Central banks around the world have been purchasing huge quantities of high-priced government bonds, whose value – as a result of their own interest-tightening actions – has subsequently fallen precipitously. Unfortunately, they have given encouragement to private financial institutions to follow suit, with harmful consequences. Central banks, far from promoting stability, have thus delivered a masterclass in how to organise a financial crisis.
We observe a contradiction between intentions and results. It reminds me of Goethe’s classic tale of the sorcerer’s apprentice whose clumsy use of magical powers produces an uncontrollable trail of disaster.
Through this chain of events, central banks have weakened their own balance sheets, as well as their reputation and independence. As they struggle to deal with inflation, the decline in central banks’ credibility can be reversed only if they are able to restore stable prices.
The proximate cause for this sad state of affairs has been the extended period of quantitative easing by major central banks. This continued for at least six months longer than necessary between 2021-22, despite an upsurge in inflation evident well before the outbreak of the Ukrainian war in February 2022.
Central and commercial banks alike have amassed risk by building up unjustifiably long positions in government bond markets on the misguided assumption that these instruments were secure from significant fluctuations in value. The losses that have occurred at Silicon Valley Bank and other institutions were sparked by price declines in government securities deemed to be riskless.
Unlike central banks, commercial banks must price their bond holdings at market valuations, making them vulnerable to depositor flight – a danger that central banks do not face.
The central banks’ holdings are not marked to market under the accounting convention that they are held to maturity – even though they are part of monetary portfolios, which could – and no doubt should – be sold before then.
The episode is reminiscent of a professor asking his students to work out a mechanism for a financial crisis. The pupils recommended that a central bank decides a strategy that has now been followed by some underperforming commercial banks as we have seen recently in the US.
These banks bought securities at high prices bid up by central banks’ own previous bond-buying actions. The commercial banks understood that those securities would be protected from sharp price falls, in view of oft-repeated ‘guidance’ that interest rates were unlikely to rise markedly. The central banks did not point out that, if this assumption proved incorrect, the financial construction would be destroyed. In fact, the bet was highly likely to go wrong. By reducing interest rates to close to zero and continuing QE for an unreasonably long period, central banks increased credit and demand in the economy, which was likely to lead both to inflation and to speculative investments that would eventually go sour when interest rates eventually rose.
Contagion between central banks and commercial banks
The result has been contagion between central banks, which are protected from risk by their constitutions, and commercial banks, which are not – especially if they operate in an ill-regulated environment and are badly managed.
The losses on the central banks’ books are high in purely balance sheet terms. Arguably, they are of limited economic and political significance because central banks are not subject to the normal codes of accounting and bankruptcy. If central banks ever needed recapitalisation, they would need to call for funds on terms which would be impaired by the poor state of central banks’ balance sheets. This would pose a problem for the European Central Bank, whose shareholders are not governments but national central banks that would have to seek funding from taxpayers in ways that could spark political problems.
By their management of monetary policy, central banks have contributed to inflation and helped to undermine the financial system. Unfortunately, there may be more problems ahead. To control inflation, economic and credit growth must slow. Even after the tightening of the past nine months, interest rates in real terms remain significantly negative in Europe. This produces a dilemma that is detrimental to central banks’ independence.
When I was governor of the Banque de France, I was legally under the control of the Treasury since the bank had not yet attained its independence under the legislation for the setting up of economic and monetary union. However, I resolved that, if my finance ministers wanted me to do something against my principles, I would resign.
This is better than the situation we have now, where central banks are legally independent, but in factual terms are heavily involved in fiscal matters and dependent on financial markets. The most likely outcome is a bout of stagflation. This will be favourable for debtor governments but unfavourable for the creditors – a constellation that will produce its own set of political and economic strains.
Jacques de Larosière is a former director of the French Treasury, managing director of the International Monetary Fund, governor of the Banque de France and president of the European Bank for Reconstruction and Development.