Why the ECB Should Take More Risks

Mrs. Merkel and Mr. Schäuble are worried. The ECB is planning to buy the sovereign debt of its member states and Mr. Schäuble doesn't trust his southern European partners. He thinks that Portuguese, Spanish and Italian debt is risky and he knows that Greek debt is.

Bankers are supposed to be boring. And central bankers are supposed to be boring in spades. What would happen if the Fed were to bet the farm, buying shares in an internet start-up that subsequently goes bust? The public purse would be on the hook for the loss. At least, that’s the theory. That theory is wrong.

The central banking business plan is a money-spinner beyond a venture capitalist’s wildest dream. Buy an asset, any asset, and pay for it by issuing little pieces of colored paper. Collect the interest payments and dividends from the assets and use them to pay for your house, your car and a holiday in Spain. If you happen to be the central bank of a sovereign state, pay the interest and dividends to the treasury to help reduce the tax bill of your citizens.

Does it matter which assets you buy? Conventional wisdom says yes. A central bank should buy safe assets, typically promises issued by its own national government that will never fall in value. The Fed buys T-bills on the private market. The Treasury pays the interest and principal to the Fed, and the Fed turns around and pays them straight back to the Treasury. The point of all of this is to keep enough of the little pieces of colored paper passing from one person to another to “oil the wheels of trade”.

What if the Federal Open Market Committee were to put all of the Fed’s assets into the stock market the day before a stock market crash? If the Fed were privately owned, it would be put into receivership. After the crash, it has liabilities of $2,500b. These are the circulating pieces of colored paper. But its asset portfolio has been decimated by the market crash and the market value of those shares has fallen from $2,500b to $1,000b. What a calamity! Surely the taxpayer must rush in and recapitalize the Bank by pumping in another $1,500b. Not so.

Central banks, like the rich, "are different from you and me". Their debts are all in the form of those little pieces of colored paper. And the magic of central banking is that you and I will carry on passing those pieces of paper from one to another without ever trying to cash them in for something else. There was a time when the UK government printed the promise to “pay the bearer on demand, the sum of one pound” on its notes; at the time, a pound note was redeemable in gold. That time is long gone. All you will get at the Bank of England now, if you try to redeem your ten pound note, is two fives.

What does all of this have to do with the ECB? Mrs. Merkel and Mr. Schäuble should sleep easily in their beds. The interest payments on ECB assets are returned to national governments in proportion to a formula that weights each country by its relative size. As Paul DeGrauwe pointed out recently in a VoxEU post, as long as the ECB sticks to this formula when it buys sovereign debt, the only people to suffer from an Italian default will be private holders of Italian bonds. The net worth of the ECB may take a temporary hit, but that shouldn't bother European taxpayers, least of all the Germans.

Extraordinary times require extraordinary measures. There was a time when central banks were privately owned. The Swiss National Bank still is. But the Bank of England, the Federal Reserve and the European Central Bank are supra-national institutions that play by different rules. We should not be concerned if sovereign states are permanently in debt. This has been the case with the UK and the US treasuries for as long as the US and the UK have existed as sovereign nations. What is true for a national treasury, is also true for a central bank.