Addicted to central bank painkillers?

Claudio Borio (BIS) and Piti Disyatat write about the dangers of low interest rates at VoxEU. Using an argument that has been put forward many times by the BIS (Claudio Borio and co-authors), low interest rates during booms and expansions can create bubbles and financial instability. Central banks need to be aware of the costs of low interest rates.

The authors, while accepting the idea that low real interest rates might be the outcome of low growth and secular stagnation,  argue that central banks cannot simply be seen as passive agents adapting their policies to the macroeconomic environment; they are responsible for low interest rates. In their words "money and finance are not neutral". Quoting from the article:

"Not only can financial factors – especially leverage – amplify cyclical fluctuations, but they can also propel the economy away from a sustainable growth path. By influencing decisions to invest, variations in financial conditions affect the evolution of the capital stock, and hence, future economic fundamentals. An expanding capital stock during booms may help to constrain inflation and obviate the perceived need for monetary-policy tightening. At the same time, large changes in relative prices that typically occur in financial booms divert resources into surging sectors in ways that are not easily reversible. The long-lasting impact of the financial cycle becomes especially evident in the bust phase. The cumulative build-up in debt and associated resource misallocations – especially the overhang of capital – leave a legacy that takes time to resolve."

To support their claim, the authors produce a chart that shows how debt (public and private) has increased dramatically during the years where interest rate were coming down.

Their conclusion:

"More stimulus may boost output in the short run, but it can also exacerbate the problem, thus compelling even larger dosages over time. An unhealthy dependence on painkillers can be avoided, but only if we recognise the risk in time."

I have no objection to the idea that money and finance are not neutral and that central banks can have an important role in financial markets. But the analysis above is too simplistic and potentially misleading.

The logic it puts forward is that arbitrarily-low interest rates set by the central bank generate an unsustainable behavior in terms of accumulation of debt that is behind the bubbles we built in the good years and the crisis that resulted from the bursting of those bubbles.

What is always missing in this analysis is the fact that the world is a closed system. The debt that appears in the chart above has to be bought by someone. Those liabilities are assets for someone else. Who are the buyers? And who "forces" them to buy those assets at that price/yield?

Before we continue any further let's rule out the hypothesis that it is the central bank who is buying those assets. The easiest way to understand that it cannot be the central bank is that the chart above starts a lot earlier than the time when central banks' balance sheets started to increase (the second reason is that for every asset that the central bank buys it issues a liability but this will get us to a more complicated argument).

There is a simpler way to explain the chart above. A shift in the supply of saving by some agents/countries resulted in a decrease of interest rates and an increase in borrowing by the rest of the world. Some of this happens within countries, some happens across countries. This could still be an unsustainable development as borrowers go too far and lenders do not understand the risk involved but it is not simply be caused by the irresponsible policies of the central bank.

It could also be that, in addition, we have seen a significant increase in gross flows of assets and liabilities that do not result in a change in equity or net wealth but that they lead to an increase in the size of balance sheets across agents (i.e. increased leverage). Simplest example is households buying real estate with mortgages but it can also be financial institutions increasing leverage. This increases debt but it increases assets as well. This, once again, can generate instability but the borrowing that we see must come from somewhere else in the economy (not the central bank). Understanding that side of the balance sheet is important to have a complete story of what caused the crisis and what it takes to get out of it.

Antonio Fatás

Is liquidity stuck at banks?

Last week the ECB announced new monetary policy actions to help restore growth in the Euro area and bring inflation closer to its 2% target. Interest rates were reduced and further provision of loans to commercial banks were announced. In addition, there is a plan to implement purchases of asset based securities.

The effectiveness of recent monetary policy actions by central banks has been met with some skepticism because it does not deliver the necessary increase in lending to the private sector. While liquidity is introduced, it seems to get stuck in the accounts that the commercial banks hold at the central bank (reserves). Because of this, both the Bank of England and now the ECB are implementing injections of liquidity that are linked to increased lending to the private sector by the financial institutions that are borrowing that liquidity.

The role that reserves play in the recent monetary policy actions by the ECB leads some times to confusion. Some seem to think that the high level of reserves that banks hold is a measure of the failure of central banks to generate additional loans to the private sector. The logic is that reserves stay high because of the lack of willingness to lend. This is the wrong view of reserves, they cannot simply be seen as resources that are waiting to be provided as loans to the private sector.

Reserves are a liability in the central bank balance sheet that it is created when the central bank decides to allocate more loans to commercial banks or when it decides to buy securities. If a commercial bank decides to give a loan to one of its customer (household or business), the reserves do not disappear. Once that customer uses its loan for a purchase, these reserves are transferred from one commercial bank to another, but the level of reserves remains constant.

How can reserves go down? In the case of the ECB, most of the injections in liquidity have been done via loans to commercial banks. Reserves will only go down when commercial banks pay back their loans with the central bank (or when the central bank decides to reduce the amount of loans it provides as some of the outstanding ones are repaid). So any increase in the provision of loans by the ECB will lead to an increase in reserves. Below are the two series: loans to commercial banks (an asset for the ECB) and reserves of commercial banks at the ECB (a liability at the ECB). Both series are in Billions of Euros (Source: ECB).

The evolution of both series is identical. The large increase in loans (LTROs) that started in the Fall of 2011 led to a large increase in reserves. Since then, both series have been coming down as Euro commercial banks have been repaying their loans (voluntarily). So the balance sheet of the ECB has been shrinking dramatically over the last months. The new wave of loans announced by Mario Draghi is likely to increase both series again (although by how much will depend on how Euro financial institutions feel the need to tap into additional ECB funding).

The fact that the two series move together does not mean that the actions of the central bank are ineffective. It is possible that the availability of funding for some banks leads them to provide more loans to the private sector. What one cannot do is judge the success of these actions by the level of reserves in the financial system. The level of reserves will not change when the private loans are given.

As a point of comparison, the profile of the series above for the US Federal Reserve is very different: they keep trending up, no decrease at all. The reason is that the US central bank has increased its balance sheet by buying securities. So reserves are created agains the purchase of those securities. In this case, the level of reserves is even more directly linked to the actions of the central bank. It is only when the central bank decides to sell those securities that the level of reserves will come down. And this is the new step that Draghi has promised in his press conference last week, the ECB is willing to engage in true quantitative easing via the purchase of asset based securities.

Antonio Fatás