central banks
Comments On Asset Prices And Inflation Targeting
This is an unedited manuscript excerpt, from a chapter that discusses how asset price changes relate to inflation.
Even if one believes that asset price increases represent inflation, the general reaction among North American central bankers would be to think you are crazy if you think asset prices should be included within an inflation target mandate. (I am less sure about the reaction of Continental European central bankers.) Although they might accept that exuberance in financial markets should be toned down, targeting asset prices directly poses many problems.
Embedded in this reaction is the conventional belief that raising the policy rate tends to slow inflation, while cutting them tends to raise the inflation. I must note that many proponents of Modern Monetary Theory disagree with that conventional belief – but explaining that divergence is out of the scope of this book. (It is explained in my book Modern Monetary Theory and the Recovery.) For simplicity, I will accept the conventional view here.
(One related problem is that if interest rates directly feed into inflation, then inflation will rise if the central bank hikes rates. This conflicts with the conventional view. As such, the Bank of England stripped the mortgage interest component out of the Retail Price Index.)
If we just look asset prices, we see two major problems with having them show directly up inside the inflation measure used in the inflation target. Firstly, financial asset prices are quite volatile relative to most consumer prices. Secondly, there is no way of targeting risk asset prices without blowing up the economy. (Although bonds are a financial asset, it is easy for the central bank to stop their prices from changing – they can peg interest rates along the curve. This idea sends most conventional economists straight to the fainting couch, it has been done historically (such as in the Second World War in the United States, and more recently, Japan). However, locking interest rates in this way largely eliminates flexibility in setting interest rates, which is conventionally believed to be necessary for inflation targeting.)
Equity prices go up and down much faster than the business cycle. If the central bank targeted them directly, they would end up cutting and hiking rates multiple times within a business cycle, which is presumed to destabilise the economy. Furthermore, equity prices may react to central bank movements. For example, imagine that equity prices are rising too rapidly. The central bank then hikes rates to counter this. Imagine then that equity holders panic, and prices collapse. What is the central bank supposed to do – cut rates again? (This is obvious to anyone other than the people who pin the blame for their inaccurate equity forecasts on the central bank, which is remarkably common among people who tend to be wrong about equity markets.)
Rapid interest rate movements by the central bank are going to spook borrowers and lenders. Markets would likely build in large risk premia, and pretty much everyone would start sourcing finance in other markets.
Even targeting slow-moving house prices poses dangers. To the extent that house prices reflect long-term interest rates, rising house prices are a side effect of a low interest rate environment. That environment is typically the result of the central attempting to avoid a recession when economic growth is sluggish. Hiking rates to target house prices is runs exactly counter to the desire to boost growth. Meanwhile, interest rates are not the only thing affecting house prices. Idiotic decisions in other spheres of policymaking can generate a housing boom or bust. Finally, the housing market is like any market run by humans – it has mood swings. The housing market may remain impervious to rate hikes for some time – until there is a panic that precipitates a collapse. Given the importance of residential investment within the economy, and the risks posed by widespread mortgage defaults, housing busts generally trigger ugly recessions.
My view is that the belief that central banks can easily target asset prices comes from an extremely dubious analogy to the Gold Standard – where the gold price was pegged. However, the reasons why the Gold Standard functioned no longer apply to any financial asset.
· Once international financial capitalism developed, the Gold Standard is best seen as a currency peg system. What mattered economically was the fixed exchange rates between the major economies. Gold was just the mechanism to adjust for capital flows across currencies. No financial asset can replace this at present -even gold. Unilaterally pegging your currency to a risk asset like gold is not going to change much. If your economy is large, you are just running a price control scheme for one financial asset – which other actors will attempt to exploit. If your economy is small, your exchange rate will fluctuate wildly based on speculation in some other market.
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The political establishment built its world view around being willing to make sacrifices to restore previous exchange rates. However, only a small handful of people think this is a good idea, and so pegs lack political credibility.
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Gold is a collectible that generates no cash flow, and its consumption by industry is largely insignificant when compared to existing above-ground inventories. Other assets either have cash flows that need to be priced or are commodities with relatively small inventories. There is no way for them to credibly have constant prices in a dynamic economy.
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Earlier generations of financial market participants had an ideological belief that the gold peg system was credible. Modern market participants will speculate against any peg arrangement. The problem with defending pegs is that attacking them is a low-risk investment (since the price is largely locked) with a high potential pay off if the peg breaks.
If risk asset market prices reacted in a predictable fashion to the policy rate, it should be easy to generate models that generate massive profits by inputting market-expectations for the policy rate – which are decent over short horizons (outside crises). Such models are noticeably small on the ground. Although people (including myself) enjoy giving central bankers a hard time, most of the sensible ones have come to terms with that observation.
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(c) Brian Romanchuk 2024
Late Central Bank Comments
Since I am still chugging away with edits, I have not been spending much time watching developments in markets. I just wanted to off some brief comments on events from central banks last week. I have a longer manuscript section for publication later this week.
The Bank of Japan threw in the towel on negative interest rates last week. Yay, yen interest rates will go back to their low positive “normal.” This change is not that significant, other than on a psychological basis. I have not been following Japanese data closely, but my tendency is to expect glacial changes in economic conditions.
The Federal Reserve released the projections of the FOMC members. I have never been a big fan of spending too much time dissecting those projections — the main issue for markets is determining when the FOMC is completely out to lunch. However, they have deepened their expected rate cuts over this and the following years (the projections are for December year end).
Although I think a couple cuts to the psychological level of 5% is fairly plausible, I am unsure about the sustainability of slow-paced rate cuts. During an expansion, the usual tendency is for growth and inflation to bump up and down around their “steady state” levels (which may be only obvious in retrospect). There will be periodic “growth/inflation scares” that suggest that the economy might accelerate.
Meanwhile, the loons in the risk markets will over-extrapolate any rate cuts. There will be screaming about the Fed (or the FED!) inflating asset bubbles if risk assets do what they do most of the time (go up). American policymakers spend way too much time obsessing about equity markets. (Greenspan was seen as a major culprit behind this tendency, but I do not spend a whole lot of time worrying about much earlier eras of policymaking.) It will be very easy to say “Mission Accomplished” after a few token cuts if the bubble narrative takes off again.
Things are different if the real economy starts to convincingly roll over. However, it is hard to sustain baby step rate cuts in such an environment.
As such, I would not take the rate cut path in the markets too literally. Instead, one can come up with plausible stories for divergences in either direction from the path of forwards. This is the mirror of the case of gradual rate hikes being priced into the curve when the central bank is widely expected to remain on hold.
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(c) Brian Romanchuk 2024
Why The "Friedman Thermostat" Analogy Should Be Uncomfortable For The Mainstream
Nick Rowe’s article on Milton Friedman’s Thermostat has popped up in online conversation. For those of you unfamiliar with it, it is about inferring statistical relationships between inflation and interest rates. Although I agree that it is possible to do some silly correlation analyses between those variables1, if we think about the analogy more carefully, it points to concerns with the mainstream approach.
Imagine that I was teaching you some version of “introduction to engineering mathematics” and for some insane reason I gave you and your project partners access to a typical Canadian house with an oil furnace in the winter. I want your team to develop empirical formulae for the determination of interior temperature near the thermostat. For simplicity (and to avoid awkwardness to my argument that I discuss in the appendix), let us assume that the furnace works in a straight on/off fashion: it fires up to 100% heat output, runs, then shuts off completely.
We can then imagine that Nick Rowe submitted this response (from the linked article).
If a house has a good thermostat, we should observe a strong negative correlation between the amount of oil burned in the furnace (M), and the outside temperature (V). But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P). And we should observe no correlation between the outside temperature (V) and the inside temperature (P).
An econometrician, observing the data, concludes that the amount of oil burned had no effect on the inside temperature. Neither did the outside temperature. The only effect of burning oil seemed to be that it reduced the outside temperature. An increase in M will cause a decline in V, and have no effect on P.
This response would not make me happy if I graded it. To be fair to Nick, he is setting this response up as being from a dim econometrician. But even as a straw man, it leaves a massive logical problem, and his statements about the alleged correlations are in fact incorrect/misleading. We Canadians put furnaces inside houses for a reason, and any engineering undergraduate should know what that reason is.
Canadian outdoor winter temperatures range from uncomfortable to lethal. Any house other than a “passive house” will lose heat and eventually the indoor temperature will start to approach the outdoor temperature. (Unless there are gaping holes in the building envelope, there will be some heat trapped, so it would remain somewhat warmer. It also protects from wind chill, which is the real safety issue, not the absolute temperature.)
For a furnace that swaps between “fully on” and “off” modes, if it is possible for the thermostat to work as expected, we have two regimes. For now, we assume that there are no other major factors driving hear flow — it is night, no woodburning stove, limited electricity consumption, no cattle providing body heat in the basement.
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When the furnace is off, temperatures generally decay towards some steady state value that largely depends on the outside temperature and wind velocity/direction (since building envelopes in practice leak).
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When the furnace is on, the temperature decays towards what is expected to be an uncomfortably warm temperature (depending on the sizing of the furnace, outdoor temperature, insulation, etc.).
Despite Nick Rowe’s assertions to the contrary, if we select the correct time scale, we do see a “correlation” between temperature change and instantaneous fuel usage. (This “correlation” would break down if the sun/wood stove/cattle are providing enough heat to independently raise the temperature, or outdoor temperatures are not constant, etc.)
The only way Nick Rowe’s statement that “But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P)” is true if M is monthly or seasonal oil burning. But even there, if we took a bunch of similar new houses in a neighbourhood with the same North/South facing, total energy consumption (need to factor heating from electricity consumption within the house, not just the furnace) would in fact be correlated with the average thermostat settings. Middle aged dads grumble to family member to turn down the thermostat and wear a sweater for good economic reasons.
You Need to Have An Idea How the System Works
If one were just handed the raw data from the house without any explanation of what they were, it would likely be difficult to pick out a sensible relationship between the variables. You would need some knowledge of the system dynamics to realise that outdoor temperature, wind speed/direction, and other heating sources would need to be tracked and quantified in order to get a model that goes beyond “when the furnace turns on, room temperature generally goes up.”
In other words, you cannot just use statistical analysis to do magic, you need some fundamental analysis of the system as well.
Back to Interest Rates
The true lesson from this analogy is that in order to do statistical tests on the relationships between the variables of a system, you need at least some idea what the dynamics of the system are supposed to be. Realistically, you need a model of system dynamics that you can test against the data. Although there are attempts to use mathematical magic to infer system models solely based on observed data, my bias is that this is not going to replace fundamental analysis.
The reason why correlating the policy rate with inflation is silly is that we know something about the dynamics of the system. The policy rate is a variable set by a small clique in a boardroom, and the setting is somewhat arbitrary. They certainly believe that there are more than one possible option to take in most meetings. Conversely, the inflation rate is some sort of weighted average of price changes taken by entities across the whole economy. The correlation just tells us about the psychology (reaction function) of central bankers.
In order to sensible statistical analysis of the effect of interest rates, you need a quantitative theory/model to test. But it has to be an actual quantitative theory. For example, saying that “lags are long and variable” can only be described as pseudo-scientific hand-waving to excuse model failure.
The problem is that there is an infinite number of potential models in which interest rates appear. We cannot test them all within the finite lifespan of the solar system. All we can do is look at proposed models (or families of models that can be captured as a group).
I will then run through some basic classes of models, in increasing order of complexity.
The Policy Rate Matters
These models are probably what a lot of people have in mind when thinking about the central bank, and the earliest ones tested. (I assume the original Friedman analogy referred to these attempts.) The basic concept is that if the nominal policy rate is above some “trigger” value, then inflation and/or GDP growth will fall (with some lag). The policy rate is a single-valued lever which drives the economy up or down.
(Given that most conventional economists think in terms of a real “trigger value” for the policy rate, we need to make the appropriate inflation adjustment to get the nominal trigger value.)
You can then test the predictions of this framework against actual policy rate and observed inflation/growth data. Note that the existence an inflation target does not matter: you are testing what actually happens on a sensible frequency for business cycle dynamics (monthly, possibly quarterly).
Without any knowledge of that literature, I think it is safe to summarise it as that no stable relationship was discovered. I base that assessment on the existence of the r* literature — as r* is an attempt to measure the trigger level for the policy rate. The r* model outputs tells us that the estimated r* is moving so fast that we do not have a reliable guidepost to policy. By construction, it fits the historical data, but going forward, the estimate tends to move if the real policy rate is moving. (If the economy enters a steady state, the predicted r* converges to actual.) Until there is a model that predicts r* based on other variables available in real time, it cannot be subjected to falsification tests.
Expectations
Given that treating the policy rate as a single-valued policy lever is a dead end, we need to retreat into more complex model structures. The theoretical assumptions of neoclassical economics pushes towards “expectations” to augment/replace the spot policy rate.
Within a standard modern neoclassical model with “Real Business Cycle” roots, “expected values” are easy to work with. All entities in the model are aware of an alleged “equilibrium” that determines the probability distribution of forward prices of everything (including interest rates and the price level) out to infinity. You just read off the expected values of the price distributions.
Back here in the real world, we do not have forward prices of everything (never mind the full probability distribution). And the forward prices that exist are generally believed to have biases. We can use surveys, but then we do not know how representative or biased those surveys are.
One can be bloody-minded and try to use observed conventional and inflation-linked bond pricing to determine “risk neutral” expectations for interest rates and inflation. The immediate problem is how to feed this information into a statistical test. A continuous yield curve on a single day contains a lot of information. (Theoretically infinite, but really closer to the number of instruments in the fitting.) The simplest way to compress this information is to just use a single bond price, typically the 10-year yield.
Although most countries have a decent data set of 10-year conventional bonds, inflation-linked data generally only appears after inflation dynamics were generally uninteresting (until 2020, anyway). So either one needs to use surveys, or use models to make expectations up (which creates model selection problems).
Since there is a lot of ways of compressing market-based expectations series, the jury remains out whether we can find one that works. I am in the camp that we will run into the same problem as r* for any variation of “expected rates.”
Reaction Function Changes Matter
One of the distinctive features of modern DSGE macro is the argument that changes to the central bank’s reaction function matters for outcomes. That is, the outcome of a single rate meeting does not matter, rather what matters is what this says about the future behaviour of the central bank. This effect is certainly going to be true in DSGE models by construction (although we run into the calendar time versus forward time gap). However, I am uncertain how this is operationalised into the real world.
The only measurable quantities related to “reaction functions” I can point to is the observed yield curves. One can interpret the yield curve as the implied reaction function output based on the “expected” economic outcomes that is embedded in the yield curve. (This expected economic outcome reflects what market participants forecast, not the central bank’s forecast.) Changes to the reaction function would show up as changes to the shape to the forward curves.
I have not followed this area enough to comment further (beyond my concerns about the non-measurability of the reaction function).
Expectations Fairy
The final and hardest to test theories involve the dreaded Expectations Fairy. The central bank allegedly determines outcomes almost instantaneously by changing its target. Although this sounds crazy, it is actually how DSGE models are supposed to work (outcomes are driven by expected values at equilibrium, and the current central bank target drives the equilibrium).
Most neoclassicals skate over the awkward implication of this, but the “Market Monetarists” pushed this idea to its limit in their writings in the 2010s. I do not want to put any words into Nick Rowe’s mouth, but I think it is safe to say that the arguments in his linked article have Market Monetarist ideas embedded in them.
In the early 2010s, it was possible to point to the apparent success of inflation targeting — on average, most central banks hit their target since the inception of formal targets until that era. At present, there are a lot of holes in that theory — Japan’s persistent miss, the undershoots of targets in the 2010s, and then the pandemic experience. Although I imagine that the Market Monetarists can find a way to explain this, I remain skeptical.
In any event, if one believes that inflation will always hit the inflation target because of expectations, Nick Rowe’s claims about the non-existence of correlations makes sense. The problem is that we can easily reject that claim — inflation certainly missed target, and so we can do analysis on the misses.
Concluding Remarks
The policy rate is not set at random, nor is it the result of “economic forces.” At each meeting, it is set by a small group of human beings who follow a set of beliefs about interest rates. If they set it the “wrong” level, it is very hard to find examples of there being immediate negative consequences, so they do have freedom of action. (If there is a pre-existing crisis, “wrong” levels of interest rates can generate reactions.) Given the content of Economics 101 teaching, we cannot be surprised that the policy rate follows the inflation rate with a lag. Given that inflation is normally thought of as a lagging economic variable, we end up with interest rates often exhibiting the same cyclical behaviour as other variables. (Although this is not universal, the Japanese policy rate was remarkably non-cyclical.) If everything is pro-cyclical, deciphering statistical relationships between them is inherently difficult. You need policymakers rejecting Economics 101 and moving interest rates counter-cyclically to get interesting data for testing.
The funny thing about this topic is that using interest rates to control inflation2 is the main ideological plank of neoclassical economics from 1975-2010 (at least), yet there is a remarkable inability to give a quantitative demonstration that can convince outsiders about the effectiveness of the policy. Engineers can generate quantitative guidelines for furnace sizing that stand up to outside scrutiny, the same cannot be said for changes to the level of interest rates.
Appendix: Non-Saturating Heating
It is possible to get closer to Nick Rowe’s ideas about correlation if we look at what happens if have heaters whose heat output was adjusted continuously between zero and some upper limit that is not normally hit. (The furnace I described only operated at either the lower or upper limit.) It would be easy to rig up such a system with baseboard heaters, although I am not sure about the wisdom of the approach.
If the control law in the thermostat were properly tuned3, we could end up in a situation where the temperature hits a steady state at the target temperature — the heater output would be calibrated to match the heat loss. Although we would have sensor noise, we might get runs of near-constant interior temperature.
We can then do the following exercise: identify each period of near constant temperature, and just record the average temperature (which is supposed to equal the thermostat setting) and the heater average power consumption setting. If we look at those pairs of numbers over time, we would see that the power consumption would (most likely) vary.
Ah ha, we get the claimed data distribution — indoor temperature constant at target, with varying power inputs.
The problem is that we achieved this result by deliberately obliterating the time axis. If we examine the time series during the “steady state” intervals, they are both constants (within limits of noise), and constants are correlated. Instead, we would do our model estimation based on the rest of data set, when the interior target has moved away from target, and the heater is acting to bring it back. Given that we do not embed time machines in thermostats, we know that there will be deviations from target that allows this model fitting (i.e., there is no “expectations fairy” that always causes temperature to remain on target at all times).
Meanwhile, the fact that the steady state power consumption changes over time is not surprising given that we know that houses face different heating needs over time. If room temperature depended solely on power consumption, nobody would put on/off switches on furnaces. In other words, we knew in advance that the steady state power consumption would change. We need a model — such as looking at other factors that affect room temperature (differential with outside temperature, wind, other heat sources) if we want a way of predicting the steady state power consumption. Correspondingly, we need a model to predict “steady state” interest rates if we follow conventional beliefs.
The reason to do a correlation analysis between the policy rate and inflation is that it is guaranteed to indignant replies from mainstream economists.
I am lumping using the money supply to control inflation with interest rates given that they were linked in practice, and not everyone entirely bought the Monetarist story.
At the minimum, would most likely need a full PID controller to eliminate the steady state offset.
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(c) Brian Romanchuk 2024
Central Banks And Crises
This article is a wrapping up of a sequence of articles on the topic of “central banks as banks,” which is expected to form a chapter in my book on banking. This version of the text is a brainstorming exercise — I expect that it would require a massive re-write to get into a book. I am presenting it in this format since it was a topic that came up in comments on earlier articles, and I also want to finish the train of thought starting in my online articles. It is breezy, and it relies on discussions that appeared in my earlier book Recessions: Volume I. I am going to suggest that readers spend their bookstore gift cards buying that book rather than repeating too much from it; my banking manuscript is going to have to be more stand alone. I also am relying on stream-of-consciousness assertions, and would need to backfill references once the text is closer to finalised.
Happy New Year!
If things are going well, the role of the central bank within the banking system of a developed country is largely invisible. The wholesale payments system just works, and there are no serious worries about the private banks that are the core of the financial system. Instead, most commentators just worry about central bankers’ abilities to centrally plan the capitalist economy by nudging a policy rate up and down and making cryptic statements about the economic future. (Of course, those of a hard money bent are continuously predicting calamities since nobody is adopting their demand that the currency be pegged to whatever collectible they favour.)
During a crisis, the role of the central bank in the banking system comes back into focus. Given the trauma of the Financial Crisis of 2008, we might have a generation of central bankers and central bank watchers who are more attuned to crisis management. However, stability breeds complacency, and we should expect the importance of crisis management to fade as youngsters move up and push their agendas.
The Inevitability of Financial Crises
Crises driven by finance are part and parcel of industrial capitalism. My thinking largely follows the story of Hyman Minsky, who in turn followed Keynes. I will just outline the structure of the argument without offering references. From my own writings, this would be covered in Recessions: Volume I, while Hyman Minsky has a lot of readable material on this topic.
If we look at the Kalecki Profit Equation (link to primer), we see that (net) investment is a source of aggregate profit to the business sector. We need to keep in mind that cash flows tend to be circular — wages are paid out as an expense, but unless those wages are saved, the cash flows return to another business as revenue. For investment, they are a cash flow out of firms (or households if they invest in housing) that is not an expense (depreciation will eventually occur) but they create revenue for the firms providing the investment goods.
The justification for fixed investments is the expectation of profit, while the act of investing itself generates aggregate profits. This creates a self-reinforcing feedback loop (“positive feedback loop” if you are an audio engineer). Although profits can be used to finance investment, in the real world, a lot of investment is done by companies speculating about future profits. This implies that the investment needs to be financed by debt (since equity financing is too expensive for any but the most risk averse).
This creates the tendency for capitalist economies to “melt up” — an investment-driven profit boom. We can capture this effect in classical (1950s era) investment accelerator models. The problem is that this feedback loop works until it doesn’t. Sooner or later, businesses and households pile on too many dubious investments, and lenders develop cold feet. At which point, the process goes into reverse.
Everything I have written so far is just a consequence of how industrial capitalism works. We then need to ask what the financial system is doing while all this is going on.
Financial Instability
If one reads financial commentary, it would appear that the entire purpose of the financial system is to gamble on literally everything. In fact, that is just the world view of most financial market participants. This outlook is self-reinforcing, but believe it or not, the credit markets do finance activity in the real economy. The credit markets are split between the formal banking sector and non-bank finance — or the “shadow banking sector” if you want it to sound cool.
The fundamental problem with capitalist finance is that there is an overwhelming bias to hold short-dated instruments with a low perceived credit risk, while fixed investment cannot naturally be financed by such instruments. (The closest we get is trade receivable financing.) The financial sector needs to do some magic to bridge this mismatch. The traditional banking model notoriously does this with deposits being used to finance loans. The shadow banking sector achieves this by issuing short-dated instruments that are allegedly safe and used to finance positions in long-dated credit assets. To the extent that the shadow banking sector is safe, it relies on lines of credit backstops from the formal banks — and they have the implicit backstop of the central bank.
Minsky-Ism
Although Hyman Minsky thought of himself as following Keynes, his writings are certainly easier for a lot of us to follow. Although parts of his Financial Instability Hypothesis are catchy and get a lot of attention (Ponzi Units!), I think you also need to pay attention to his description of institutional changes in finance. (For example, see “Central Banking and Money Market Changes” in the collection Can “It” Happen Again: Essays on Instability and Finance.) The key is that the financial system is not static: its structure changes over time in response to regulatory action, and market forces that pushes for “innovations” (that coincidentally wiggle out of said regulations). The views here are mine, and may at this point be only tangentially related to what Minsky meant, but he would be a source to turn to if you want a reference.
The short version of the idea is as follows. Given the maturity mismatch between the overall mix of lenders and borrowers, in order to generate growth, we need financial intermediaries to bridge the gap. However, such a mismatch can lead to a financial crisis, which will result in the classic behaviour of putting in reforms that will prevent a repeat of the exact same crisis (horse, barn door, etc.). A crisis tends to cull some of the more imprudent credit market participants, and so we would probably avoid a repeat of the same crisis even if nothing is changed. However, industrial capitalism (generally) needs credit growth for incomes to grow, and so there is pressure to find “innovative” “safe” ways to bridge the maturity gap. (The innovation invariably is finding structures that are economically equivalent to debt, and they are “safe” because they are so “innovative” that the people dealing in them are unaware of the credit risks.)
The real kicker is that “stability is destabilising.” New financial practices are often put into place with good safety margins — the novelty of the instrument allows greater credit spreads to be charged, covering potential losses. Meanwhile, credit standards are tight in the aftermath of a previous financial crisis, so there is no need for the new instruments to offer too much embedded leverage. These safety margins validate the new financial practice as safe. (And in the sense of realised losses being less than what was priced into the instrument, they are safe.)
And if one has ever run into finance professors in the wild, one discovers that the answer they almost invariably prescribe to a situation where there is a “safe” profit to be made: put more leverage on that sucker. Firms loosen lending standards, allowing more leverage against assets. At the macro level, this increases leverage allows a greater price for the asset being levered. Once again this validates the decision to loosen lending standards.
I do not recall Minsky using these words exactly, but there is a Darwinian selection at work: stodgy financial firms that do not loosen lending standards will lose market share to those that do. This is ensures that the funding mix will move towards aggressive intermediaries — even if other lenders hold the line on standards. (That is, this shift does even not require participants’ attitudes to change, their weighting will shift anyway. Entities loosening standards turbo-charges this.)
Of course, the loosening of standards dooms itself. Since the core problem is lending short-term against long-term assets, the formal banks are likely have been drawn in somehow. In the Financial Crisis of 2008, the formal banks in many developed countries mainly kept the garbage off their regulated balance sheets — they just ended up involved with “bankruptcy remote” (lol) off balance sheet vehicles.1 (If the formal banks have not been drawn in, the central bank is free to let the speculative bubble to melt down — not matter what the market capitalisation of the bubble is. One of the problems that the financial press has is that people conflate “market capitalisation” with actual cash flows. Every major sporting event sees the collapse of the market value of losing bets — yet this has no effect on the macroeconomy. Although the equity market might be useful as an indicator, very little money is raised by equity issuance, so the equity market could be shut down for a considerable time and firms could continue to function. This is unlike the credit markets, where debt needs to be rolled almost continuously.) The formal banks can only survive if they can draw on financing from the central bank — which is exactly why people are willing to lend to them in the first place.
Can This Be Stopped?
A standard reaction to the previous argument is outrage — typically at bankers, financial capitalism, or “socialist” central bankers (depending upon ideological sympathies). I view financial crises to be one of the inevitable side effects of industrial capitalism, like pollution and idiotic advertising. It is easy to prevent the last crisis — the problem is that the best and brightest in finance will just end up with a new way of generating a crisis.
Many free marketeers who are unhappy with banks are angry at the “welfare state for bankers.” Although it is unwelcome seeing bankers being bailed at by the government, pretending that non-bank finance can survive a major crisis without a central bank bailout is wishful thinking. The non-bank financial sector has a straightforward selective pressure: credit risk ends up in the hands of the participants least able to understand the magnitude of the risks they are running. Sooner or later, that is an unstable edifice — and will take out the real economy if intervention does not occur. Politicians are not going to let their economies be wiped out to defend some abstract notion of “free market capitalism” when they are being inundated with calls by panicky “free market capitalists.”
On the other hand, hoping that regulators will save the day also requires a hefty dose of wishful thinking. Although behaviour might be more discreet in the aftermath of a crisis, sooner or later the free market dogmatism embedded in neoclassical models will result in regulatory capture of the regulators. In the Financial Crisis, central bankers were too busy patting themselves on the back about achieving “the Great Moderation” to even be aware of what was happening in the shadow banking sector. However, even if they had paid attention, there is no reason to believe they would have been anything other than cheerleaders, arguing that the gaussian copula models scientifically proved that a financial crisis was impossible.
The elites in a capitalist society are not going to favour crippling growth by refusing to allow financial practices that appear to be safe. Although one can point to periods of stodgy, conservative financial behaviour, the last one — the 1950s — required The Great Depression, World War II, and Communists Under The Bed — as backstory. Even then, behaviour loosened up by the mid-1960s.
Concluding Remarks
We have been through some major financial upheavals, and warning about financial crises is possibly still somewhat “edgy.” (The underlying reason why it will always appear to be novel is that the neoclassical framework has no satisfactory way to model a financial crisis.) The problem is — if everyone is prepared for a financial crisis, one will not happen. You need somebody taking really stupid risks with a whole lot of money to derail mature capitalist economies. At the end of the day, all the central bank needs to do is lend against any instrument that can fog a mirror to get the core of the banking system functioning again.
An entirely plausible scenario is that we could stumble along for a couple decades with only mid-level scandals and financial stupidities, while financial crisis bugs repeatedly proclaim the onset of the next crisis (invariably in the second half of the next year). That is, they will end up looking like aged cranks who proclaimed the next wave of inflation every year from 1984-2020. (For those who might think that is not so bad, ask yourself: how old were you — or your parents — in 1984?) At which point, things might be relaxed enough for everybody to break out their Minsky quotes once again.
In my view, the best that you can hope for is that the central bank has some cynical senior people who are somewhat aware of what monkey business the financial sector is up to, and do not assume that markets tend to stable equilibria if regulators remove pesky “imperfections.” They might spot problems early enough that the damage from over-exuberance can be contained. Having this market expertise probably requires the central bank to be continuously involved in lending against private securities as a means of creating the monetary base — as opposed to just plopping its balance sheet into central government securities that allow it to ignore private credit (the problem with neoclassical thinking from 1945-2008).
Some formal banking systems blew themselves up, e.g., Ireland. Northern Rock failed in a somewhat traditional fashion by relying too much on wholesale finance, the Icelandic system allowed itself to be captured by somewhat unreliable characters, etc.
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(c) Brian Romanchuk 2024
Should Everybody Have An Account At The Central Bank?
This will be my last posting before Christmas, and depending on what I get up to, possibly the last of 2023. This article is somewhat of a placeholder for my manuscript chapter. It is a group of related topics that I think belongs in there, but not ones that I spent much time looking at. I will revisit this text when I put the manuscript together.
Happy Holidays (and probably) Happy New Year!
In this article, I will breezily run through a few topics that are related to the idea of “everybody getting accounts at the central bank.” Many (but not all) of these proposals are being put forward as a means to fixing the problems with the private banking system that were exposed during recent financial crises, and/or proposals to del with the somewhat backward retail banking infrastructure of the United States of America (and perhaps a few other countries).
One possible variant of these ideas is that the central bank (or the central government via a “postal bank” system) operates in direct competition to private banks — they offer loans and accounts. Alternatively, the central bank could just move into offering retail payment and deposit services, without offering loans itself.
Postal Banking
I am going to use “central bank” herein as a shorthand for the central government offering banking services more widely. In practice, this might not be done by the existing central bank, under the argument that central bank generally has zero expertise in offering such services. (I believe that the Bank of England used to offer accounts to a limited number of people, but dropped those facilities. I need to get a reference for this alleged history.) In order to match private banking services, one would need widespread retail outlets. Post offices already provide that retail footprint.
Rather than duplicate the post office infrastructure build out, it makes sense to offer banking/payments services at post offices — postal banking. This a system that exists to a certain extent in various countries. A reinvigoration or expansion of postal banking might result in greater availability of banking services to all citizens, but how this would be done would depend upon the conditions in the legal jurisdiction. Although it might improve conditions for some people, such a move is not going to have a major macroeconomic impact since firms and most individuals will not use postal banking services.
From a Canadian perspective, it is not clear that postal banking would amount to much. At present, many “post offices” are franchises run out of retail businesses (often pharmacies). (Go to https://www.canadapost-postescanada.ca/cpc/en/our-company/business-opportunities/become-an-authorized-retailer.page? to check out franchising opportunities.) As such, the central government has only limited control over the branches, and although they are going to have access to payments systems, they cannot take financial risks. Beyond adding some payments options, it seems much easier to slap a mandate on the handful of private Canadian banks that they serve all Canadians (within reasonable limits). This might not work in fragmented banking system (like the American one), but it is much more efficient to browbeat a few private senior bankers than try to replicate their branch system.
Lending?
Another set of proposals involves the central bank getting involved in direct lending decisions to non-banks. As discussed earlier, I am opposed to this. Central governments are involved in lending programmes — for example, student loans — but they quite often offload credit analysis and servicing to the private sector. The government just takes on the credit risk, although they can charge a fee for that. (For example, the Canada Mortgage and Housing Corporation (CMHC) — a Crown Corporation — insures most mortgages that are originated with a loan-to-value ratio above 80% (the rest are insured privately).
Although one can readily argue that such programmes should be expanded, doing so is a political decision. There is no economic magic created by having the central government directly “create the money” for loans versus taking on the credit risk of a private bank loan. In either case, somebody in the private sector is transferred cash under programme specifications — with the hope that the money is paid back — and this transfer is matched by the issuance of liabilities that are either direct liabilities of the central government, or private sector liabilities wrapped with a central government guarantee. Although those two types of liabilities might appear different, they are economically equivalent.
The key point to note is that if the government wants to go hog wild underwriting private sector credit risk, it does not need to involve the economics doctorates at the central bank who have zero expertise in credit analysis.
Central Bank Offering Safe Bank Accounts
We can now move to what some view as a major concern — people should have bank accounts with the central bank so that they do not have to worry about the credit risk behind their “money.”
The idea is that if the central bank allowed everybody to bank with them, everybody would rejoice and financial crises would allegedly be impossible. This theory runs into two serious problems.
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Choice of bank for holding deposits generally depends upon the other services offered by the bank. For example, we ended up banking with the bank that offered the best mortgage rate on our first house — which I assume is a fairly typical situation. The credit risk to deposits is pretty much at the bottom of the list of criteria I would use, courtesy of the existence of deposit insurance (a topic that is discussed further below).
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Unless all lending activity is nationalised, credit risk has to go somewhere. Removing it from the banking system will just push it to non-bank finance — where most of the real financial crises have arisen in recent decades. (The Silicon Valley debacle appears to be an exception, however that crisis just tells us that nobody in San Francisco should be allowed to work for a private or central bank.)
There is nothing stopping the private sector to have credit risk free payments/”deposit” system — just tie Treasury bill funds into the payments system. The problem is that it is not in anyone’s economic interest to offer that service for free — the need to be paid for running the payments system. The reality that deposits are loans to banks gives them an incentive to provide the payments services at a “reasonable” price — as well as the reality that deposit services are a “loss leader” that allows the sale of more profitable services (e.g., mortgages). Even if the government mandated the provision of 100% safe deposit facilities, it is unclear that anyone other than the most risk-averse would use them.
Unlimited Deposit Insurance
If the objective is to provide deposits with no credit risk whatsoever, we can just remove the limit on deposit insurance. (At the time of writing in Canada, the limit is $100,000, in the United States, $250,000.) This creates the economic equivalent of a deposit with the central government without requiring the central government to put a bank branch in every small town in the country. In a financial crisis, it is clear that the limit is somewhat of a fiction — the central government is probably going to cover all deposits to prevent a panic.
One could easily argue that we should not have ambiguities that allows a crisis to happen — if the government is going to bail out all deposits, then it should say that up front. Although I am not a huge fan of fictions, I think the legal ambiguity is useful. Unlimited deposit insurance takes away the discretion of regulators to allow a fraudulent bank to get wiped out. Although one might attempt to shed a tear for the poor widows and orphans caught up in the calamity (who are somehow able to muster deposits above the insurance limit), it is entirely possible that the major “depositors” who would get bailed out are in on the scam in some fashion.
In a country with a few large banks, such fraud concerns are perhaps not an issue. But in a country like the United States where the barriers to setting up a bank are low, we cannot expect regulators to pre-emptively catch all problem banks. Unlimited deposit insurance implies a need to regulate on the basis that no bank is expected to fail — which is not the American situation.
“Backup” Risk-Free Deposits Would Make Crises Worse
Creating risk-free deposit options that are not used in normal times (because they are uneconomic) would just make financial crises worse. The premise of conventional banking is that they have sticky deposit bases, and the core banks of the system are presumed to be the safest, so they do not face a flight-to-quality risk. Creating risk free accounts at the central bank that are only used in crises just creates an incentive for a run on the core of the banking system — which is exactly the nightmare financial crisis scenario you want to avoid.
Wholesale Payments System — Nationalise It
One of the campfire horror stories that experts love to discuss is the potential failure of the wholesale payments system in a country. The response to that is straightforward: nationalise it if things look ugly. Until then, you let the private banks worry about containing credit risk so that you do not have to.
Central Bank Digital Currencies
The final angle is the possibility of central banks hopping on to the crypto-currency hype train and creating their own “digital currency” that is not the national currency. (“Digital currency” is a bit of a silly name in that electronic transactions on digital computers represent the vast majority of daily transaction volume.)
From what I have seen of the discussions of these currency proposals, they seem aimed more at micro issues (privacy, accessibility) and not macro.
Concluding Remarks
The willingness of politicians to have the central government stick its nose into lending decisions is going to rise and fall with political trends. Having the government outsource the implementation of lending to private lenders and instead just providing lending guidelines uses much less resources than setting up a parallel lending infrastructure that might be redundant one election later.
Having the government get involved in retail payments is a question that might have different answers in different countries. That said, postal banking has been in decline, and it is not clear that it is the most efficient way to deal with actual problems.
Finally, we are left with question of financial system instability. The expected final instalment of this series will look at financial instability — would 100% credit risk free deposits make a difference?
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(c) Brian Romanchuk 2023
Should Central Banks Lend Unsecured To The Private Sector?
This article continues my sequence of articles on central banks as banks, which is projected to be a chapter in my banking manuscript. This article is relatively lightweight, but I wanted to break this issue out of another planned article.
What assets central banks should have on their balance sheet is controversial for some people, but for the post-World War II to 2008 Financial Crisis period, developed countries without currency pegs just held government bonds without raising questions from the bulk of economists. The Financial Crisis forced central banks to buy private sector assets, which re-opened this debate. This article looks at one type of private sector assets to be held — uncollateralised loans to the private sector.
I am assuming here that the currency is not pegged, which necessitates holding the peg instrument (typically gold or a “hard currency”). Even if the currency is pegged, the central bank may hold assets that are not the peg instrument, and they face the questions of what those other assets will be.
Non-Credit Assets?
As noted earlier, the central bank is in the same boat as other liability-matching investors. Their liabilities are almost entirely short-dated “deposits” and currency notes — which are bearer claims on central bank deposits that can be redeemed at any time. Nevertheless, it seems unlikely that the private sector would attempt to redeem the entire monetary base within a few months, so the central bank (like other banks) can assume that a certain amount of its liabilities are “sticky” and so it does need 100% of assets to be short duration. This allows for silliness like buying foreign currencies (which do not match local currency liabilities), equities, and gold. Central banks have done such purchases, but they tend to be a small weighting of the balance sheet. My concern here is the rest of the balance sheet, which needs to match liabilities.
The question might arise: why cannot the central bank just “print money” when facing outflows? The entire point of the central bank’s liabilities shrinking is that the private sector no longer wants to hold “government money.” It could attempt to force “money” onto the private sector by buying something to counter the attempted shrinkage, but that is going to break the “rules of the game” for the monetary system, and is going to get push back. If it buys more illiquid assets, this compounds the liability-matching problem.
Private Credit
Lending to the private sector (in whatever format) will create a credit portfolio that has a maturity structure that can be matched against potential outflows. That is, if there is a good weighting of short-dated maturities, the portfolio will self-liquidate — or at least be able to be liquidated near par — in response to a balance sheet shrinkage.
Historically, this lending to the private sector is generally done in a collateralised form: lending at the discount window, or against collateral in a repurchase transaction. (I am only concerned with the economic effects of lending, and not the financial accounting or credit risk dimensions of different “lending” types.) This greatly limits the need for credit risk analysis at the central bank. Their counter-parties are banks that the central bank is allegedly regulating, and the collateral is supposed to be high quality and provides backup credit protection. If there is a default on the collateral, that is the counter-party bank’s problem. The central bank only takes a loss if the bank goes bust and the collateral defaults. Although events like that can happen, it is probably a systemic blow up that the central bank was supposed to be stopping. I will discuss collateralised lending later.
Why not unsecured?
Unsecured Lending to Banks
Although many populist bank critics are unhappy with the central bank lending to private banks via collateralised lending, doing so is just a way to keep financing flows circular. Under the assumption that the collateral is good quality, then it is not exactly “free money” for the banks — they need to have unencumbered good quality assets on their balance sheets in order to access this funding. If they run out of those good quality assets, they are going to be getting a visit from regulators in short order to put their enterprise out of its misery.
Things are different if no collateral (or dodgy collateral) is posted. In which case, it is a gift to the banks, and it raises a lot of questions. The central bank could easily do a terrible job regulating banks, and then lend money to said banks to cover up their lack of care. Although there is no real resource cost associated with this, the cash flows are effectively an income flow. Doing so creates the worst possible economic system: crony capitalism at the banks underwritten by the central government. Although fans of central planning might not be bothered by this situation, it is going to run into obvious political problems at the ballot box in most developed countries sooner or later.
Private Sector Bonds
The central bank could easily set up a bond fund and even if it is paying market wages, the cost would not be that large when compared to the cost of keeping hundreds of economics doctorates on the payroll. The problem with having a corporate bond portfolio is that it would end up being managed in exactly the same way as private sector bond funds (“best practices”).
This means that when the corporate bond market blows itself up, we would have highly paid bond managers working for the central bank running down the halls demanding a bailout from their central bank coworkers. The role of the central bank around any large bankruptcy is going to be a political issue. For example, if one of Quebec’s “national champions” goes belly up ahead of an election, there would be a lot of politicians screaming for the heads of the central bankers in Ottawa that did not bail the firm out.
Direct Lending Programmes
Finally, the central bank could lend to non-financial entities. The problem is that unless the programme is restricted to large firms, this would greatly increase the need for credit risk management and assessment personnel. That is, the central bank would be acting even more like a private bank, instead of be a bank for a few selected clients (private banks, the central government).
The reality is that a loan is effectively an income transfer until the loan is paid back. Spending government money is the prerogative of the legislature, and I am in the camp that does not believe that this power should be handed over to unelected bureaucrats. To the extent that the central government is in the lending business (and they generally are), the rules and losses are the responsibility of the fiscal arm of the government.
Not everyone agrees with that stance, some people are attracted to the “financial engineering” of using the central bank. This might be necessary in the horror show of the Euro system, but it is unnecessary elsewhere. If a programme cannot attract the support of elected politicians, why fund it? Meanwhile, this would just turn central bankers into punching bags when the programme blows up.
Concluding Remarks
Unsecured lending by the central bank to the private sector is just a means of handing control of the public purse to unelected bureaucrats. Views on the advisability of this are largely a personal political stance.
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(c) Brian Romanchuk 2023
The Central Bank And Government Finance
This article continues the sequence of articles on central banks as banks. This article was as brief as possible since it overlapped my book Understanding Government Finance (available for sale cheaply at online bookstores, and I emphasise that it would be an amazing Christmas present for friends and/or enemies (depending on what you think of my writing)). I might need to expand upon the less obvious points herein if this text does get into my book manuscript.
Central banking largely evolved the way it did due to the exigencies of wartime finance. The central government needs control over its financial operations in wartime, and any attempts to interfere by the private sector would be viewed as akin to sabotage. For a free-floating sovereign (and currency pegs are typically broken during major wars), the system guarantees that the financial flows will continue to flow.
As I discussed in Understanding Government Finance, the system is relatively straightforward, but it is unintuitive if you start with the misconception that the objective of government finance is for the government to “raise money” from the private sector. Instead, the system just allows the government to follow archaic accounting norms while ensuring that payment flows remain circular.
Wholesale Payments System Recap
I will assume for simplicity that we have a wholesale payments system that has counterparties that are only private banks, and the central government, which we divide into the finance arm (“Treasury”) and the central bank. (Since the central bank acts as the agent for the Treasury, it is really on the central bank that is the counter-party, but we need to break out the Treasury for this discussion to make sense.) If the government opened the wholesale payments system to non-bank entities for some reason, we just assume that the non-banks have to follow the same conventions as the private banks. We also assume that payments system balances for private banks will correspond to balances held at the central bank.
We will also assume for simplicity that the private banks are expected to keep their end of day balance with the payments system at $0 (the pre-2020 Canadian system). If the system featured positive reserve balances, then the target ends up being that positive balance, which does not really change the discussion herein — there is just a level shift of the target.
Under the reasonable assumption that the number of private banks is finite1, then the previous assumption implies that the total private sector net balance with the payments system at the end of the day is $0. Since the payments system is zero sum, by implication that implies that the consolidated central government balance is also zero (since it is the remaining counter-party to the entirety of the private banking system).
This then implies that the net money in-/out-flow of the consolidated central government is $0 every single business day. (It might be unbalanced during the day, but it has to be brought back to balance by the end of the day.)
Central Government has to Cancel Out the Treasury
The implication is that if the Treasury has a net financial flow during the day, the central bank has to undertake transactions that generate the opposite flow. (If the target for reserve balances is non-zero, the central bank has to make sure the change in the consolidated government balance matches the change in target level, if any.)
Let us imagine that the government had spend and tax transactions that net out to zero one day, but the Treasury issued $10 billion in bonds. This means that the Treasury has a $10 billion monetary inflow from the private sector — the bonds have to be paid for by the private banks, possibly under the instruction of clients who were the ultimate purchasers of bonds. By implication, the central bank has to have a $10 billion cash outflow for the balance target to be met. If the only assets the central bank holds are central government bonds/bills, it has to sell $10 billion in old securities (or do repo transactions) to match the $10 billion in new issuance.
That is, the central government did not draw in “new money” from the private sector, it just pushed out new securities in exchange for old.
This sounds weird, but it is just how the mathematics works.
No, the Private Sector Did Not “Create” the Money
One of the crackpot anti-MMT lines is that the private sector “creates the money” that pays for the bond issuance. Yes, bank lending creates banks, and those deposits might allow a non-bank client to put in an order at the bond auction. However, you could imagine a strange intermediary firm that allowed their clients to exchange wiener schnitzel for bonds at auction. This does not imply that government bonds are “paid for by wiener schnitzel,” rather, there is an intermediary deciding it likes wiener schnitzel. The intermediary itself has to wire “government money” on the wholesale payments network to the Treasury (technically, the central bank, since they typically run auctions) to pay for the bonds, and the intermediary then deducts the deposit (wiener schnitzel) from their client by agreement.
The private sector always starts the day with a $0 balance of government money — there is no pool of “money” to be drained to pay for the bonds; the central bank has to supply the “money.”
Well, Where Do Bonds Come From?
An alert reader will have noted that the bond auction created exactly zero net government bond holdings during the day — the old bonds that are sold to pay for the new one cancel out the issuance. So, where do bond holdings (which are non-zero) come from?
The answer is not along the lines of “When a mommy bond and a daddy bond love each other…,” rather, we need to drop the assumption of tax and spending cancelling out. If the Treasury runs a payments deficit during the day, it is sending money into hands of the private sector. The central bank needs to cancel that out — by selling bonds that it owns. This creates the net bond flow to the private sector.
As expected, the size of the fiscal deficit will determine the increase of government liabilities in the hands of the private sector (some of which might be banknotes, which need to be paid for by wiring money to the central bank).
Conventional Accounting
The analysis so far has just looked at the private sector, which is the counter-party to the consolidated central government. If we split the Treasury and central bank, we also need to track the balance of the Treasury at the central bank. A sensible society would argue that this balance is purely an accounting construct and can be ignored, but we do not live in that society. Instead, we see that bond issuance increases the balance of Treasury at the central bank. Subsequent deficit spending will tend to run that balance down, and so new issuance is needed to keep the balance positive.
As long as the central bank ensures that interest rate markets are orderly — literally its job — the Treasury will always be able to squeeze out new bonds to keep its balance positive at some price. (I.e., if bond yields go up, interest rate expenses go up.) Default is pretty much only possible if the central bank decides to force the default. (Why “pretty much” — we can imagine non-financial reasons for a default.)
Why Issue Bonds in the First Place?
Anyone writing on this topic on the internet is going to face comments from MMT fans arguing that government bonds do not need to be issued, allowing society to skip the elaborate financial game-playing described earlier. I will now just run through the conventional justifications for bond issuance without endorsing them.
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It is needed to meet the arbitrary accounting rules (a positive balance at the central bank). This is not an economic necessity — changing the rules makes it disappear. I note this as some people refuse to accept that governments can unilaterally change regulations.
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It creates a yield curve to allow the private sector benchmarks for its borrowing. Although this is useful, it is a niche concern.
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The yield curve allows interest rate policy to control the economy. The usefulness of interest rate policy is an ongoing controversy between MMT proponents and pretty much every body else.
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It provides credit risk free assets that are extremely useful for private pension and insurance provision. Given that governments have pushed a significant proportion of voters into private pensions (both defined benefit and defined contribution), this is not an easily reversed policy at this point.
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Having credit risk assets stabilises the financial system. Private sector bond prices melt during a financial crisis; only central government bonds have a hope of retaining their value.
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Ending issuance would put “bond vigilantes” and people who write about government bonds out of work. (Since I am semi-retired, not a major concern for me.)
Concluding Remarks
Central banks were not set up as a charity to employ economists with delusions of grandeur, they are there to ensure the smooth functioning government finance. The system is set up to allow extremely chunky transactions to take place. Ensuring that everybody can pay for cheesy poofs at the corner shop is an afterthought.
With this article out of the way, I can turn away from the structure of central banking and start discussing some of the many controversies about them.
If we have N banks, each with a balance of $1/N, the aggregate balance is $1 as N goes to infinity.
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(c) Brian Romanchuk 2023
Central Bank Balance Sheets
This article continues my series of articles on central banks as banks.
Central bank balance sheets (in the modern era, at least) are relatively simple. There is a split between banks with a currency peg and those without. After that, the key point to keep in mind that the minimum size of the central bank balance sheet is not under the control of the central bank — other actors create a minimal demand for their liabilities. The only freedom of action for central bankers is growing beyond the minimum, which they did not do before the days of Quantitative Easing (QE). The article finishes off with a discussion of consolidation.
This text overlaps material found in my book Understanding Government Finance.
The key driver of a central bank’s balance sheet size is its liabilities. The central bank will have a small sliver of common equity, which in the modern era is owned by the central government. Since some central banks were historically private banks, there are a few cases where some common shares of the central bank are still traded on the stock market — but the central government typically owns the vast majority of the equity, and has control of the institution. There is a lot of silliness about the Federal Reserve being owned by private banks — they own preferred equity, which does not confer “ownership rights” (e.g.. a claim on central bank profits).
The main typical classes of liabilities for the central bank include (not including any trade credit they incur as part of their operations).
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The central government, possibly other governmental entities keep deposits at the central bank. These balances are not part of the “monetary base” and are typically ignored in discussions. Since the central government owns the central bank, the deposit is just one arm of the government owing to an other, so its economic significance to outsiders is effectively nil. (This will be returned to when consolidation is discussed.)
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Government-issued currency (banknotes) are typically liabilities of the central bank. (Private banknotes still exist, such as those issued by some banks in Scotland.) These banknotes can be returned to the central bank in exchange for a deposit liability (by banks). The amount of banknotes in circulation is driven by the needs of households and consumer-facing businesses (as well as the underground economy). Although the level of interest rates might influence the amount of money held as banknotes (they are assumed to do so in neoclassical models), nobody who has not been brainwashed by neoclassical theory believes that the central bank can directly determine the amount of banknotes demanded (and supplied by the government).
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Private banks might need to hold deposits at the central bank as a result of reserve requirements (which are based on the amount of demand deposits). The amount of required reserves is fixed within a accounting period, and the amount of reserves required is driven by the balance sheet decisions of the private bank and its customers. Once again, even if interest rate policy influences the size of private bank balance sheets, it does so indirectly and with a lag — the amount of required reserves in an accounting period is not under the direct control of the central bank. The central bank has no choice but to supply those deposits, as otherwise one or more private banks must fail their required reserve test. That is, the central bank will have caused a bank failure(s) as a result of peculiar policy decision — which is not politically tenable.
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Private banks might not trust each other, and decide to hold excess liquidity in the form of claims on the central bank (excess deposits, a positive balance with the payments system). Private banks doing this is a sign of a financial crisis — a sign that the central bank messed up regulating behaviour. These balances are quite obviously not under the control of the central bank.
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Finally, the central bank can force excess deposits onto private banks (beyond what they need for required reserves and any crisis demand) via purchasing assets. (When the central bank purchases something via an electronic transfer, it creates a deposit balance to the bank of the recipient. That bank can send that balance to another bank, but it remains a deposit at the central bank. The only way to “delete” that balance is to exchange it for banknotes.) These are the only liabilities whose magnitude is under the direct control of the central bank. This means that when a central bank engages in “QE” it can inflate its balance sheet — but can only reverse back to whatever the minimum liability demand is.
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Central banks might “borrow” money in open market operations to reduce reserve balances. This is typically structured as a paired sell-buy transaction on a bond, generically known as a repurchase (“repo”) transaction. This is a change of the mix of liabilities, but does not change the amount outstanding.
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Central banks could issue bonds — but they generally do not. One way of ending the silliness of governments pretending that they have to listen to “bond vigilantes” is to have the central bank issue bonds. This is seen as unacceptable as it would put a lot of fiscal conservatives out of work.
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Central banks owe each other money when they enter into swap line agreements. (Which I ignore for the rest of this article.)
If we look at the Bank of Canada for (most of) the 1994-2020 period, almost the only liability held by the private sector was banknotes — there were no “reserves.” This corresponds to the “simplified system of government finance” I described in Understanding Government Finance.
In summary, most of the liabilities are the result of the decisions of other actors, and the central bank has to supply them. They can crank up the size of their balance sheet beyond the minimum, but it is not clear why that is a good idea.
Assets — Depends on the Peg Status
What assets a central bank holds has an important dependence upon whether the currency is pegged. If the currency is pegged, it is possible for selected counter-parties to redeem the local currency for the peg asset. Since the central bank probably does not want the riff-raff showing up at the front door, this is going to generally be private banks or foreign central banks. In the Bretton Woods system, it was only foreign central banks that had the right to redeem U.S. dollars for gold, but older versions of the gold standard would extend the right to the private sector.
If your currency is redeemable for an external instrument — gold, hard currency — the central bank has little choice but to hold that instrument as an asset on its balance sheet for the redemption promise to be credible. Some academic monetarists argue that the central bank can pin the price of anything via “expectations,” but nobody in their right mind takes those people seriously. How much of its balance sheet needs to be held in the form of the peg asset is an exercise in psychology. If the peg is credible, nobody redeems their currency, and the currency needs little backing. But as soon as the peg credibility is questioned, the central bank needs a lot of the peg asset.
My expertise and interest is with developed countries with non-pegged currencies. (The euro is not really an exception — the member countries are pegged to a non-pegged currency. The member national banks face challenges that are both similar and different to a country with an external peg.) For these central banks, there is no need to hold a “peg asset,” although most have legacy holdings of gold, as well as foreign currency reserves (that are typically with a small weight relative to countries with currency pegs). I will now discuss their asset allocation decision.
Central Bank Assets For Non-Pegged Currencies
The main liabilities of central banks are as liquid as they can get — demand deposits, and bearer banknotes that are redeemable on demand. As a result, the central bank needs liquid assets if there was demand to reduce its balance sheet.
The natural match for the liability structure is a fixed income portfolio. And like a private bank, a central bank can have a good idea how many of its liabilities could plausibly be redeemed, so it can get away with extending the duration of its assets somewhat. That is, it has a portfolio of short-dated fixed income assets that it can sell at close to their balance sheet carrying value to meet redemptions, and another portfolio with more duration that could be liquidated slowly if necessary.
We then run into the question: should the assets be debts issued by the central government or the private sector? What type of fixed income instruments?
This used to be a controversy, leading to ideas like the “real bills doctrine” (which I am going to let the reader look up on the internet if they are not familiar with it). However, World War II and mainstream economic thinking led to central banks holding balance sheets that were 100% central government bonds and bills, as well as repurchase agreements on those bonds. Then, the Financial Crisis of 2008 hit, and central banks ended up buying a variety of private sector assets (of varying dubiousness) as part of a programme of “de-risking” key parts of the financial system.
I might return to the debate about the purchasing private sector assets by the central bank later. I will just finish off this line of thought with the concept of seigneurage (which has alternate spellings “seigniorage” and “seignorage”). The rate of interest on currency notes is 0%, as also was the case for required reserves at the Federal Reserve. The central bank is holding a portfolio of fixed income assets that people hope earn a positive rate of interest. This implied that the bank should run a steady profit — at least as long as the New Keynesians with their negative interest rates are kept away from the rate decision committee. This profit was called seigneurage, harking back to the cut the sovereign took when precious metals (including foreign coins) were minted into coins at the royal mint. However, this is not a profit created by the minting of new money, rather it is the carry generated by the central bank portfolio versus its 0%-costing liabilities. (The advent of QE has meant that central banks were forced to pay interest at close to the policy rate on deposits at the central bank, turning them into de facto overnight bills issued by the central bank.)
Consolidation
Consolidation is an accounting term referring to merging the balance sheet of a wholly-owned subsidiary onto its parent company. (Wholly owned means that the parent company owns 100% of the common equity of the subsidiary.) Instead of presenting two balance sheets, the two balance sheets are added together — but with intra-company entries netted out. This netting needs to be done to avoid double-counting entries, and to ignore “ghost debt” that is purely an intra-company affair.
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If the subsidiary has $100 in equity, that would show up as a $100 asset on the parent’s non-consolidated balance sheet, which would imply a corresponding $100 in equity in order for the balance sheet to in fact balance. If we just merged all the balance sheet entries, that $100 equity would show up twice, as it appears on both non-consolidated balance sheets.
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If the parent lends money to the subsidiary (or vice-versa), it might matter for tax purposes or in a bankruptcy, but otherwise, it is the parent company lending money to itself. If the subsidiary defaults on the debt, so what? The parent owns it already.
Any time you pick up the balance sheet of a multinational corporation, you are looking at a consolidated balance sheet. Even bush-league multinationals will end up with thousands of corporate entities across multiple jurisdiction due to the magic of international tax accounting and financial engineers run amok.
We then get to central banks. Modern developed central banks are wholly-owned subsidiaries of the central government (or almost wholly owned in oddball cases like the Bank of Japan). Under generally accepted financial accounting standards, the central should be consolidated with the central government. This means that intra-governmental debts — like deposits — should be netted out to zero. And for the purposes of economic modelling, we should consolidate since the intra-governmental transactions have no effect on the rest of the economy.
We can interpret seigneurage in two ways.
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If we do not consolidate, the central government issues debt, the central bank buys some in order to supply money, then the central bank returns the carry profits to the central government. This carry offsets some of the total debt issuance.
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If we consolidate, we just look at the amount of government debt and money held by the private sector, since the central bank’s holdings of government bonds nets out with the associated liabilities of the central bank. The interest expense is reduced relative to the gross issuance of debt, some of which was bought back by the central bank. There is no need to add in “seigneurage income” into projections of government revenue — we just calculate interest expense based on the mix of money/debt held by the private sector.
There is no doubt that consolidation is cleaner and eliminates problems in economic models. One of the issues with mathematical modelling of the economy is that there is a large number of variables to track, and non-consolidated balance sheets add yet more variables. Furthermore, we need to add behavioural relationships that determine the intra-governmental transactions. The problem with that is that those transactions have no effect on the rest of the economy, and so there is no means to pin down those behavioural relationships.
Please note that the previous statements are less true if the central bank is managing a currency peg. In that situation, the central bank can default (on its redemption pledge), and so we need to model the default process. Similarly, the only reason to care about the non-consolidated balance sheet for a non-pegged currency is if you can come up with a plausible default scenario (which I generally cannot).
Nevertheless, whether or not one can consolidate the central bank with the central government is a stupid economic debate. The objections generally come from critics of Modern Monetary Theory (even though other people like central bankers will consolidate for convenience) based on crackpot theories or bad faith attacks. As stated, it is a stupid debate — I certainly can consolidate the central bank, because I know how accounting works. Consolidation is not necessary for any conclusions, since a well-defined model will give exactly the same results for the non-governmental variables regardless of whether you consolidate or not. You consolidate because it is easier, and you do not do it if you are worried about the central bank/government defaulting.
Up Next?
I have run through most of the basics, but I have at least one more background primer before I get to more exciting central bank debates.
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(c) Brian Romanchuk 2023
Central Bank Banking Basics
This article continues the plan outlined in the previous article “Central Banks as Banks.” As I described therein, this is projected to become a chapter within my banking primer. I am not going to describe private banking — as that is the job of other chapters — but I will cover the issues of inter-bank transactions. This article is about fundamentals that we normally do not think about.
As the name suggests, central banks are at the centre of the banking system. The objective of a well-run banking system is that you do not have to worry about how it works. So long as everything under the hood is operating, you do not need to enquire how the money gets from one account to another. By not worrying about those details, we tend to only focus on the flashy bits of central banking (e.g., trying to hit an inflation target) instead of the banking system regulation part.
“Peer-to-Peer” Monetary Exchange
We need to step back and ask: why banks? If we assume that we have a monetary economy, why not have a system where individuals and firms directly transfer “money” to each other without intermediaries?
For some people, this sounds ideal — we have an economy where people pay for everything by handing each other lumps of gold, or directly transferring crypto currencies. However, for law-abiding citizens, this is unattractive — precious metals (and paper claims on safeguarded gold) present theft risk, and making large transactions would be unattractive. (Popular media like the movie Spartacus had the Romans making large commercial transactions with sacks of gold coins; they had the economic equivalent of banks — as discussed in “The Monetary Systems of the Greeks and Romans,” by W.V. Harris.) The inability to sue to recover crypto-currencies makes them also useless for large commercial transactions, as well as poses risks around losing passwords (or heirs not having access to a password).
Although economic theory suggests that everyone “wants to hold money,” in a sophisticated economy where there is trust among economic actors, people want intermediaries of some sort to hold most of the “money.” This means that most “money” ends up being a credit relationship.
One Intermediary
The simplest possible system for intermediation is to have a single intermediary. Everyone would hold accounts with that one intermediary, as well as holding bearer certificates (e.g., banknotes) that are convertible to claims on that intermediary.
This intermediary is almost certainly going to resemble a bank, and the only question is who owns it.
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Foreigners: you have adopted a foreign currency. Although this might be acceptable in some countries with poor inflation performance, it is not going to be popular in countries used to economic sovereignty.
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The private sector. Although some free marketeers might like this, this is not a stable long-term arrangement. This private monopoly intermediary would stand in the way of war finance, and as soon as an existential war risk is faced, that entity would be nationalised.
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It could be a public central bank — in a system where there are no private banks. This is popular with some people, many of whom comment on my website. I am not in that camp, as I believe that a well-regulated banking system (integrated with non-bank finance) provides the least instability in capitalist finance. (Finance is inherently destabilising, so all we can hope to do is keep the instability somewhat contained.)
Once we exclude these possibilities, we end up with a situation with multiple intermediaries.
Multiple Intermediaries Leading To Central Banks
If we have multiple intermediaries, we run into an immediate problem. What happens if the two sides to a commercial transaction use different intermediaries? (If they use the same intermediary, then the intermediary just adjusts the two balances without requiring any external transactions.)
We end up with the intermediaries facing the same problem that law-abiding citizens faced: they need to transfer the underlying “monetary asset” between themselves to allow transactions to go across them. If “money” is a precious metal, this means that there will be regular shipments of highly valuable metal, which poses theft risk.
The way to clear these problems up are to have “senior” intermediaries that clear transactions for smaller ones. Client transactions are cleared through a system of connected intermediaries. There is no requirement that there is a single “most senior” intermediary, but we will now get to reason why developed countries moved in that direction.
What is Money?
We now need to face the question: what exactly do our monetary units correspond to. There are two cases.
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Pegged currency. The monetary unit is pegged to some external unit, either gold, or a hard currency. (Or possibly a gold-linked hard currency.) The value of the local currency is driven by the credibility of the peg, which typically requires holding backing assets (or generating a considerable trade surplus that allows it to credibly draw in backing as needed). Although there is a convenience factor to there being a central intermediary, it is not required.
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Unpegged currency. The monetary unit is the unit of account on a senior intermediary. Since that senior intermediary can create the unit of account at will, it is going to end up as the “central bank.”
In the second case, there is no requirement that the central issuer of the currency be a government, but it seems unlikely it would be anything else. Historically, we had somewhat out-of-control corporations like The Hudson’s Bay Company that could get away with issuing tokens and maintaining the value of those tokens, but that was really only possible because the Company was acting as a de facto government. Otherwise, only the more gullible members of the public would take too seriously an unbacked private currency. (Although the crypto-currency craze has shown that such people exist.) Meanwhile, the spectre of war finance means that the government will sooner or later be the monopoly issuer of the (base) unit of account (leading into standard MMT primer topics).
My interest and focus is on developed economies that have non-pegged currencies (with the Franken-currency of the euro being a sort-of exception). Although the mechanics of a pegged and non-pegged currency might be superficially similar (e.g., there was no major domestic shock to operating procedures when Nixon closed the Gold Window), how the systems behave in a crisis is radically different.
Wholesale Payments Systems
I will now finish off with some general comments about wholesale payments systems. (Retail payments systems — how consumers pay for stuff — is not in my area of interest.) A payments system allows members (typically banks, but lobbyists are pushing for opening up to non-banks) to transmit large blocs of money to each other.
Each currency bloc has its own system, and there is also the issue of transmitting money to other currency blocs. The systems are complex, and most discussions are aimed at the handful of entities that interact with those systems. Given the variance across jurisdictions and my views on their economic impact, I will not attempt to delve into the subject.
The key observation is that the payments system is supposed to be a means of transmitting cash from Entity A to Entity B by the end of the day. Assuming everything goes well, all the payments into and out of the payments system net out to zero. As such, the balance sheet of the payments system is supposed to be effectively zero (beyond whatever infrastructure is on its balance sheet).
The risk that everyone worries about is that a big member fails, and then the payments might not net out to zero. Somebody owes a member money? Who? How is the debt resolved? Given that it is unclear what the bankruptcy judges will say, it is extremely likely that everyone involved would try to freeze transactions — causing a near-instant collapse of the system.
Since it is clear that a non-deranged central bank would view that as a very bad outcome, the payments system would end being bailed out. That is, the wholesale payments system is too big to fail — and properly should be seen as a contingent part of the central bank’s balance sheet.
This leads us to the simple (and standard) way of looking at inter-bank transactions: we assume that they are intermediated directly on the central bank’s balance sheet. If Bank A directly wires money to Bank B, we think of it as Bank A running down their settlement balance at the central bank, and Bank B raising theirs.
There is no need for the balances to be positive during the day. If we take the pre-2020 Canadian system as an example, the target for end-of-day balances was $0. (This is the “simplified system of government finance” that I described in Understanding Government Finance.) That is, the bank starts with a balance of $0, sends and receives money based on client orders (and its own transactions) during the day, and then the bank treasury desk needs to get the balance back to $0 at the end of the day (by undertaking some wholesale transactions). Unlike fairy tales spread by unreliable sources (mainly economic academics), banks do not wait for a positive balance before sending money out — if everyone did that, the system would be frozen at the beginning of the day.
This system is extremely useful for clarifying thinking: banks are sending “central bank balances” back and forth all day, even though their net holdings at the end of the day are expected to be zero. That is, we cannot look at the balance sheet entry (which are end-of-day) to infer anything about “transaction capacity.”
Reserves — Largely an Anachronism
One of the unfortunate side effects of American cultural imperialism is that the most popular undergraduate economics textbooks were in fact written by Americans. Balances at the central bank were called “reserves” for the very good reason that there were almost entirely required reserves. Banking regulations insisted that banks end the day with a target settlement balance, with that target based on the size of their deposit balances (based on arcane distinctions between types of deposits). This balance was a “reserve” allegedly against liquidity drains (not to be confused with loan loss reserves). However, since the funds were immobilised, all they really did was act as a tax on the bank back when reserve balances did not pay interest.
Eventually, the Americans followed the path of other developed countries and effectively abolished reserve requirements. Whether or not people will stop calling settlement balances “reserves” remains to be seen.
Up Next?
Although I might jump to a completely different topic, I think the next article will be about central bank operations and/or its balance sheet structure.
Email subscription: Go to https://bondeconomics.substack.com/
(c) Brian Romanchuk 2023
Inflation: Facts & Pernicious Myths
Edited: I meant to add a number of articles to the page on Inflation. Then it turned into more. I think readers will find it worth their time.
Are Major Central Banks Doing Enough to Fight Inflation?
— James K. Galbraith Project Syndicate April 14, 2022
He begins “Say what? Seriously? OK, I’ll give it a try, but promise me this is not a joke…The notion that central banks fight inflation is a pernicious myth, spread by their officers, acolytes, and by credulous reporters. Central banks raise interest rates. The blather about inflation is eyewash.”
Beware the Inflationary Bogeyman • Recent price increases in the U.S., and demands for a forceful response by the Federal Reserve, have brought back memories of the 1970s and all of the economic and political disasters of those years.
— James K. Galbraith Common Dreams, Project Syndicate – November 20, 2021
CPI, commodity charts Quite a few price increases, which the media now calls ‘inflation’ even though inflation is a continuous increase in the price level.
— Warren Mosler (@WBMosler) Mosler Economics/Modern Monetary Theory Nov 12, 2021
An MMT Perspective: Interest Rates and Inflation with Warren Mosler
— Warren Mosler (@WBMosler) Real Progressives June 26, 2021 (01:05:31)
Manhattan Project to prevent Hyper-Inflation
— J.D. Alt New Economic Perspectives March 26, 2020