Monetary financing by central banks is a bad proposal
Government debt cancellation would be bad old wine in elegant new bottles
by Mojmír Hampl
Wed 23 Jul 2014
On 4 July, Meghnad Desai and David Marsh published a thought-provoking and provocative article Options for QE exit. Their proposal that the Bank of England should effectively ‘cancel’ a large chunk of the UK’s debt by transferring the government paper it has acquired back to the UK Treasury is quite similar to the idea of burying debt forever in the European Central Bank (ECB) as presented last year by Pierre Pâris and Charles Wyplosz.
The biggest obstacle to this plan, according to the authors, is that it would cause the central bank to incur a loss and put it into a position of negative equity. Speaking from personal experience, I would regard this as the smallest obstacle. The central bank is by definition the only institution in the economy that cannot default on debt denominated in the currency it issues, and as such it can live surprisingly well with negative equity.
The Czech National Bank has lived for years with negative equity of up to around 5% of GDP without experiencing any ill effects on its reputation or operation. The Slovak central bank adopted the euro comfortably with an uncovered loss and is still functioning happily within the euro area, even though its accumulated loss still makes almost 25% of its balance sheet. Other central banks around the world are in a similar situation.
The idea that an accumulated loss threatens the financial independence of the central bank used to be promoted vociferously by Jürgen Stark, a former ECB executive board member who, in the face of opposition, even managed to get it incorporated into the ECB’s convergence reports. This illogical idea appeared to have been no more than a vain attempt by Stark to make it more difficult for new countries to join economic and monetary union (EMU) in the future.
Contradicting the attacks made a few years ago on our colleagues at the temporarily loss-making Swiss National Bank, the Czech National Bank’s long experience with negative equity shows that, if everyone gets used to the idea of not expecting the central bank to return a profit, its independence can be strengthened rather than weakened.
Yet a central bank’s ability to live with long-term negative equity does not mean it should deliberately create negative equity in the manner advised by Desai and Marsh. We could perhaps discuss this idea if it formed part of a ‘big bang’ – a fundamental reform of the financial system of elastic money.
We could consider cancelling the debt once and for all and then moving towards some variation of the Chicago plan. In other words, we could completely abandon elastic money and instead view debt destruction at the central bank as a symmetrical counterbalance to the situation where the central bank creates money and debt in good times with the aid of the monetary system.
In such a case, however, we would need to ask first why government debt should be destroyed in preference to private debt created in the same way in the same monetary system. Why shouldn’t the ‘big bang’ also apply to borrowers via mortgages and consumer credit?
Performing a manoeuvre such as government debt cancellation without changing the system would be a classic case of inconsistent policy. It would be difficult to implement more than once without permanently undermining confidence in the system as a whole and without destroying the fundamental belief that debt should be repaid.
Why would anyone repay their debts if there was an elegant means of deciding, in a majority vote, that debts should not be repaid, but rather destroyed en masse every now and again on the initiative of the government? I am alluding here to the ostensibly semantic problem where Desai and Marsh assert that the central bank is ‘owned’ – and therefore controlled – by the government.
I this really so? Standard central banks around the world might be public institutions and be part of the state (even though in many countries they also have private owners and shareholders), but they are not ‘owned by the government’. Indeed, they are supposed to be independent of the government and its instructions. In other words, the government should not even have the theoretical ability to ask the central bank to do what Desai and Marsh are proposing.
As I understand it, all the difficult and sometimes controversial decisions that central banks – including the Czech National Bank – have made at times of crisis have been instigated by central bankers themselves, not by governments.
At their own behest, and to fulfil their mandates, central bankers have freely and independently taken actions such as quantitative easing (QE) and intervention against their own currencies. If that were not the case, or if it ought not to be the case, as Desai and Marsh suggest, we would no longer be discussing the nuances of whether central banks sometimes risk overstepping the fine line between monetary and fiscal policy. No, the authors’ proposal would mean that the central bank and the government are one and the same. And that is quite hard to accept.
I believe that their proposal is nothing more than a technically more elegant variation on the same theme that plagued Europe in the 19th and 20th centuries, namely monetary financing of the government by the central bank.
For sound historical reasons we in developed economies have banned this hard and highly addictive drug which brings so much delight in the short term yet so much ruin in the long term. History often repeats itself, but it doesn’t have to. When you see bad old wine in elegant new bottles, it is sometimes best to leave the bottles unopened.
Mojmír Hampl is Vice-Governor of the Czech National Bank. This article is the latest in an irregular OMFIF series on the size and make-up of central banks’ balance sheets.
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