What central bankers are really up toFortune & Freedom
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Nick Hubble | 01 Nov 2021 |
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Dear Reader,
Thanks for all your emails about my upcoming video which investigates, "Why can't central banks just buy all the debt?" Many of them have had an influence on how I'll go about producing the video.
Today, we'll delve into a pair of complications which I've been umming and ahhing about including in the video or not. After all, if I can explain them here, I can explain them on camera…
But first, a quick recap about the underlying idea.
Central banks sit outside the economy and inject money into and out of it, thereby controlling the money supply inside the economy.
If the economy is burdened by too much debt, the central bank can just buy that debt by creating money and purchasing bonds, and thereby solve the problem.
But it doesn't actually work like that…
The central bank conducts most of its monetary policy via the banking system of the economy. When it comes to the conduct of monetary policy, you can think of the banking system as an intermediary between the central bank and the economy.
So, when the central bank creates money and injects it, it doesn't usually inject that money into the economy directly, it injects it into the banking system. The banks then pass this on by making more loans, which is how the money supply that you and I actually experience rises (or falls, if the banks don't make loans).
So, it's not technically money that's injected by the central bank, but "bank reserves". How much money the bank can lend out to its customers depends, in part, on how much bank reserves the bank has in its account at the central bank. When the central bank increases the amount of bank reserves which banks hold, the banks can lend more.
But here's the problem. Just as you can lead a horse to water, but not make it drink, a central bank can pump a banking system full of bank reserves, but it can't make the banks lend that money out. Thus, the banking system doesn't necessarily pass on the monetary policy shift.
This explains why the vast amounts of quantitative easing (QE) that we've seen over the past 15 years don't necessarily become inflation. The money gets clogged up in a banking system that is reluctant to lend.
There are two ways around this. One is for the central bank to buy assets from places other than banks, injecting the money more directly into the economy.
Or the government can use the central banks' support of its spending to spend even larger deficits.
That's where we're at now. And the consequences of it are finally showing up in inflation numbers. But what about the other point worth adding to my video?
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Can central banks go bust?
What happens if the central bank itself goes bust? You see, the premise of our question is that central bankers buy debt, thereby solving the problem of too much debt in the economy. But that debt can be defaulted upon, or its value can fall.
If you or I hold assets that fall in value, we can get into trouble. If it happens to banks, they can get into big trouble. What happens to the central bank in this scenario?
If the value of the assets which central banks buy goes down, the central bank itself could technically be broke.
But it's not really clear what that actually means, because the central bank is such an odd institution which, as I keep emphasising, sits outside the economy.
What rules apply to it?
Well, that varies between different countries. But I'm not especially interested in the rules, because they can easily be changed. And they usually are in a crisis.
Only constitutions, which can only changed by a referendum, are any real constraint on politicians, as the EU member states are discovering when it comes to Poland. But let's not go there today…
In the upcoming video, Jim Rickards describes what happened when he asked an American central banker about the Federal Reserve going broke.
The response was… well, you'll have to wait for the video. But I will reveal a little here…
If the value of the assets held by the central bank go down, the central bank's capital would be wiped out, just like a bank's capital would be wiped out if enough people default on their mortgages.
But remember, the central bank sits outside the economy. It's not clear whether it would matter if the central bank is "trading insolvent" as it were.
A central bank is not subject to the same rules as the rest of us.
For example, as Jim Rickards explains in the video, they are not subject to "mark to market" rules which compel hedge funds to check daily that their assets are worth more than their borrowings.
It's worth mentioning that, in some nations, under the current laws, the government could be forced to invest money into the central bank if the value of its assets were to fall too far. But whether this needs to happen is not clear.
And rules can change…
Now I haven't had time to fully verify or investigate the following reader mail, but it discusses what would happen in the UK, when it comes to one of the Bank of England's policies, if the central bank makes losses. I've added emphasis in bold:
| I'm an enthusiastic investor and follower of economic cycles, and 100% in tune with your writings on Quantitative Easing. I'm also a chartered accountant with long experience in the property industry and degrees from Cambridge University and London Business School.
I would like to draw your attention to an aspect of QE which analysts appear to have missed - an unexploded bomb. HM Treasury has fully indemnified the Asset Purchase Facility, which means that it has to pay for any losses incurred by the Bank of England subsidiary involved. It is the exact public sector equivalent of a company guaranteeing losses on its own shares, a crime that imprisoned three out of four perpetrators in the 1980s Guinness scandal.
Worse still it seems that HMT is trying to keep the terms of the indemnity a secret. The Economic Affairs Committee HMT has repeatedly refused a to publish it with no good reason given. See the Economic Affairs Committee July 2021 report "QE a dangerous addiction" paras 153-157.
With rising inflation, significant losses are likely. I estimate 170 billion or more. I've assumed 4% interest rates throughout the yield curve which I don't think is unrealistic given current expectations of inflation and the need for positive real interest rates to correct it. You could quickly do your own NPV estimates based on the 895billion disclosed in the accounts of the Bank of England Asset Purchase Facility Fund Limited at 28 February 2021.
A commercial firm would have to account for that loss immediately under the GAAP rules, but I suspect HMT will use a cash basis thus deferring the loss. The language used in their answers to the Economic Affairs Committee indicates exactly that - they talk about the impact on interest payments, never about how any capital losses would be reimbursed if the bonds were sold at current market prices. They will surely have to at least disclose a contingent liability, which may cause equal market concern.
This should be interesting to your readers. It is another way in which HMT is trapped in QE and won't dare to stop until the market is fully informed. The sooner the unexploded bomb is exposed, the better for everyone.
W.S.
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So, if this is correct, if the Bank of England loses money on its assets purchased under the Asset Purchase Facility, the Treasury would have to bail it out.
Of course, this is a bit of a misnomer because the Bank of England is also helping to finance the government by buying their loans. That's why John Butler calls the whole thing a charade and merry-go-round in his segment of the upcoming video.
No doubt I've given you a headache's worth of confusion by now. But that's sort of how the whole thing works. It confounds people into ignoring it.
Still, understanding the mechanics is what leads me to conclude that a huge bout of inflation is coming. The big question is whether there will be another crash first, as central bankers raise interest rates to rein in inflation.
Tomorrow, we'll look at whether this is even possible. That is unless Nigel and I find time to sit down to discuss the latest Budget, in which case you'll receive the discussion a day later.
Nick Hubble
Editor, Fortune & Freedom
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