Does the central bank’s balance sheet matter?

A growing number of economists are advocating granting central banks the power to make payments to households. Brad DeLong puts it in historical context, bemoaning the failure of the “social credit” politicians in the 1930s. Most recently, Mark Blyth, Simon Wren-Lewis and I argue in The Guardian that the Bank of England should be given this power – not with a view to using it now, but as a contingency. Currently, contingency planning amounts to keeping our fingers crossed and hoping there is no negative shock to demand – that is irresponsible. Further QE, negative interest rates, and attempts to raise the inflation target are all terrible policy options – probably ineffective, and potentially self-defeating. Making payments to the household sector, by contrast, is in many ways preferable to conventional monetary policy.

Encouragingly, the predominant objection to this proposal is rarely about efficacy. The main area of concern is the potential impact on the Bank of England’s balance sheet – and, by the implication, on future control of inflation. This subject can be made very complex and confused. But the crux of the matter is straightforward, and the balance sheet issues that arise are not unique to our proposal.

So what is the balance sheet problem? When the Bank creates money and pays it to the household sector, there is an increase in bank reserves held at the central bank – the electronic equivalent to notes and coins. Conventional accounting treats these as liabilities (as it does physical cash), therefore the first accounting effect is a reduction in the “equity” of the Bank: its accounting liabilities (bank reserves) are rising, and its assets are unchanged. Equity (net assets) declines. An equivalent issue can of course arise with QE. Accounting equity is impaired by any fall in the value of the gilts that are held on the Bank’s balance sheet (the UK treasury provided an indemnity to protect against losses when QE was introduced – although it didn’t bother in the case of the funding-for-lending scheme).

Now the equity of a central bank is absolutely not an important issue in its own right, in contrast to a private bank. Firstly, bank reserves are not “liabilities” in any normal sense of the word. In short, the central bank never has to repay them, and any “interest” it pays is voluntary – it can even impose a negative interest rate. Reserves are simply treated as liabilities by convention.

It would also be very easy to create equally meaningless accounting “equity” as a central bank. I have argued elsewhere, that the central bank could just make infinite maturity, interest-free, loans to households (economically equivalent to a cash transfer). Immediately, assets increase in equal measure with liabilities.

So accounting “equity” is not the issue. What does matter is the Bank’s ability to control interest rates in the future.

One concern, which is unique to direct payments made to households, is that the Bank receives no additional interest income, while potentially increasing its interest payments to the banking system – assuming it pays a positive interest rate on reserves (if the interest rate on reserves is negative, the Bank would generate income by making cash transfers). There is, of course, a very obvious solution to this problem. If we want to make the effect on the Bank’s balance sheet identical to that of QE, every time the Bank makes a transfer payment to households, the government could transfer gilts of equivalent value to the Bank. In which case, the impact on the Bank’s net interest income is identical to the case of QE.

So, the effects on “equity” and the impact on net interest income are trivial objections. Accounting equity has no independent significance when applied to a central bank, and the impact of transfer payments on the Bank’s net interest income (assuming interest is being paid on reserves) could be addressed by simply transferring gilts of equivalent value automatically – making the balance sheet effect identical to QE – or by providing an “indemnity” as with QE.

Although many people focus greatly on these issues, they are really a distraction from what matters. The important issue for monetary policy after any significant expansion of the central bank’s balance sheet, is what to do if, at a future date, there is too much monetary base. This can happen as a consequence of almost any easing of monetary policy. In fact, by definition it is a bigger problem for the policies that increase reserves the most (i.e. QE).

So what can a central bank do if reserves are too high? I think we have a complete answer:

1) Raise the rate of interest on reserves (the IOR);

2) Issue debt or sell bonds on its balance sheet (this amounts to the same thing);

3) Raise reserve requirements (the Bank of England does not use them currently, but easily could);

4) Make other regulatory changes that increase private sector demand for reserves or raise the spread of market interest rates over base rates, for example, by raising capital ratios.

Ok. So the important question is how does “QE for the people” challenge the efficacy of 1-4? It doesn’t. Consider raising the IOR. It is perfectly possible, that the Bank of England will have significant negative net interest income in the future if the appropriate level of base rates significantly exceeds the income from its holdings of gilts. Would this be a greater problem if the Bank made payments to households and did less QE? If the treasury automatically transfers gilts to the Bank when it makes payments, there is no difference. If it does not, we don’t know a priori which policy has a greater effect on net interest income. It is almost certainly the case that less base money creation is required under transfer payments than under QE, so the losses on gilt holdings could well be greater than the loss of net income entailed by our proposal.

Either way, the challenge of a potential negative net interest margin at the Bank of England is neither a problem unique to our proposal, nor is it difficult to address. The Bank can simply avail of 2-4, all of which either reduce the need to raise the IOR or reduce the stock of reserves. All have the effect of improving the Bank’s net interest income.

Finally, I want to say something about 2, and in particular why I think the Bank should be able to issue gilts for monetary policy purposes (or equivalently, it should be able to call on the government to transfer gilts to its balance sheet – that is more important than any “indemnity”). Arguably, the Bank already has this power de facto. In the early days of QE, Jim Leaviss, a colleague of mine, raised the issue of canceling the gilts at the Bank of England – a proposal Melvyn King somewhat glibly dismissed. This is really semantics. QE at the zero-bound is economically equivalent to canceling government debt. After all, the interest income gets remitted to the Treasury (net of IOR, which at the zero bound would be zero). At zero interest rates, buying government bonds under QE and then selling them back to the market at a future date in order to shrink the monetary base is precisely equivalent to canceling them and then issuing new bonds.

In reality, the defining, unique, property of a central bank’s balance sheet is the power to create base money. If there is too much base money and the central bank has insufficient assets to sell, it must resort to policies 3 or 4; alternately, it must be given the assets to sell by the government or the power to issue bonds. This is true whether the base money has been expanded through QE or transfer payments to households. It could even be true in a scenario where, for whatever reason, there was a dramatic reduction in the banking sector’s demand for reserves.

One of the key points we make in the Guardian article is that the distinction between monetary and fiscal policy is largely one of institutional design. I would add that the critical dividing line between monetary and fiscal policy is the ability to create base money. Debates over what is fiscal and what is monetary policy obscure the important principles which should be defended. It is right that an independent central bank should have control over base money. What QE has made clear is that there is potentially an asymmetry in the central banks’ existing tools: base money can be expanded at will, but contracting it may require a commitment from government to supply assets.

Accepting this distinction, the principles worth defending are the operational independence of the Bank subject to an inflation-target. Simplicity, transparency, and if possible equity in the distributional effects of the Bank’s policies, are also desirable yardsticks by which to measure its policies. QE, forward guidance, funding-for-lending, and negative interest rates are all extraordinary attempts to manipulate asset prices, balance sheets and the sectoral allocation of capital. Granting the Bank of England the power to make payments to households may be a more genuine innovation – because it does not involve intermediation by banks – but this would be a bizarre reason for rejecting a policy which is simpler, fairer, more transparent in its effects, and more effective.

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

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