Monday, October 15, 2012

Will central banks cancel government debt?

In his Financial Times blog, Gavyn Davies looks at the question of 'will central banks cancel government debt'.

As the IMF meetings close in Tokyo this weekend, it is obvious that governments are struggling to find the correct balance between controlling public debt, which now exceeds 110 per cent of GDP for the advanced economies, and boosting the rate of economic growth. 
The former objective requires more budgetary tightening, while the latter requires the opposite. Is there any way around this? 
One radical option which is now being discussed is to cancel (or, in polite language, “restructure”) part of the government debt that has been acquired by the central banks as a consequence of quantitative easing (QE). After all, the government and the central bank are both firmly within the public sector, so a consolidated public sector balance sheet would net this debt out entirely.
Regular readers know that there is a much better way to control public debt and boost the rate of economic growth:  require the banks to fund the central banks' holdings of government securities by holding excess reserves in a non-interest bearing account.

Let us see how this compares against central banks canceling the government debt they own.
This option has always been viewed as extremely dangerous on inflationary grounds, and has never been publicly discussed by senior central bankers, as far as I am aware [1].
Banks funding the government debt using excess reserves has no impact on inflation.  Score:  banks 1, central banks 0.
However, Adair Turner ... made a speech last week that said more unorthodox options, including “further integration of different aspects of policy”, might need to be considered in the UK. 
Two separate journalists (Robert Peston of the BBC and Simon Jenkins of The Guardian) said that Mr Turner’s “private view” is that some part of the Bank’s gilts holdings might be cancelled in order to boost the economy.... 
However, the notion will now be widely discussed. It is easy to see how the idea could appeal to a finance minister facing the need to tighten fiscal policy during a recession in order to bring down the public debt ratio.
Both central banks canceling government debt and banks funding the central banks' holding of government debt effectively bring down the public debt ratio.  Score still:  banks 2, central banks 1.
Why is this such a radical idea? No one in the private sector would lose out from the cancellation of these bonds, which have already been purchased at market prices by the central bank in exchange for cash. 
The loser, however, would be the central bank itself, which would instantly wipe out its capital base if such a course were followed.
At a very superficial level it looks like if banks fund the central banks' government debt holdings and receive nothing in return that clearly the banks lose.

However, there is a very good argument that the banks do not actually lose.  Rather they are simply repaying to the government the cost of the financial crisis that they created.

Please re-read the preceding paragraph as it is very important to understand that a sizable percentage of the current outstanding government debt resulted from programs funded by the government to deal with the financial crisis.  Money that the government would not have spent if there had been no financial crisis.

In effect, the increase in government debt related to the financial crisis is the bill that the banking sector has to pay for creating the crisis.

Score:  banks 3, central banks 1.
The crucial question is whether this matters and, if so, how. 
In order to understand this, we need to ask ourselves why governments finance their deficits through the issuance of bonds in the first place, rather than just asking the central bank to print money, which would not add to public debt. Ultimately, the answer is the fear of inflation. 
When it runs a budget deficit, the government injects demand into the economy. By selling bonds to cover the deficit, it absorbs private savings, leaving less to be used to finance private investment. 
Another way of looking at this is that it raises interest rates by selling the bonds. Furthermore the private sector recognises that the bonds will one day need to be redeemed, so the expected burden of taxation in the future rises. This reduces private expenditure today. Let us call this combination of factors the “restraining effect” of bond sales. 
All of this is changed if the government does not sell bonds to finance the budget deficit, but asks the central bank to print money instead. In that case, there is no absorption of private savings, no tendency for interest rates to rise, and no expected burden of future taxation. The restraining effect does not apply. Obviously, for any given budget deficit, this is likely to be much more expansionary (and potentially inflationary) than bond finance.... 
Now consider what would happen if the bonds held by the central bank were cancelled, instead of being one day sold back into the private sector. Under this approach, the long-run restraining effect of bond sales would also be cancelled, so there should be an immediate stimulatory effect on nominal demand in the economy. If done without amending the path for the budget deficit itself, this would increase the expansionary effects of past deficits on nominal demand, and would also reduce the outstanding burden of public debt associated with such deficits. 
The central banks have now purchased so much government debt that the effects of such an action could be large.
Making banks fund the central banks' holdings of government bonds achieves the same benefits that Mr. Davies highlights without the risk of inflation.

Final score:  banks funding central banks' government bond holdings 3, central banks canceling government debt 1


marcbrown said...

How central banks could!!

Richard Field said...

Thanks! A much more accurate title for the post.