In economic policy nowadays, the unthinkable suddenly becomes the inevitable, without pausing for long in the realm of the improbable. Nowhere has this been more true than in central banking, where the recent huge expansion in the size of balance sheets would have seemed inconceivable as recently as four years ago.
Markets have not only accepted this use of the printing press with equanimity, they have become increasingly dependent upon it. Most economists are also very relaxed about it, frequently describing it either as inconsequential, or even as entirely irrelevant. But how can a policy intervention which has underwritten the liquidity of the entire western banking system be described as irrelevant?
I do not share the alarmist view that an explosion in central bank liabilities must inevitably lead to higher inflation. That basic monetarist link has already been shown to be invalid, at least over short periods, and at least when a liquidity trap is in operation. However, the recent use of central bank balance sheets has been so unusual and potentially so profound that the underlying economics deserves much more careful examination than it has been receiving lately.
Not only has the unthinkable become the inevitable, it has also become the unprecedented. Central bank balance sheets have often expanded very rapidly in the past, but this has almost always been accompanied by a similar surge in inflation. The recent explosion in central bank liabilities is unprecedented because it has neither been caused by a prior rise in inflation which is then accommodated by the central bank, and nor has it in itself triggered a subsequent burst of inflation. Consequently, the correlation between the monetary base and the rate of inflation, which usually works in both directions, has broken down.
The current monetary policy setting, which involves a deliberate increase in the central bank balance sheet as a means of rescuing the banking system, and thereby avoiding deflation, is virtually without precedent. The one exception which I can find to this rule is the case of Japan from mid 2000 to 2005, when the Bank of Japan’s balance sheet increased by more than 50 per cent, without this having any discernible effect on inflation or other economic variables.
However, the recent rise in central bank balance sheets in the US, the eurozone and the UK have all been much greater than that in Japan a decade ago. And it has occurred on a global scale.
There are two reasons why this has happened.
First, the central banks have engaged in their traditional role of 'lender of last resort', except on a much greater scale than ever before. Liquidity injections, in the form of repo agreements with the private banking sector, have been the main factor here. Under these agreements, private banks have received central bank liquidity in exchange for collateral in the form of government and other (increasingly risky) debt instruments. These arrangements have replaced the funding which banks normally acquire via the money markets, which have largely dried up since the credit crunch.
In the absence of these injections, private banks would have been forced to delever their balance sheets in order to remain liquid. In all probability, some would have gone bankrupt, causing contagion throughout the financial sector and the economy at large. While no one doubts that these central bank actions have been necessary, they have lasted much longer than ever before.
It is not much of an exaggeration to say that large parts of the financial sector have been quasi-nationalised. As liquidity injections have become semi-permanent, the private banking sector has existed only at the mercy of the central banks, and the distinction between solvency issues and liquidity issues in the private sector has been increasingly blurred. The rise in the central bank balance sheet has prevented the need for further, and more overt, injections of capital into private banks by governments, and therefore by taxpayers. Whether this alternative would have been politically feasible is a moot point.
Second, the central banks have purchased enormous quantities of government bonds outright. In this earlier blog, I calculated that around one half of the bonds issued to fund the budget deficits of the US, UK and eurozone since 2008 have been acquired by the Fed, BoE and ECB.
For the most part, this has been described as a deliberate effort to ease monetary policy, after short rates have hit the zero bound. The idea has been to change the mix of fiscal and monetary policy, with the former being tightened (because of perceived constraints on government balance sheets) and the latter eased. The fact that the central bank is just an arm of government, and that the balance sheet distinction between the two is therefore just a fiction, has been glossed over.
Accordingly, central banks have engaged in outright purchases of government debt from the secondary market. Although this has enabled them to claim that they are not "directly" financing governments through monetisation, that is in fact exactly what they are doing, albeit at one remove. The consequence has been that the private bond market has had to absorb much less long-term government debt than otherwise would have occurred, and the bond yield has been held down as a result, perhaps by as much as 100-200 basis points. The discipline which might otherwise have been imposed by the 'bond market vigilantes' has therefore been held in abeyance, at least for a while.
The short-term advantages of this rescue job by the central banks are obvious to all. The longer-term consequences are much less obvious.
Copyright The Financial Times Limited 2012.