Central bankers face a balance sheet reckoning
LONDON, May 26 (Reuters Breakingviews) - Central banks’ balance sheets have exploded in size since 2008. After interest rates started rising last year, several of those institutions have reported losses. That’s not a problem, we’re told, since central banks are not bound by ordinary accounting rules. Recent research, however, finds that financial crises are more likely to occur after periods when their balance sheets have massively expanded. Besides, losses erode both the credibility and independence of monetary authorities, making it harder for them to fulfill their inflation-fighting mandate.
In recent years, the typical central bank has combined the asset growth and asset-liability mismatches of the Silicon Valley Bank with the leverage of Lehman Brothers and the balance-sheet opacity of Enron. The expansion of balance sheets is unprecedented. According to a new paper by Niall Ferguson and colleagues, published by Stanford University’s Hoover Institution, central bank assets relative to GDP are at multiples of their historic average and nearly twice the previous peak reached during World War Two. The Federal Reserve’s assets of $8.5 trillion sit on a mere $42 billion of capital. Last year, the Fed reported its first loss since 1915. A number of other central banks from Australia to Sweden are in the red.
Central bank accounts are the stuff of headaches. Some use fair-value accounting, with changes in the market value of their securities reported in the profit and loss account. Others don’t mark their assets to market, even for securities that they aren’t intending to hold indefinitely. The Bank of England uses conventional financial reporting standards, but holds securities it acquired through quantitative easing in a special purpose vehicle, The Bank of England Asset Purchase Facility Fund. Central bank profits are usually distributed to the government – the Fed has handed more than a trillion dollars to the U.S. Treasury since 2000 – but losses are retained on the balance sheet. The Fed actually records its losses as “deferred assets,” which means that however much it loses it can’t slip into negative equity.
Central banks are not like ordinary banks, we are told. They don’t exist to make profits or avoid losses, but to conduct monetary policy. Their earnings are immaterial. Solvency in the conventional sense doesn’t apply to them. Since they have no depositors, they can never suffer from bank runs. Since they create their own liabilities - in the form of money - they can never run short of funding. Several central banks, including those of Israel and Mexico, have in the recent past successfully operated despite having negative equity.
Whether it’s good practice for central banks to inhabit this Alice-in-Wonderland world is another matter. In “The Reckoning: Financial Accountability and the Rise and Fall of Nations”, the economic historian Jacob Soll suggests that the rise and fall of nations and empires is reflected by their changing attitudes to accounting. Poor book-keeping, he says, leads to “financial chaos, economic crises, civil unrest and worse.” The Medici family in Renaissance Florence thrived when their bank’s books were kept in good order, but the family’s power collapsed when they neglected the accounts and took undue risks. Likewise, the failure of the French House of Bourbon to maintain proper accounts contributed to their eventual overthrow, says Soll.
Accounting is not just an essential feature of capitalism. It also ensures that governments are held accountable as far back as the Dutch Republic of the seventeenth century. According to Adam Smith the Bank of Amsterdam – the world’s first central bank, founded in 1609 – ran smoothly because its books were balanced. The fact that central banks until the twentieth century were required to redeem their notes in gold forced them to keep orderly accounts. As Anne Murphy writes in “Virtuous Bankers: A Day in the Life of the Eighteenth-Century Bank of England”, the zero balance produced by double-entry book-keeping conveyed a sort of virtue. There’s something inherently troubling about the modern central bank’s cavalier attitude towards accounting.
Ferguson and his colleagues examined fourteen central bank balance sheets over a period of 400 years. In earlier centuries, major balance-sheet expansions by these institutions were generally linked to financing war. In modern times, central banks have tended to roll out the safety net at times of financial distress. The authors find that liquidity provision by dovish central bankers have generally served to stabilise economic output, boost asset prices and avert deflation. This is what happened after the global financial crisis of 2008, when central bankers pulled out all the stops to avoid a depression.
Central bank hawks on the other hand, are typically slow to expand their balance sheets during crises. They express concerns about moral hazard, and worry about asset price bubbles and excessive risk-taking. While doves obsess about deflation, hawks fret about inflation. In the short run, asset purchases by central banks help prop up the financial system. Still, history vindicates the hawks: “The time until the next systemic financial crisis is significantly shorter after major balance-sheet expansions,” Ferguson and his co-authors conclude.
In the post-Lehman era, doves ruled the roost. Over the past year, however, rising interest rates have roiled the financial markets. Once again, central banks are unfurling their safety nets. At the same time, their over-extended balance sheets make it harder to keep inflation under control. Since central banks now pay interest on their reserves - in effect, a form of short-term government debt - each rate hike immediately raises the government’s debt costs. As central banks sell securities to soak up excess liquidity, they will realise losses. Central banks with weak balance sheets are less credible bastions of a fiat currency.
Former Banque de France Governor Jacques de Larosière compares the recent actions of central bankers to Goethe’s sorcerer’s apprentice, whose naïve invocation of magical powers ends up in disaster. The veteran monetary policymaker bemoans that “central banks have weakened their own balance sheets, as well as their reputation and independence.” De Larosière anticipates a bout of stagflation. If there’s one lesson to take away, it’s that balance sheets matter. No one should be exempt from the discipline and accountability they impose – not emperors or kings, and least of all central bankers.
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