Central Bankruptcy. Why Quantitative Easing could threaten the solvency of the central banks

The news this week that the US Federal Reserve is recommencing its quantitative easing programme on an open-ended basis, and that the European Central Bank is going to start buying the bonds of the peripheral Eurozone States to fulfil Mario Draghi’s commitment “to do whatever it takes” to save the Euro, call to mind an incident in my own investment career just over 20 years ago.

At that time, I was interested in buying shares a small property development company called Bellwinch, in which Iain Duncan Smith, now the Coalition Government’s Work and Pensions Minister, was then a director. My purchase was not a big one – from memory, perhaps between £20,000 and 30,000 – but the market in Bellwinch shares was so narrow and illiquid that I got a call from my broker. “You can only buy in tranches no greater than 5,000 shares,”  he told me, “and each tranche will be at a higher price, so your purchases will drive up the price.”

I told him to proceed at this basis, and felt a naive satisfaction when I saw the price increase published in the Financial Times the next day.  For the first time, I had managed to move the markets!  Furthermore, I was now sitting on a profit on my earlier purchases, which had been at lower prices than the official FT price!

But within 24 hours, the penny had dropped.

If my purchases had pushed the share price up, then, when I came to sell, my sales would also drive the price down – so I would be able to exit from the position, if at all, only at a substantial loss.

This is exactly the position in which the world’s Central Banks now find themselves.

It may explain why Professor David Miles, in his Scottish Economic Society lecture earlier this week, made no comment on when the Bank of England might unwind its quantitative easing programme. Perhaps the Monetary Policy Committee are worried that, if they try to sell off their gilt holdings, it will drive gilt prices down, resulting in large losses for the Bank of England.  Even worse, a fall in gilt prices would result in a rise in the cost of servicing the National Debt, making it even more difficult for the Coalition Government to tackle the fiscal deficit.

But at least the Bank of England can be reasonably confident that the British Government will continue to pay interest on its bonds.

The same cannot be said for the European Central Bank. As the ECB buys increasing amounts of peripheral Eurozone bonds, concerns must increase that it may never get its money back. There are very real doubts as to whether the Greek or Portuguese Governments will be in a position to service their debts.  Even the solvency of the Spanish Government looks increasingly doubtful.

What of the position of the US Federal Reserve?  US Federal Debt has now increased above $16 trillion, and is rising by more than $1 trillion per annum. It is now well above 90% of American US GDP – the tipping point at which Professors Reinhart and Rogoff found that sovereign governments struggle to service their debt, in their analysis of financial crises down the ages.

Private investors are increasingly wary of buying American Government bonds at yields that are negative in real terms. So the only buyer keeping up US bond prices is the Federal Reserve Bank.  If the Fed ever tried to sell, it would drive prices down and sustain significant losses.

Even more worryingly, if US Federal debt continues to spiral upwards, there will come a point at which the Federal Government struggles to meet its interest payments. At that point, the solvency of the US Federal Reserve Bank will also be under threat.

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5 comments

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  1. It seems to be accepted policy for central banks to debauch their currencies in a desperate attempt to buy short-term political and social stability for the guaranteed price of long-term chaos. In the US savers are being forced out of cash into riskier investments by these policies. In the UK, the government urgently needs to relieve retirees from the obligation of taking out paltry annuities with their pension pots. Current central bank measures are rewarding profligacy and slaughtering the prudent throughout the west.
    Baby Boomers have had it all their own way up to now. Is this the nemesis of the Woodstock generation?

  2. Thank you for the well written explanation. I’m not an investment professional or an economist, but have been making a diligent effort to understand the policies and the results. Rational thinking tells me that there SHOULD be greater inflation in prices – as you define it properly, a symptom – than we’re seeing based on the sheer quantity of QE’s that have occurred since 2008.

    There is amazingly little written about WHY the incessant QE’s have not resulted in greater inflation and just as little about how these central banks can possibly unwind this mess.

    I read your earlier article about just where some of the QE money has been absorbed and of course, that makes a lot of sense.

    In the US, official inflation numbers do NOT include commodity prices, which is absurd, since it is food and fuel prices that have dramatically increased.

    As you say, selling off the bonds / securities purchased is a method of unwinding. Is that selling off what drives interest rates up in and of itself or is increasing rates a potentially separate act?

    Once again, thank you for your well written explanations.

  3. I realize you’re addressing this to Mike, but I have a possible perspective on your very good question as to WHY the QE’s have not resulted in greater inflation. Actually, there has been massive inflation through the back door. Millions of savers & retirees expect to rely, at least in part, on the interest from bank deposits, money market funds, CDs and pension annuities. Collapsing interest rates have meant that all those who rely on traditional savings have been shafted by QE, which means that, with seriously compromised incomes, their spending power has collapsed . Prices have therefore risen constructively for millions of people relative to their incomes. This may not be called inflation, but the effect is just as insidious.

  4. Gavin,
    Thank you for your reply. I appreciate and welcome such thoughtful information and opportunity for discussion, regardless of whether it is Mr. Nevin or otherwise!

    In part, we both danced around a serious problem: I talked about official inflation numbers not including commodity prices in the calculation, you talked about the backdoor penalties experienced by savers and retirees, which you said, “may not be called inflation”.

    We clearly agree – the label applied by those with incentives to shape shift explanations or deny reality are irrelevant. The impact, the outcome is all that matters. The end result of repetitive massive QE to date is the classic hidden tax. And that is before whatever isn’t “absorbed” has even begun to hit the system or damage from unwinding it – if that is possible. I repeat that I don’t understand how it is possible without nightmarish-like scenarios that make U.S. Federal Reserve solvency seem like a “small” problem.

    I hope I’m missing something.

    But, speaking of the meaning of words: In your earlier remark you pointed out: “In the US savers are being forced out of cash into riskier investments”. These are the people referenced in your reply about the backdoor shafting, obviously.

    I’m troubled for a number of reasons, but one of them is what is defined as “safe” and “risky” at this stage. Haven’t those words lost most, if not all of their meaning, considering the labeling of risky investments as AAA which led to all manner of “low risk” fund managers to invest in them?

    Even pension, insurance, and money market funds were at risk. In fact, it was, reportedly, in large measure, the run on money markets in the middle of September ’08 that resulted in Henry Paulson’s late night session at the White House and the bailout proposal. Apparently, Attorneys General in at least 10 states were considering swooping into seize a number of insurance companies re-insured by AIG, for example.

    What are the risky investments of which you speak? Commodities? More mortgage derivatives? U.S. Treasury Bonds?

    1. In replay to Shelli’s comment: a key reason why QE has not increased inflation to a greater extent in the UK is that the velocity of circulation, or rate at which money circulates around the economy, has fallen sharply, as banks, companies and households have hoarded cash. They have done this partly to rebuild their pension funds and investment income, whose value has been damaged by QE. I haven’t looked at the position in the USA but suspect the position may be similar there – with the increase in the monetary base offset by the rate at which money is circulating around the economy.

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