Contribution to the panel The Eurozone crisis: Fiscal profligacy or capital flows as final causes
As the ECB begins this week its Public Sector Purchase Programme (PSPP), also known as QE, banks in the Eurozone begin selling a variety of sovereign bonds and securities from European institutions and national agencies to their National Central Banks. The sales will be settled in “central bank money“. So the question today is: Do we know what central bank money is?
This is my brief explainer (forthcoming in The Encyclopedia of Central Banking, coedited by L. Rochon and S. Rossi).
1. What is central bank money?
Central bank money (CBM) is a liability on the balance sheet of the central bank denominated in units that are given the name that defines the currency. So, one dollar is a unit of liability of the Federal Reserve System, and one euro is a unit of liability of the Eurosystem. This central bank liability is an asset to anyone holding it, either in the form of a credit balance in the holder’s account at the central bank or in the form of a physical object (a banknote).
In either form, CBM is valuable because it is, by law, the only means of settlement of any payments due to the central bank or to the government. This means that CBM is redeemable by using it as a means to reduce our debts to the central government. This makes it a generally desirable settlement asset also with parties other than the central bank or government, as its holder trusts that it will be accepted by others as a means of fulfilling payment obligations. In addition, there may exist legal tender laws declaring that the legal system recognizes banknotes as a means that, when offered in payment of any debt denominated in the currency unit, must be accepted as payment and that extinguishes the debt.
We now turn to the differences that exist between the two forms of central bank money: banknotes and credit balances at the central bank.
A banknote is a physical object that provides a means of extinguishing debt with no intermediary. It is typically preferred for small-value payments when the transaction cost of alternative means is proportionally large or to prevent the tracing of transactions when parties desire anonymity of payment for privacy, tax evasion, or other illegal reasons. Note that coins function in the same way except that coins are typically issued directly by the treasury office of governments and therefore are technically “state money,” not CBM.
The quantity of banknotes outstanding at any given time includes banknotes in circulation held by the non-bank public and vault cash in banks’ storage. This quantity is demand-driven: the central bank supplies banknotes to the banks to remove unfit banknotes and coins and to meet bank clients’ requests.
Because a banknote is an object and must be produced, the central bank provisions itself with printed banknotes and ships them to banks when needed. Banks distribute banknotes to their clients as they demand them. When banks need more banknotes to meet the public’s demand, they request them from the central bank and have their accounts at the central bank debited for the corresponding amount. When banks hold more banknotes than desired, they return them to the central bank, which in turn credits their accounts.
3. Credit balance at the central bank
A credit balance at the central bank is a claim on the central bank that may be held only by a limited range of entities to which central bank accounts are available. These typically include licensed banks, the government, foreign central banks, and international financial institutions such as the International Monetary Fund, or the Continuous Linked Settlement Group (for foreign currency settlement). Authorized holders of accounts at the central bank can transfer their balances to other holders, in which case the central bank will debit the account of the payer and credit the account of the recipient. Thus, the main difference from banknotes is that banknotes circulate freely, while credit balances can be transferred only between authorized holders. One can view banknotes as a credit balance at the central bank that circulates as a physical document that may be handed directly to others as a settlement asset.
Not being physical objects, credit balances are not manufactured like banknotes and come into being as credit entries recorded on the account of the holder. A newly credited unit of CBM in this form (namely one that is not a counterpart of an equivalent debit on the account of another holder) comes into being only when the central bank makes a payment (like a purchase, a loan, or an interest paid) to one authorized holder. Likewise, a net reduction of balances results from every payment that the central bank receives from its account holders (like a sale, a loan paid off, or interest charged).
Those credit balances that are held by licensed banks provide banks with a settlement asset for their bank-to-bank transactions. The accounts where banks hold such settlement balances are known as “reserve accounts” or “bank reserves.” Although the term “reserves” suggests the notion of funds set aside for future contingencies, banks use such balances daily to fund payments. They are preferably designated “bank liquidity balances.”
A bank uses these assets as settlement balances with other banks through the interbank funds transfer system, an infrastructure that permits the storing of records of balances owned by banks and the transfer of funds from one bank to another. In such a system, banks hold funds at a common agent (the central bank acting as “settlement institution”), while payments between banks are made by exchanging the liabilities of the central bank. A bank is normally permitted to loan such assets to other banks.
Accordingly, bank liquidity is a component of the overall credit balances at the central bank. Its overall amount changes in response to every payment banks make to or receive from the central bank or other non-bank holders of central bank money, notably, the government. Hence, an expense incurred by the government adds to bank reserves, while a tax paid to the government or the purchase of newly issued government securities drains bank liquidity.
Today, Italian media published the news that prices in January were 0.6% lower than a year ago, calling such deflation a disease, a contagion. The fact that a component of deflation is the falling price of oil should be good news for an oil-importing country such as Italy. But no! National TV (RAI) insists that deflation is a nightmare, and other media wish for inflation to come back thanks to Draghi’s QE.
Some call deflation a national emergency and yet, they seem to have a hard time explaining why prices getting lower is such bad news. Indeed, it seems that they can’t explain it, at least not until they no longer confuse the symptom for the disease.
One explanation they give is that deflation means lower GDP at current prices, and this makes the Debt/GDP ratio look bad. This should speak for how foolish the Debt/GDP rule is, rather than be a real cause for concern. To me, bad news is any economic indicator that tells me something bad is happening to the real standard of living of people. Unemployment at 13.4%, and youth unemployment at 43.9%: Let’s talk about this nightmare (not to speak of Greece’s nightmare squared).
Another explanation is truly peculiar (but well known to economists who are familiar with the expectations hypothesis). In such a view, deflation is bad because consumers expecting falling prices postpone their spending and cause the current prolonged stagnation. Well, actually, if Italy’s deflation were caused only by falling oil prices, there would be reason to celebrate, and no reason why the ECB should want to take us back to 2%, except another foolish rule. If the VAT were cut by 50%, deflation would get even bigger, at least for a one-time adjustment. Yet, consumers would be much better off.
Deflation is a symptom
When domestic prices fall because imports like oil get cheaper, deflation is a (good) signal of better terms of trade. No nightmare, no contagion. Italy’s current deflation partly reflects this positive (to Italy) opportunity.
Current Italian deflation is a problem because it reflects the fact that wages are stagnant, and wages are stagnant because demand is stagnant, and demand is stagnant because private debt is not capable of funding investment, and public debt is prevented (by the Debt/GDP rule discussed above) from doing so.
The point of Draghi’s QE is not the amount. It is the principle.
It is not the much discussed size of the ECB operation. Rather, it is the fact that the ECB has become a buyer of government bonds issued in the countries that are members of the Eurozone.
This is the really big news in the Eurozone where, until last week, the ECB’s monetary operations did not include the possibility of trading in the government securities market in the same way the Fed, the Bank of England, or the Bank of Japan do.
With QE, the ECB has become an actor in the government securities market and, as happens in the U.S,, the U.K., or Japan, this provides continuous liquidity to the bonds being traded, removing default risk.
The ECB could have achieved this same goal without QE, simply by announcing that it would enter the government securities market in its monetary policy operations. Technical and political circumstances were such that Draghi achieved this same result through an operation called an expanded asset purchase programme. While Draghi sold this program as being inflationary (meaning, it will help restore a below-but-close-to 2% inflation rate), in fact it is not (the ECB will spend 60 bn euros each month to buy 60 bn euros of private and government securities), and yet what really matters and what makes Draghi’s QE announcement historical is the fact that the ECB has become an actor in the government securities market of the Eurozone.
Because Draghi’s QE removes default risk from government debt, deposit insurance (now funded at the national level) becomes more credible, and TARGET2 imbalances will get smaller.
QE will not last forever. But the new attribute of the ECB as a dealer in government bonds is here to stay.
The single truth and sure result of last week’s SNB move is that, from now on, the value of the Swiss franc will be the outcome of “market forces”.
Any policy aimed at lowering the national currency value (and thus its purchasing power for foreign products) is justified to support exporters. It is not the right policy for increasing national employment and living standards. As far as the public interest of Switzerland goes, there is no reason to cry over Thomas Jordan’s decision. (If you had borrowed Swiss francs massively to invest into dollars or euros, that is your problem.)
The SNB also lowered interest rates further down into negative territory. And this is more problematic to the well-being of Switzerland. Negative rates are no stimulus to the economy. A negative rate is a tax on banks and their clients and has a contractionary effect on demand, incomes, and jobs.
It is now too early to judge where the market-determined value of the Swiss franc will go. It is possible that once all the hedged positions around the world are cleared, it will stabilize not too far from where it was.
But in case it doesn’t, and the Swiss franc remains 15-20% more expensive on currency markets with big negative rates, Swiss producers are likely to face a drop in sales of some consequence. An increase in domestic demand is thus needed to prevent a decline of incomes and jobs in Switzerland.
The economics of the flow-of-funds tell us that this can only happen in conjunction with a further increase of either private or public debt. Given concerns with high household debt in Switzerland, a policy that removes the debt brake from public investment in infrastructure looks the most attractive approach for enhancing employment, incomes, and productivity.
In February 2011, I was in the audience of a lecture given by John Taylor on the “exit strategy”. One main theme was that the policy of the Fed called “Quantitative Easing” meant a high risk of monetization and inflation, if not hyper-inflation, in the U.S. economy. In the Q&A session, I asked Professor Taylor why he thought that “monetization” is inflationary. I argued that Quantitative Easing boils down to portfolio shifts in banks’ balance sheets, and that asset reallocation does not seem to be causing an increase in demand, nor a price increase. Continue reading
SIR – You described the ECB as moving forward at “breakneck speed”, while businesses and workers in the Eurozone are not doing likewise (“Busy, busy”, September 4th). But more should be said about the trajectory along which the ECB seems to be advancing so quickly. As the ECB embarks on QE, you note that the ABS market is “simply too small” to boost growth and the sovereign bond market, while large enough, is politically unfeasible.
I would raise a more fundamental question: What does the ECB expect to achieve by removing (from banks’ balance sheets) assets carrying positive yield and replacing them with “reserves” (that now yield a minus 0.2%)?
The notion that QE encourages bank lending and that reserves multiply into bank loans is flawed. A number of academic and practitioner articles have dispelled the myths surrounding money creation and QE. If this is true, then the ECB may be moving at “breakneck speed” toward a brick wall.