Tuomas Malinen+ Your Authors @mtmalinen PhD econ. Chief Economist of GnS Economics. Adj. Professor of Economics @ Uni Helsinki. Economic growth, economic crises, monetary unions and central banks. Apr. 06, 2020 5 min read + Your Authors

This is something I've planned to do for a long time. There are wide-spread misconceptions on #centralbanks that need to be set straight.

So, a (long) thread on why Central bankers are not "superheroes".

Let's start with a cheerful poll. 😊 1/26
#Fed #ECB #economics

It seems that majority of my followers are both insightful and wise 👍.

The results also lead to the conclusion, which I now try to elaborate a bit more. 2/
@Amdalleq @CNBCJulianna @KellyCNBC @DiMartinoBooth @KatriKulmuni @bondstrategist @BradHuston

First, few words on QE.

The purchases of assets in QE-programs are done through commercial banks.

Banks buy the securities from other banks, investors and households and the central bank credits the reserve balances to the accounts of banks to balance their balance sheet. 3/

This means that QE-programs are a form of 'central bank credit' to the #economy.

They are NOT merely "asset swaps" nor are they "debt monetization" or "money printing".

Central banks give out money and receive a collateral.

That's all you need to understand about QEs. 4/

However, such large-scale asset purchases can lead to considerable losses through asset depreciation, which is where the "plot" thickens.

Several CB:s in history have, actually, been recapitalized by respective governments due to the losses incurred from such programs. 5/

In a simplified balance sheet of a central bank, money (currency), the government’s bank account (domestic liabilities) and the reserves of commercial banks and net worth are on the liabilities-side.

Net worth is determined as the capital of the central bank and ... 6/

...valuation adjustments for changes in the foreign-exchange rate and investments.

Asset-side of the central bank's balance sheet include securities, foreign-exchange reserves (net foreign assets) and loans to commercial banks.

Thus, when a central bank buys assets,... 7/

...like government bonds, it simply either creates money directly or debits the reserves of commercial banks to maintain balance between assets and liabilities.

In the programs of quantitative easing, central banks have enacted the latter option. 8/

A central bank earns income in the form of interest from its holdings of securities.

If the liabilities contain just required central bank reserves and currency, the central bank has “zero-cost” of financing. If the liabilities include any excess reserves and foreign or... 9/

...domestic liabilities, the central bank pays an interest.

In general, the value of foreign and domestic assets have a significant role in a central bank’s income stream.

Losses to a central bank tend to arise from interest obligations, subsidy payments,... 10/

...multiple exchange-rate practices, “guarantee” schemes and unfavorable changes in net asset valuations (securities).

The QE programs made central banks vulnerable to the last of these.

When a central bank accrues a loss beyond its stream of net interest rate income... 11/

..., that is gross interest income minus expenses, and "seigniorage", it starts to eat through the capital of the central bank.

Essentially, and unsurprisingly, the central bank follows normal accounting practice.

However, because the central bank has control... 12/

...over the monetary base (currency + reserves), it can create demand for its liabilities (currency) by buying government securities and earn seigniorage revenue.

Essentially, seigniorage is the difference between the “printing” costs of the legal tender... 13/

...(money or "monetary base" including also reserves commercial banks hold at the central bank) and its nominal value.

This is the ONLY difference between a central bank and a commercial bank.

The central bank can claim to be solvent due to the future income... 14/

...stream from seigniorage, even with negative net worth, while a commercial bank cannot.

But, covering a large loss from seigniorage will require a large growth in its monetary base, which tends to be highly inflationary.

A rapid growth in monetary base means that the... 15/

...money in circulation increases faster than production.

Consumers and firms start to expect higher inflation and "inflation expectations" explode leading to very fast increase in consumer prices.

The expectations, not the actual printing, tends to be the reason... 16/

...for hyperinflation. But, it STARTS from the uncovered printing of the central bank.

Monetary system ALWAYS reflects the real #economy, i.e., production. It cannot, e.g., lead it without destructive consequences.

We know this from Weimar, Zimbabwe and Venezuela, etc. 17/

So, while a central bank can, theoretically, cover all conceivable losses, this can only be accomplished through money printing leading to eventual destruction of the monetary system through hyperinflation.

The other option is that the government covers... 18/

...the losses of the central bank.

While some central banks have managed to operate relatively effectively also with negative net worth, which would mean insolvency of any other financial institution, such abnormalities have always occurred under two critical conditions: 19/

1) Central bank has been backed by stream of tax revenues, i.e., a Treasury.
2) Government debt and financial market conditions have been stable.

NONE of these apply, e.g., to the ECB currently.

There has not been a single central bank in history, who has survived... 20/

...without a Treasury having its back. Alas, it's highly likely that the #ECB will fail at some point.

So, any ideas that central bank could operate with negative equity are false, and extremely risky.

A central bank needs to be recapitalized under heavy losses. Period. 21/

So, what I hope to have managed here is the understanding the central banks are, essentially, just banks of the government.

They have the ability to twist the accounting rules, but that's it.

They can, and will fail, like all financial institutions without... /22

...sufficient equity or or a government bailout, when faced by large losses.

It's crucial to acknowledge that the massive asset risks central banks have accumulated in their balance sheets during the past few years, can topple them. 23/

The options to cover their losses are: recapitalization or destruction of the monetary system through (uncovered) money printing, and that's it.

Central banks are not "superheroes", they don't have "superpowers" and they sure as hell are not "masters of the universe". 24/

They are mere 'mortals', with some magic tricks up on their sleeves.

We CANNOT trust them to solve any of our financial or debt problems, because they have created a majority of them.

We need to look beyond central banks to run our economies in the future. 25/

I don't yet know, what such a system would look like.

But, it absolutely should NOT include the "all-powerful" central banks.

They've been a menace, and they need to go, or least their powers need to be wound down considerably.

Stay safe! /End

You can follow @mtmalinen.


Tip: mention @threader_app on a Twitter thread with the keyword “compile” to get a link to it.

Enjoy Threader? Sign up.

Since you’re here...

... we’re asking visitors like you to make a contribution to support this independent project. In these uncertain times, access to information is vital. Threader gets 1,000,000+ visits a month and our iOS Twitter client was featured as an App of the Day by Apple. Your financial support will help two developers to keep working on this app. Everyone’s contribution, big or small, is so valuable. Support Threader by becoming premium or by donating on PayPal. Thank you.

Follow Threader