By buying up private sector assets – and so extending their balance sheets – central banks can both support businesses directly and underpin financial markets in times of crisis. This ‘qualitative’ easing is likely to be needed to deal with the sharp Covid-19 downturn.
Central banks fall into different groups. This article mainly considers a specific type: the central bank of a sovereign nation with its own currency, its public debt denominated in its own currency and a floating exchange rate. This includes the US Federal Reserve (‘the Fed’), the Bank of Japan, the Bank of England, the People’s Bank of China, the Swiss National Bank, Sweden’s Riksbank and the Bank of Canada. It also covers the European Central Bank (ECB) and the 19 nations it represents.
Other central banks are in a different position. One important group is the individual national central banks of the euro area member states, which are branches of the supranational central bank: they have risk on their balance sheets and no discretionary access to seigniorage revenue. Effectively, their own-risk exposures are akin to the foreign currency-denominated debt exposures of emerging market and developing country central banks.
Another group are the central banks of many emerging markets and developing countries, which often have foreign currency debt on their balance sheets. Yet further considerations are needed for central banks of countries with a fixed exchange rate, such as Hong Kong and Denmark. The largest economies, however, fall into the first type, the focus of this article.
What should central banks do?
The Fed assumes a special position in the pantheon of sovereign central banks because of the ‘exorbitant privilege’ enjoyed by the United States as the supplier of the world’s leading reserve currency. This relaxes the budget constraints of both the state and the private sector in the United States by facilitating the issuance abroad of dollar-denominated debt instruments. We should therefore expect the Fed to be most vigorous in using the size and composition of its balance sheet as countercyclical instruments.
Most advanced economy central banks have considerable scope to increase the size of their balance sheets and change its composition towards less liquid and riskier assets (including a wide variety of claims on the private sector). Most of them have been engaging in such quantitative and qualitative easing (QQE) but much more is required. The reason is that the Covid-19 pandemic is an unprecedented, combined demand and supply shock compounded by a further fear-and-uncertainty-driven Keynesian aggregate demand contraction.
The risk, which policy can offset, is the effects of the impairment of the creditworthiness of many borrowers – households and non-financial enterprises. Private sector financial intermediaries have experienced serious damage to their balance sheets and are unable or reluctant to roll over maturing exposures let alone engage in new lending and other forms of credit extension. This is why the state – in the form of the central bank – needs to fill this hole, providing direct credit and extending its balance sheet.
Are there risks to central banks?
It is key to note that there is no danger to central bank solvency from the balance sheet operations I propose. Also, while an exit strategy from these operations may be feasible, it is not necessary. Central banks have been lenders of last resort and marketmakers of last resort following crises for centuries. There is no evidence that expanded balance sheets need to be unwound quickly.
Instead, what we should expect to see during an economic calamity that triggers a financial crisis – the situation we are in today – is a deepening of the lender-of-last-resort and marketmaker-of-last-resort roles of the central bank. The boundaries between private and public credit extension should become vague and porous and for a while may well vanish completely.
What has happened so far?
The size of the balance sheet of the Fed increased from $4.1 trillion (19.2% of 2019 GDP) in the week from Monday 6 January 2020 to $7.2 trillion (33.6% of 2019 GDP) in the week from Monday 30 November 2020. Over the same period (Friday 3 January 2020 till Friday 27 November 2020) the size of the Eurosystem balance sheet increased from €4.7 trillion (35.1% of 2019 GDP) to €6.9 trillion (51.5% of 2019 GDP).
I consider these increases, and the current sizes of the balance sheets, to be quite modest given the extraordinary circumstances encountered by financial intermediation in the United States and the euro area. The Bank of Japan over the same period increased the size of its balance sheet from 104.4% to 127.4% of 2019 GDP – see Figure 1.
Figure 1: Balance sheet (% of 2019 GDP)
Source: Bloomberg Finance LP, Deutsche Bank
One explanation and justification for the still surprisingly modest size of the Fed’s balance sheet is that financial intermediation through the banking system is much less important in the United States than in the euro area or Japan. Firms are more likely to issue bonds or offer equity stakes – that is, intermediation through non-bank financial intermediaries and the capital markets is correspondingly more important.
But while this point is correct, it misses the fact that a central bank is not just a bankers’ bank, it is a marketmaker for non-bank financial intermediaries. It should really be called ‘central bank and central marketmaker’. The policy problem is that intermediation through capital markets as well as through banks has become dysfunctional as a result of the Covid-19 crisis. Central banks should step in to remedy the situation.
This has been recognised through the creation, since the start of the Covid-19 pandemic, of many emergency facilities by the Fed. Regrettably, effective 31 December 2020, the US Treasury has withdrawn its support for four sets of facilities (the Term Asset-Backed Securities Loan Facility, the Municipal Liquidity Facility, the Main Street Lending Program which operates through five facilities, and two Corporate Credit Facilities).
That still leaves the Paycheck Protection Program Liquidity Facility, the Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, and the Primary Dealer Credit Facility as net additions to the arsenal of emergency measures.
What should the new US administration do?
The new US administration should reinstate the four sets of Fed facilities that have lapsed, but more than that is required. Equity markets have been remarkably robust throughout the pandemic, but we should be prepared for disappointments here also. Like the Bank of Japan, which has just become the largest Japanese stock owner, the Fed should arrange exchange-traded fund facilities to permit it to trade stocks on a large scale at times of its choosing.
More generally, there is no tradable asset class that should be off-limits to the Fed as investments. This includes not just all primary securities for which it is possible to identify a market price but also asset-backed securities and other derivatives, including credit default swaps.
If banks become excessively cautious and conservative, it should be possible for the Fed to lend directly to non-financial entities. The Fed should also be able to take debt and equity stakes in banks and other financial intermediaries.
It is not enough, however, just to create a facility or set of facilities. The central bank should ensure that use is made of these facilities. Here most of the Fed’s new emergency facilities have been failed to achieve their goals – with barely any take-up of the massive available space of all facilities other than the Paycheck Protection Program Liquidity Facility.
It may be argued that all this would turn the Fed into Gosbank – the central bank of the former Soviet Union. But the distinction between the private and the public domain becomes increasingly irrelevant as markets fail and disappear and effective collective action becomes a necessary condition for economic survival.
The Fed and other central banks of advanced economies have a unique opportunity to turn the size (larger) and composition (riskier) of their balance sheets into instruments of macroeconomic management. It is time to become significantly more aggressive.