Imagine you’re a smart young rich kid. You invent a money-printing machine. You use it to magic up money to buy $100 in assets. It turns out, though, you didn’t make a great investment and the assets end up being worth on $90.
Do you (a) Be grateful that you’re $90 better off or (b) Call up your Dad to tell him you need $10 to make up your losses?
The debate about potential ECB asset purchases continues to focus incessantly on the issues surrounding potential losses, with the ECB playing the role of the rich kid asking his Dad for an unnecessary bailout.
Take this from my old mate Hans Werner Sinn (via Constantin Gurdgiev).
Apparently tax-payers will have to make up for a shortfall of profits from the ECB if there are losses on ABS purchases. In saying the ECB will have reduced profits, Sinn focuses solely on losing the $10 and forgets about the $90 profit.
One could question whether money creation by the Eurosystem is really just pure profit. Doesn’t this expand the supply of liquidity to the banking system, increasing the amount of money on deposit with ECB and thus increase the interest payments it has to make to banks? Not now – the ECB currently charges banks to keep money on deposit with it so this factor now actually raises the profitability of money creation. (Interest on reserves is also not a necessary feature of a central bank operational framework – the Fed managed fine without it for years.)
I think there are two reasons there is so much confusion about these issues.
The first is the arcane way that central banks do their accounting. All money that is created is counted as a “liability” even if, like bank notes, it doesn’t actually ever impose a cost. Central bank capital measures based on subtracting reported liabilities from reported assets thus grossly underestimate the true financial value generated by central banks. (See here for a more detailed discussion).
Central bank profit and loss measures are calculated in line with this wholly uneconomic methodology. In the analogy above, the central bank would report a $10 loss because its assets had increased by $90 while its “liabilities” had increased by $100. Reporting a loss in these circumstances doesn’t actually make any economic sense but is sure to generate lots of hand-wringing from people who imagine something terrible has happened.
The second problem is the widespread failure to understand that central banks are fundamentally different from commercial banks. Central banks do not need to have assets greater than liabilities and cannot “go bust” due to losses on asset purchases. That said, most of the international policy community seems happy to perpetuate this myth.
For example, consider this Very Serious report from the BIS last year. It recommends that central banks should maintain positive capital, not because they need to, but because the public might be confused about this stuff and so it’s best not to get them too concerned. A quick flavour of the thinking:
«we have no doubts about the central banks that are currently shouldering extraordinary financial risks. But our confidence is based on an understanding of the special character of central banks that may not be shared by markets and others.»
So if financial markets believed central bankers needed to wear Hawaiian shirts, would it be best to ditch the suits and start drinking pina coladas at press conferences?
There may be another case where an international policy organisation recommends an incorrect policy solely because private investors believe strongly the incorrect policy must be solved, but I can’t think of one offhand.
These points are not intended as a recommendation for central banks to purchases whatever assets just take their fancy. There is an important opportunity cost here. For example, the money could have been distributed to the public by providing each person with a fixed amount of money. So it’s important that the purchases are made in a fair and transparent way using market prices.
The other cost usually cited is that money creation may lead to inflation. But in the case of the ECB’s ABS purchases, this is a feature not a bug. The whole point of it is to raise inflation back to the ECB’s target level. The fact that the programme also fits with the ECB’s secondary goal of supporting the general economic goals of the EU is welcome but not crucial.
Anyway expect lots more of this stuff over the next few months as the widespread lack of understanding of central bank balance sheets continues to see irrelevancies held up as crucial economic principles.