Central banks, safe assets and that independence question

This is version 2 of this post, since I got it massively wrong the first time round. Thanks to cig for correcting me (see comments). 

Simon Wren-Lewis weighed in on the safe assets discussion last week - his post is here and I strongly recommend a read even though it is definitely wonkish (I had to read it twice). Simon's discussion of collateral effects on interest rates adds a dimension that has so far been missing from the debate and helps to explain why long-term, as well as short-term, debt is needed by the financial system - a point that Pozsar misses. Long-term government debt can be used as collateral in the creation of shorter-term private sector "safe assets", which reduces the need for short-term government debt as collateral.

Simon suggests that government depositing cash from excess government borrowing at the central bank, as I suggested, would not be tenable. He doesn't explain why, so I thought I would have a go.

When you consider the central bank and treasury as a consolidated entity, the cash balances at the central bank and the borrowing net out and are eliminated. Neither the excess borrowing nor the uninvested cash show up on the consolidated balance sheet. So it can't be a consolidated balance sheet risk problem. However, as I've noted before, just because something is eliminated in accounting terms doesn't mean it disappears in reality. Unconsolidated, the government has debt, and the central bank has cash.

The fact that the government's excess cash is lodged safely at the central bank means that default risk is zero. Central banks can create money ex nihilo, so there is absolutely no possibility that the money could not be returned. From the point of view of the government's creditors - or depositors, as I would prefer to call them - this makes the debt completely risk-free, and therefore should mean that the interest rate on that debt is very nearly zero. But from the point of view of the central bank, it has serious implications for the conduct of monetary policy.

Intuitively it seems reasonable to suppose that the Treasury depositing excess cash at the central bank would cause a huge increase in the monetary base. But I've done a bit of research into the makeup of the monetary base, and it seems that central deposits are excluded from the monetary base calculation. In which case, in theory the Treasury could deposit as much cash as it wished and there would be no effect on reserves at all. However.....that's not quite right. I looked up exactly how the US Federal Government conducts an auction and receives payment. The NY Fed produces an extremely helpful document explaining how it works.

When the Fed auctions bills or bonds, payment is nearly always made via commercial banks which have reserve accounts at the Fed. The only exception to this would be an individual who wrote a cheque directly to the Treasury, in which case that cheque would be credited directly to the Treasury's account at the Fed and there would be no impact on reserves. All other payments go through reserve accounts: the reserve accounts are drained by the amount of the debt purchased, and the Treasury's deposit account is credited. Therefore Treasury debt issuance drains reserves. Debt issuance on the scale required to meet the financial system's need for safe assets would drain reserves by a very considerable amount. In effect it would be a huge monetary tightening. It would undo the effects of all the QE the Fed has conducted.

There are a few things the Fed could do to undo the contractionary effect on the monetary reserve of all that debt issuance:

1) Cut interest rates. Er, no - at the moment it can't. Or not very much, anyway. I don't wish to get into the negative rates argument again, but the zero bound is binding in an economy that still uses cash and I am personally unconvinced that negative rates would necessarily be expansionary.

2) Buy up the debt the Treasury has just issued. That would completely defeat the purpose of issuing it, which is to provide safe assets to the financial system.

3) Buy private sector risky assets. This could tie in nicely with Simon's idea that the government could build up a portfolio of risky assets, but I doubt if he meant it to be the central bank that bought them. It would mean the central bank conducting quasi-fiscal operations (taking stakes in public enterprises) and accepting credit risk. And it is questionable whether the central bank has the expertise to manage such a portfolio.

I don't pretend to be an expert on central bank operations, so there may well be other options too. All of these are things that the Fed could do by itself. But they are the tools that it uses to conduct monetary policy, not to sterilize the effect of Treasury actions. It would seem more appropriate for the actions to correct the reserve drain to be taken by the Treasury. As far as I can see there are two options for the Government:

1) Allow the Treasury deposit to be redistributed to commercial bank reserve accounts. This would ensure that debt sales didn't affect the reserve level, which in a world where debt issuance has nothing to do with financing government spending and everything to do with preventing the financial system from seizing up just might be a good thing. There seems little point in simply exchanging one type of safe asset for another, which would be the effect of that reserve drain. I'm not entirely sure how this would be done, but it seems likely that the settlement accounting would have to be reversed, leaving the balance on the Treasury account at zero and the in/out entries as memorandum items. As reserves never leave the banking system, this action would sterilize the impact of the debt issuance without placing the debt itself at risk.

(UPDATE - It seems the Bank of Canada already has such a facility. From its explanatory notes on the composition of the Bank of Canada's balance sheet (my emphasis):

3. Government of Canada deposits. The government keeps deposits at the Bank of
Canada, against which it writes all its cheques. The government also maintains
deposit accounts with direct clearers. The maintenance of these government accounts
with the Bank of Canada and the direct clearers gives the Bank of Canada an additional instrument of monetary control, called government deposit transfers.)

2) Spend the money. Back to Simon's idea of buying up risky assets, I guess. At least this would be done by the Government rather than the central bank, which at least preserves the fiction of central bank independence for a little longer.

From a safe asset perspective, I am unconvinced by Simon's suggestion that the Government should build up stocks of risky private sector assets - although from an economic point of view it has considerable merits. Yes, the fact that the central bank can always monetize debt, and government can always tax, would mitigate the balance sheet risks arising from such a strategy. But they would not be zero. Government would pay higher borrowing costs, I think. And if the risk asset portfolio suffered losses, there would be a risk of knock-on impact to the value of government debt due to resurrected default fears - exactly what we DON'T want for safe assets. As BIS said, the whole point of a safe asset is that there should be no possibility of it becoming unsafe.

Miles Kimball has suggested that government investment might be separated from government itself through the creation of a sovereign wealth fund, which could be managed by private sector investment experts. This would eliminate the "government is rubbish at picking winners" problem that is always raised whenever anyone suggests government should invest in private sector enterprises, and it would hopefully mitigate the real risk of rent-seeking and capture by special interests. But government would still be the ultimate guarantor for such a fund's debt, so it would still rest on the credibility of the government/central bank nexus. Investors may prefer explicit backing for government debt from the central bank via excess cash balances. In which case the best option is option 1 - redistribute the balance on the Treasury account. 

The other issue with all this debt issuance is that the balance sheet of the central bank would become very dependent on the Treasury. The structure would be similar to a parent-subsidiary structure where the parent loads the subsidiary's balance sheet with debt. Would the Treasury expect the central bank to pay interest on this debt - since it would be paying interest itself? If so, that would be a permanent small reserve drain - a tiny, continual monetary tightening. This might not be significant, though when policy is generally expansionary it seems a bit silly. But more importantly, the central bank would no longer be in any way independent, and monetary and fiscal policy would become inseparable.

However, due to QE we are already a very long way down this road: central bank independence is already being challenged, and coordination of monetary and fiscal policy is being recommended by some rather significant players, notably the NY Fed, which is visibly uncomfortable with the USA's political paralysis and the pressure that it is under to deliver more than monetary policy reasonably can by itself in a liquidity trap. The end of central bank independence is being promoted by central banks themselves.

The stability of any economy and the safety of its liabilities depend on the economic management team working effectively to achieve desired outcomes and deal effectively with problems. The independence of the central bank and separation of monetary and fiscal policy worked well in the past, but the crisis of 2008 and subsequent recession fundamentally changed the economic landscape. The conduct of monetary and fiscal policy in Western economies is no longer the same, and therefore the roles of monetary and fiscal authorities must change. As monetary and fiscal policy become ever more blurred, cooperation not separation becomes the name of the game. Central bank independence needs to be consigned to history.

Related links:

Safe assets and government debt - mainly macro
When governments become banks - Coppola Comment
Government debt isn't what you think it is - Coppola Comment
Era of independent central banks is over - Stephen King, HSBC
Helicopter Money - McCulley & Pozsar
Institutional Cash Pools and the Triffin Dilemma of the US banking system - Pozsar (IMF)
Why the US needs its own sovereign wealth fund - Quartz
The Treasury auction process: objectives, structure and recent adaptations - NY Fed (2005)


  1. I thought treasury departments had direct accounts with their central bank, in which case excess cash has no impact on the private banking sector. I mean Siemens has an ECB account, it'd be nuts if governments didn't...

    If the treasury issues $x of excess debt, what happens is that x is debited from commercial banks accounts at the central bank (on behalf of the ultimate buyers) and credited to the treasury's account. From then on they just sit on it. The effective monetary base is reduced by x, and there are none of the problems you describe.

    The wealth fund idea does not solve the picking winners issue, just replaces picking winner companies with picking winner managers. Good luck with that. They'd be better off buying the index if they ever need buying private assets (which they don't here).

    1. You are right. It's monetary tightening, actually, not expansion as I originally thought. Ouch. I will have to revise this post majorly.

  2. [...] Although the debate appears to be dying down, at least momentarily, Simon Wren-Lewis and Frances Coppola (see here, here, and here) have added worthwhile readings. [...]

  3. There are numerous people out there who would agree with Frances’s two concluding sentences, namely that separating fiscal and monetary policy makes little sense. The idea is popular in Modern Monetary Theory circles. The idea is also promoted in the submisstion to Vickers made by Positive Money, Prof.R.A.Werner and the New Economics Foundation. I also arged for the above policy here:


  4. The entire construct described above is at variance with the US Constitution.

    In the US, only the board of governors is a federal dept, the individual reserve banks are corporations owned by their member banks.

    This construct was a product of the gold standard era, when most gold was privately held, and the US used specie as it's currency. This specifically meant that during that era the US Federal Govt, was a currency user, but not a currency issuer.

    The advent of a fiat US currency during the Nixon Administration, changed things fundamentally. Now, the US Federal reserve remained the Currency Issuer, but no longer was there a need to obtain specie.

    What is needed now, is to recognize that the current arrangement is unconstitutional, as under the constitution, only the Congress has the authority to issue currency. The traditional means of doing so has been via the Bureau of the Mint, and the Bureau of Engraving and Printing. In today's world, needed, is a Bureau of Electronic Currency.

    Given these tools, Treasury can spend into existence US Dollars necessary to purchase goods and services needed by the Federal Govt. The Bureaus of Electronic Currency, Mint, and Engraving and Printing can meet the needs of the US Federal Reserve, by provision of coins, notes, and credits to the Fed's Account(s) in exchange for Federal Reserve Bonds, paying interest to Treasury. US Fed can continue to act as lender of last resort to it's member banks, provider of coins and notes to it's member banks, with the difference being that the US Fed accepts collateral from it's member banks to cover the disbursements, and to support Fed Bonds issued to Treasury.

    Were all banks required to invest demand deposits in US Treasury Demand Deposit Bonds paying 3%, purchased by the Fed on their behalf, and time deposits in US Treasury Savings Bonds paying 5%, purchased by the Fed on their behalf, we would have a full reserve banking system, not prone to bank runs. Banks would make loans out of their share capital, period.
    I have other ideas, but will stop for now.


    1. You would eliminate the Fed's responsibility for monetary policy, then?


  5. I also envision the creation of 24 Federal Banks, and 50 Federally Chartered Banks of the several states, one per state. The purpose of these is similar to the original function of Fannie Mae and Sallie Mae. Each bank would specialize in an industry, or trade function and would participate in loans made by private banks, via syndication.

    The advantage of this over the present system is the ability to vary the % of participation and the interest rate from industry to industry. For example, given the desire to promote Solar PV systems, the Federal Renewable Energy Development Bank could offer to take up to 90% participation in qualifying loans originated by private banks, at 1% interest. Given the need to convert present housing stock to passive solar, the Federal Housing Bank could likewise offer to take up to 95% participation in qualifying loans originated by private banks at 0.5% interest, while offering to take only 50% participation in loans for conventional dwellings at 9% interest.

    Likewise the Federally chartered Bank of the State of Wisconsin, could act as repository for all Wisconsin State and Local Government monies as required by statute, investing same in US Treasury State Investment Bonds paying 5% interest, and having the right to make loans for state and local government projects secured by state and local revenues with a reserve ratio depending upon the creditworthiness and necessity of the borrower, but likely 10% or less. This would eliminate the need for municipal bond issues, or state bond issues.

    Furthermore, PBGC could be authorized to hold and manage all pension monies nationwide, with the sole authority to invest these funds into US Treasury Retirement Bonds paying 8% interest. This would remove pension monies from risky investments, returning pensions to the earlier era of guaranteed payouts, and restoring confidence to retirees regarding their old age. Were pension monies made immune to civil action, and prohibited from being used as collateral for loans or other obligations, we would have a robust pension system geared to providing the elderly with retirement income.


  6. "CB independence is already being challenged"

    The U.S. Treasury's "overdraft privilege" was revoked for good reason. The Treasury-Reserve Accord of March 1951 is prima facie evidence.

    This brings the "Scorpion and the Frog" fable to mind. Treasury-Federal Reserve collaboration exists in its present state, because whenever in the past the FED's responsibilities were subordinate to the Treasury's, this country experienced intolerable rates of inflation.

    And that's too bad as MMT could eliminate debt's "bogeyman" - the compounding of interest expense.

    1. I don't believe I have anywhere suggested subordinating the FED's responsibilities to the Treasury's. On the contrary, in my post on government debt I suggested that in the central bank/Treasury partnership the central bank should be in the driving seat, because of its responsibility for controlling inflation. Lack of independence does not imply subordination.

      I would suggest you read McCulley & Pozsar's paper, because they discuss this very point.

  7. You mean like concealed-greenbacking? And I don't read non-fiction. I discovered the Gospel in July 1979. No one else has hit upon it. If what Bernanke actually did was actually uncoveraged by anyone he would be assassinated.

    1. What on earth are you talking about? I am talking generally about central bank independence, not specifically about the US - although the global demand for safe assets is mainly a US issue.

  8. Roc's in MVt = roc's in all transactions (PT). This serves as a proxy for nominal-gDp. I presume that if economic prognostications are infallible for the U.S. - they would likewise be for most countries. Discussions of interest rate floors, corridors, etc. are moot. There're bigger fish to fry.

    At the height of the Doc.com stock market bubble, Greenspan initiated a "tight" monetary policy (for 31 out of 34 months). A “tight” money policy is defined as one where the rate-of-change (ROC) in monetary flows (our means-of-payment money times its transactions rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

    Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), & reverted to a very "easy" monetary policy -- for 41 consecutive months (i.e., despite 17 raises in the FFR, -every single rate increase was “behind the inflationary curve”). I.e., Greenspan NEVER tightened monetary policy.

    Then, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a "tight" money policy (ending the housing bubble in Feb 2006), for 29 consecutive months, or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression).

    The FOMC continued to drain liquidity despite its 7 reductions in the FFR (which began on 9/18/07). I.e., despite Bear Sterns two hedge funds that collapsed on July 16, 2007, & immediately thereafter filed for bankruptcy protection on July 31, 2007 -- as they had lost nearly all of their value), the FED maintained its “tight” money policy (i.e., credit easing, not quantitative easing).

    I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers later filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market), on September 15, 2008.

    And Greenspan didn't start "easing" on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn't change from a "tight" monetary policy, to an "easier" monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4% (approximately coinciding with the bottom in equity prices).

    I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), & high inflation (rampant real-estate speculation, followed by widespread commodity speculation).

    Bernanke then relentlessly drove the economy into the ground, creating a protracted un-employment, & under-employment rate, nightmare.

    POSTED: Dec 13 2007 06:55 PM |
    10/1/2007* temporary bottom
    7/1/2008 commodities & (MVt) peaked
    10/1/2008 * possible recession (- roc's)
    11/1/2008 * possible recession (- roc's)
    12/1/2008 * possible recession
    Exactly as predicted:

    Even as the Commerce Department said Retail sales increased by 1.2% over October 2006, & up a huge 6.3% from November 2006.

    1. Yes, you're right. Greenspan has much to answer for, and Bernanke was way too slow in responding to the start of the crisis. The FOMC minutes from 2007 have just been released. Have you read them? They are laughable. But in the Fed's defence I would have to say other central banks were as bad or worse. Three days after Lehman the Bank of England's MPC seriously considered raising interest rates. And the ECB actually DID raise rates and kept them high, which in my view was at least partly the cause of the sovereign debt crisis. Inept central bankers are not purely a US phenomenon.

  9. It's all politics, not economics. CBs pay for what they already own. The Fed can't control the banking lobby nor interest rates.

  10. It's a moral dilemma, do you tell - or consider it intellectual property?

  11. The Fed doesn't know a bank (which creates new money whenever it makes loans or invests), from a non-bank (the turnover of existing money), i.e., doesn't know money from liquid assets (Keynesian confusion).

    Expanded FDIC insurance coverage induced dis-intermediation within the non-banks (resulting in a de facto tightening of FOMC money policy). What caused M1 money growth to surge was that customers transferred their balances between deposit classifications - from savings/investment type accounts (interest-bearing without reserve requirements), to transactions based accounts (non-interest-bearing with reserve requirements).

    M1’s growth rate simply represented both an indifference on the part of depositors/savers given historically low yielding assets, & a preference for reduced risk (saver/holders received 100% unlimited FDIC insurance in the deposit classifications where they moved their money).

    PROOF: Scaling back coverage will partially reverse prior trends. Prior reductions in RETAIL sweeps to MMDAs, & reductions in COMMERCIAL sweeps to money market instruments (T-Bills, Euro-Dollars, & institutional MMMFs), will also contribute to a higher future velocity of money & collateral.

    The precise effect is hard to measure as contrary forces were at work. I.e., Operation Twist ended Dec 31st 2012 having re-infused short-dated "safe-assets" into the money market (facilitating shadow-bank lending or money velocity).

    But savings that were formally impounded within the CB system will again be released & flow back through the intermediaries (intermediaries between savers & borrowers), where they are "put to work" (matching savings with investment). I.e., savings held within the CB system are "lost to investment" resulting in a leakage in National Income Accounting. Contrary to all economists, CBs do not loan out existing deposits, saved or otherwise.

    As savings flow back thru the intermediaries it will boost the markets/increase real-gDp. It should also re-balance the EUR/USD exchange rate (as currencies will be converted), because it will stimulate growth in the unregulated, prudential reserve, money creating, Euro-dollar banking system.

  12. "They are laughable"

    There's always been an atmosphere of arrogance & ignorance.

  13. This comment has been removed by a blog administrator.


Post a Comment

Popular posts from this blog

WASPI Campaign's legal action is morally wrong


What really happened to Signature Bank NY?