Blog Post

QE and central bank solvency

What’s at stake: The European Central Bank will most likely reveal on Thursday its plans for a program of sovereign bond buying, as it steps up its efforts to stave the eurozone off deflation. In a previous review, we addressed the question of whether the expansion of the money base should be temporary or permanent to have a meaningful impact on inflation. In this review, we provide background on the exacerbated concern of what would happen to the Eurosystem’s capital resources if a country defaults and, in particular, whether this would generate a fiscal transfer between members.

By: Date: January 20, 2015 Topic: European Macroeconomics & Governance

What’s at stake: The European Central Bank will most likely reveal on Thursday its plans for a program of sovereign bond buying, as it steps up its efforts to stave the eurozone off deflation. In a previous review, we addressed the question of whether the expansion of the money base should be temporary or permanent to have a meaningful impact on inflation. In this review, we provide background on the exacerbated concern of what would happen to the Eurosystem’s capital resources if a country defaults and, in particular, whether this would generate a fiscal transfer between members.

Paul De Grauwe and Yuemei Ji write that the most important argument used by opponents of a government bond buying programme by the ECB is that such a program mixes monetary and fiscal policy. The argument goes as follows. When in the context of QE the ECB buys government bonds from fiscally weak countries it takes a credit risk. Some of these countries may default on their debt. This then will lead to losses for the ECB, which, in turn, means that the taxpayers of the fiscally sound member countries of the Eurozone will be forced to foot the bill. Thus, when the ECB buys government bonds, it creates a risk that future taxpayers will be liable to bear losses. Put differently, the ECB is, in fact, conducting fiscal policies in that it organizes fiscal transfers between member states. The ECB has no mandate to do so.

Hans Werner Sinn writes that buying low quality paper would increase the burden on taxpayers should default occur, since taxpayers will have to make up for the drop in the distribution of ECB profits to the respective treasury departments.

The basics of central bank accounting

Karl Whelan writes that commentaries along the lines of “the ECB is taking huge risks with its balance sheet”, “the ECB risks becoming insolvent, endangering the future of the euro” or that “Eurozone states may have to recapitalize the ECB at huge cost to taxpayers” are based on a widespread failure to understand that central banks are fundamentally different from commercial banks. Central banks do not need to have assets greater than liabilities and cannot “go bust” due to losses on asset purchases. That said, most of the international policy community seems happy to perpetuate this myth.

Paul de Grauwe and Yuemei Ji write that contrary to private companies, the liabilities of the central bank do not constitute a claim on the assets of the central bank. The latter was the case during gold standard when the central bank promised to convert its liabilities into gold at a fixed price. Similarly in a fixed exchange-rate system, the central banks promise to convert their liabilities into foreign exchange at a fixed price. The ECB and other modern central banks that are on a floating exchange-rate system make no such promise. As a result, the value of the central bank’s assets has no bearing for its solvency. The only promise made by the central bank in a floating exchange-rate regime is that the money will be convertible into a basket of goods and services at a (more or less) fixed price. In other words the central bank makes a promise of price stability.

Karl Whelan writes that if a central bank purchases assets that then decline in value, it could end up having negative capital.  When a commercial bank has negative capital, it is termed insolvent and either re-capitalized or shut down.  The “insolvent” terminology is sometimes applied to a central bank in this situation but central banks are unique organizations and this phrase isn’t particularly appropriate. Wolfgang Munchau writes that a NCB facing default could just go with negative capital. It might also claim some of the ECB’s future profits as part of its own capital. It is, after all, a shareholder in the ECB. It might also use some of its gold reserves to prop up its capital. What will happen will therefore depend on the size of the default, the size of the shareholding in the ECB and the size of any reserves.

QE and fiscal transfers

Paul de Grauwe and Yuemei Ji write that in a monetary union with no fiscal union a bond-buying programme leads to fiscal transfers among countries – but not the one common in the public perception. One often hears in the creditor countries that these would be the losers if one of the governments whose bonds are on the balance sheet of the ECB were to default. This is an erroneous conclusion.

Paul de Grauwe and Yuemei Ji write that an ECB bond-buying programme leads to a yearly transfer from the country whose bonds are bought to the countries whose bond are not bought. Take that the example of the ECB buying €1 billion of Spanish bonds with a 4% coupon. The fiscal implications are now as follows. The ECB receives €40 million interest annually from the Spanish Treasury. The ECB returns this €40 million every year to the EZ national central banks. The distribution is pro rata with national equity shares in the ECB. The national central banks transfer this to their national treasuries. For example, the ECB will transfer back 11.9% of the €40 million to the Banco de España. The rest goes to the other member central banks. The largest receiver is the German Bundesbank; with its equity share of 27.1%, it would get €10.8 million.

Paul de Grauwe and Yuemei Ji write that the ECB could implement a bond-buying programme that avoids fiscal transfers by buying national government bonds in the same proportions to the equity shares of the participating NCBs if interest rates were uniform across countries. But this would not eliminate all transfers because the interest rates on the outstanding government bonds are not the same. In fact the countries with the highest interest rates would in this weighted bond-buying programme be net payers of interest to the countries with the lowest interest rates. Thus even a bond-buying programme weighted by the equity shares would involve fiscal transfers from the weaker (debtor) countries to the stronger (creditor) countries.

Paul de Grauwe and Yuemei Ji write that in the case of default on the €1 billion of Spanish government bonds, the Spanish government would stop paying €40 million to the ECB. The ECB would stop transferring this interest revenue back to the member central banks pro rata. The German taxpayer, for example, would no longer receive the yearly windfall of €10.8 million. In no way can one conclude that German taxpayers, or any EZ taxpayer, would pay the bill of the Spanish default – except in the narrow sense that they would no longer be able to count on the yearly interest revenues.

Paul De Grauwe and Yuemei Ji write that eliminating this type of transfers can be achieved by following a somewhat different interest distribution rule. Instead of pooling the interest payments the ECB receives and then distributing them according to the equity shares, one could also use a rule of ‘juste retour’. This would mean that the ECB redistributes the exact amounts of interest payments it has received from each member government back to the same government. If this rule is applied, there would be no net interest transfer before or after the default. Complete neutrality is restored and taxpayers are shielded from movements of the value of the bonds on the ECB’s balance sheet.

Paul de Grauwe writes that suppose that for reasons of reputation the member states decide to recapitalize the ECB. Will that not inevitably involve taxpayers in Germany, France, etc? The answer is no. This will just be a bookkeeping operation without involving taxpayers. When national governments decide to recapitalize the ECB to make up for the loss of €1 billion, they transfer bonds to the ECB worth 1 billion, allowing the ECB to increase its equity by €1billion. These transfers occur using the same capital shares. Thus the ECB holds government bonds worth €1 billion. As a result, each government pays interest to the ECB in the same proportion to its capital share. But at the end of the year the ECB transfers these interest revenues back to the same governments using the same capital shares.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

The US retail crisis

What’s at stake: America is undergoing a retail sector crisis, partly related to the increase of competition from online commerce. We review recent contributions to this debate.

By: Silvia Merler Topic: Innovation & Competition Policy Date: July 17, 2017
Read article More by this author

Blog Post

The Universal Basic Income discussion

What’s at stake: the concept of a Universal Basic Income (UBI), an unconditional transfer paid to each individual, was prominent earlier this year when Finland announced a pilot project. It’s now back in the discussion as the OECD published a report illustrating costs and distributional implications for selected countries. We review the most recent contributions on this topic.

By: Silvia Merler Topic: European Macroeconomics & Governance, Global Economics & Governance Date: June 12, 2017
Read article More on this topic More by this author

Blog Post

President Trump’s budget: the 3% growth quandary

What’s at stake: the Trump administration released its full budget proposal. Economists have been arguing about the feasibility of the underlying growth assumptions, and on whether there is a double-counting implied. We review the most recent contributions to this debate.

By: Silvia Merler Topic: Global Economics & Governance Date: May 29, 2017
Read article More on this topic More by this author

Blog Post

Dial N for NAIRU, or not?

What’s at stake: The concept of the NAIRU (Non-Accelerating Inflation Rate of Unemployment) has recently divided the minds in the economic blogosphere. We review the most important contributions on its usefulness, its shortcomings, alternatives and we discuss why it is such a contested concept.

By: Pia Hüttl Topic: Global Economics & Governance Date: May 22, 2017
Read article More on this topic

Blog Post

UK economic performance post-Brexit

What’s at stake: Almost a year after the UK voted to leave the European Union, its economic performance has showed mixed results. The risks of a Brexit-induced recession do not seem to be materialising. On the contrary, up until the end of 2016 the UK saw a continuation of strong consumer spending and strong output in consumer-focused activities. However, the UK economy is showing signs of slowing down in the first quarter of 2017, with weak growth in the services sector and business investments. In addition, strong consumption growth started to cool down as individuals’ purchasing power declines due to a weaker exchange rate. This leads to a question whether it is the beginning of the Brexit slowdown. We review the contributions made on this topic in the last year.

By: Uuriintuya Batsaikhan and Justine Feliu Topic: European Macroeconomics & Governance Date: May 15, 2017
Read article More on this topic More by this author

Blog Post

The US and the productivity puzzle

What’s at stake: Productivity growth fell sharply following the global financial crisis and has remained sluggish since, inducing many to talk of a “productivity puzzle”. In the US, we may be seeing what look like early signs of a reversal. We review recent contributions on this theme.

By: Silvia Merler Topic: Global Economics & Governance Date: May 8, 2017
Read article More on this topic More by this author

Blog Post

The Trump tax cut

What’s at stake: on Wednesday, the Trump administration - now 100 days old - unveiled a draft tax plan including the intention to enact a radical cut to the corporate income tax, lowering it to 15 percent. While we are still missing details on how this and other measures would be implemented, we review some of the early reactions.

By: Silvia Merler Topic: Global Economics & Governance Date: May 2, 2017
Read article More on this topic More by this author

Blog Post

The decline of the labour share of income

What’s at stake: at odds with the conventional wisdom of constant factor shares, the portion of national income accruing to labour has been trending downward in the last three decades. This phenomenon has been linked to globalisation as well as to the change in the technological landscape - particularly “robotisation”. We review the recent literature on this issue.

By: Silvia Merler Topic: Global Economics & Governance Date: April 24, 2017
Read article More on this topic More by this author

Blog Post

Embracing the silver economy

What’s at stake: The oldest human in known history was a Frenchwoman called Jeanne Calment who celebrated her 122nd birthday in 1997. Thanks to advances in technology and medicine humans living until 100, if not 122, might not be an exception in the near future. Ageing, while described as a looming demographic crisis, also offers a silver lining. Business in rapidly ageing societies is already adapting their strategies to navigate the “silver economy”. This blogs review looks at the implications of the silver economy on growth, productivity and innovation as well as the opportunities offered by the silver industry.

By: Uuriintuya Batsaikhan Topic: Global Economics & Governance Date: April 10, 2017
Read article More by this author

Blog Post

Is China’s innovation strategy a threat?

What’s at stake: A number of recent contributions accuse China of acquiring technology from abroad without respecting international rules. This blog reviews the current debate that focuses on China’s supposed push to modernise its industry and the challenges for advanced economies. By leapfrogging to high-tech manufacturing products, the strategy threatens the competitive advantage of the US and the EU. The international rules-based order is put to a test facing large-scale government support to high-value added sectors and anti-competitive behaviour.

By: Robert Kalcik Topic: Global Economics & Governance, Innovation & Competition Policy Date: April 3, 2017
Read article More on this topic More by this author

Blog Post

The American opioid epidemics

What’s at stake: The US Department of Health and Human Services (HHS) declares that the country is “in the midst of an unprecedented opioid epidemic”. Since 1999, the rate of overdose deaths involving opioids - including prescription pain relievers and heroin - nearly quadrupled. We review contributions looking at the economic drivers and implications of this phenomenon.

By: Silvia Merler Topic: Global Economics & Governance Date: March 27, 2017
Read article More on this topic More by this author

Blog Post

Alice in gender-gap land

What’s at stake: The International Women’s Day on 8 March drew attention to the gender gap again, both in pay and in employment. Ongoing research on the topic shows that the gender gap persists worldwide, from finance to arts. For it to change, bold action is needed, ranging from targeted policies to rethinking gender norms.

By: Pia Hüttl Topic: Global Economics & Governance Date: March 20, 2017
Load more posts