Central Banks: Addicted to monetary morphine

Last Updated: Thu, Mar 23, 2017 16:02 hrs
Raguram Rajan

Compounding the problems of ineffectiveness and toxic side effects, current policies cannot be reversed easily, if at all.

Withdrawing fiscal stimulus would lead to sharp slowdowns in economic activity. Reduction in government services and higher taxes accelerates contraction in disposable incomes, especially in an environment of stagnant incomes and uncertain employment. In turn, this leads to a sharp contraction in consumption. Slower growth, exacerbated by high fiscal multipliers, makes it difficult to correct budget deficits and control government debt levels.

This restricts the ability to reverse an expansionary fiscal policy, corroborating Milton Friedman's sarcastic observation: "There is nothing so permanent as a temporary government program".

As government debt grows, financing difficulties trigger a financial crisis or force reliance on the central bank for financing by monetising its debt.

ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) policies are also difficult to change. Normalisation of interest rates, reducing purchases of government bonds and reduction of central bank holdings of securities risk financial disruption.

Central banks may find it difficult to increase interest rates. Reduction of central bank purchases of bonds also risks higher rates and reduced available funding. Low rates allow over extended companies and nations to maintain or increase borrowings rather than reducing debt levels. Levels of debt encouraged by low rates become rapidly unsustainable at higher rates.

Central banks also cannot sell government bonds and other securities held on their balance sheet. The size of these holdings means that disposal would lead to higher rates resulting in large losses to the central bank as well as banks and investors. The reduction in liquidity would exacerbate this by sharply tightening the supply of credit, destabilising a fragile financial system.

If sustained, the 1% rise in rates would increase the debt servicing costs of the US government by around US$170 billion. A rise of 1% in G7 interest rates increases the interest expense of the G7 countries by around US$1.4 trillion.

Higher interest rates would also affect indebted consumers and corporations. In the US, a 1% increase in interest rates, according to a McKinsey Global Institute Study, would increase household debt payments from US$822 billion to US$876 billion, a rise of 7%. In the UK, a 1% increase would increase household debt payments from Sterling 96 billion to Sterling 113 billion, a rise of 19%.

According to the Bank of International Settlements, a 3% increase in government bond rates would result in a change in the value of outstanding government bonds ranging from a loss of less around 8% of GDP for the US to around 35% for Japan.

Asset prices, boosted by low rates, would fall sharply in response to the potential reduction in monetary support.

In effect, the policies have compounded existing issues, making the problems ever more intractable.

Central banks have convinced themselves that ZIRP and QE policies are temporary. They believe that will be able to exit from a policy of low rates when appropriate. It is reminiscent of Ashly Lorenzana's definition of addiction in her journal Sex, Drugs & Being an Escort: "When you can give up something any time, as long as it's next Tuesday".

The central question is for what period and to what extent current policies can be continued.

The stock of private sector domestic savings limits the amount of government debt, ignoring foreign borrowing and debt monetisation by the central bank. If a nation has accumulated large foreign investments, then income and capital from these can finance the government for a time.

Ultimately, reliance shifts to the ability of the central banks to monetise debt and finance the government. But there may be limits to the scope of debt monetisation.

The balance sheet expansion required by QE programs exposes a central bank to the risk of losses on its holding of securities from defaults or (more realistically) higher yields, ironically if the economy recovers and rates rise. In theory, there is no limit to the size of the losses a central bank can incur. But there may be practical constraints.

One constraint may be the potential loss on investments for a given rise in rates consistent with the central bank maintaining its operational ability and credibility.

The US Federal Reserve has US$54 billion in capital supporting assets of around US$4 trillion. The ECB has Euro 10 billion in capital supporting assets of Euro 3 trillion. The BoJ has around Yen 2.7 trillion in capital supporting assets of Yen 160 trillion. The Bank of England has Pound Sterling 3.3 billion in capital supporting assets of Pound Sterling 397 billion.

In effect, a small change in asset values would significantly impair the capital base of these institutions.

Seigniorage revenues constitute another possible limit to debt. Seigniorage is the difference between the value of money and the cost to produce it; the difference between interest earned on securities acquired in exchange for money (notes and reserves) created by central banks and the cost of producing and distributing that money. A central bank is considered solvent so long as the discounted present value of seigniorage income is greater than its other liabilities in the long run.

A further constraint is the risk of excessive inflation levels. Where its charter encompasses maintaining financial and price stability, debt monetisation may be constrained by price pressures exceeding politically, economically and socially acceptable levels.

The ultimate constraint remains preservation of the status of the currency as a medium of exchange or accepted store of value. Central banks would not risk its currency becoming unacceptable for normal commercial transactions, as in Zimbabwe and other similar cases.

While central banks have not reached the limits of their capacity to act and inflation remains low, they retain scope for action. But existing policy does not address the real issues and may not be capable of restoring economic health. But addicted to monetary morphine, central banks and market participants believe that there is no alternative.

Satyajit Das is a former financier. His latest book Age of Stagnation is now out in India. He is also the author of Traders, Guns and Money and Extreme Money.

Copyright: 2016 Satyajit Das

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