blog Post

The latest European growth-rate estimates

The quarterly growth rate of the euro area in Q1 2019 was 0.4% (1.5% annualized), considerably higher than the low growth rates of the previous two quarters. This blog reviews the reaction to the release of these numbers and the discussion they have triggered about the euro area’s economic challenges.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 20, 2019
Read article More by this author
 

Blog Post

Is an electric car a cleaner car?

An article published by the Ifo Institute in Germany compares the carbon footprint of a battery-electric car to that of a diesel car, and argues a higher share of electric cars will not contribute to reducing German carbon dioxide emissions. Respondents rejected the authors’ calculations as unrealistic and biased, and pointed to a series of studies that conclude the opposite. We summarise the article and responses to it.

By: Michael Baltensperger Topic: Energy & Climate, Innovation & Competition Policy Date: May 13, 2019
Read article More on this topic More by this author
 

Blog Post

All eyes on the Fed

Last week the US Federal Reserve left the federal funds rate unchanged and lowered the interest rate on excess reserves. We review economists’ recent views on the monetary policy conduct and priorities of the United States’ central bank system.

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: May 6, 2019
Read article More on this topic More by this author
 

Blog Post

Is this blog post legal (under new EU copyright law)?

How new EU rules on using snippets from news publishers and on copyright infringement liability might affect circulation of information, revenue distribution, market power and EU business competitiveness.

By: Catarina Midões Topic: European Macroeconomics & Governance Date: April 8, 2019
Read article More on this topic More by this author
 

Blog Post

Secular stagnation and the future of economic stabilisation

Larry Summers’ and Łukasz Rachel’s most recent study documents a secular fall in neutral real rates in advanced economies. According to the authors, this fall would be even more marked in the absence of offsetting fiscal policies. Policymaking in a world of permanently low interest rates may be hard to navigate, especially in troubled waters. We review economists’ views on the matter

By: Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: April 1, 2019
Load more posts