A Run on Central Banks?
The latest phase of the global credit crisis, which has thrust Europe into the center of investors’ concerns, raises questions about the ability of central banks around the world to continue bailing out the financial sector open-endedly. Already, the turmoil has forced a policy about-face by the European Central Bank as it resorts to making direct purchases of sovereign debt in the same way that the U.S. Federal Reserve took on Treasuries and piles of battered mortgage bonds in an effort to stem America’s historic housing crash.
The string of emergency rescues led by global central banks was certainly popular among the banks – hardly surprising considering their continued existence was at stake. But now, bankers are bemoaning the very deficits incurred by various national governments in part because of financial sector bailouts. They worry all of the commitments made in Europe and the United States might have put governments – and perhaps even the central banks themselves – on the path to insolvency. Of course, central banks can’t really become insolvent in a strict sense, since they can always print money. The anxiety then becomes the ability of the monetary authorities to tighten their purse strings in time to prevent spikes in inflation and interest rates. This is how Joachim Fels at Morgan Stanley puts it in a research note to clients:
The longer the banking crisis and the sovereign crisis last (and both are by far not over yet), the more likely we will get a crisis of confidence in the central banks who act as lenders of last resort to banks and governments. Financial and fiscal stability concerns will make it difficult for central banks to aggressively fight inflation pressures once they emerge. Inflation in the U.S. and the euro area is still low, but the UK, where inflation is way above target, may be a leading indicator rather than an aberration. The ECB is just the latest victim – the sovereign and banking crises have forced it into actions that threaten to undermine its credibility over time. The gold price and exchange rates have already been signaling a loss of (overall and relative) confidence in the value of fiat money for some time. Yet, the famed bond vigilantes are fast asleep, lulled in by liquidity, carry and roll-down.
Yes, central banks can extend unlimited amounts of credit to banks and governments. But they do so by issuing ever more of their own liabilities – money. And just as the trust in banks’ and governments’ liabilities eroded when they issued ever more, we believe that the trust in money will erode if central banks issue ever more of it.
The line of thinking harkens back to something Willem Buiter, a former member of the Bank of England’s Monetary Policy Committee who now teaches at the London School of Economics, wrote back in May 2008, when the global financial crisis was still gathering steam. In the piece, entitled “Can Central Banks Go Broke?”, Buiter, argued that central banks could indeed go broke but that this was most likely to happen in developing countries, where the bulk of debt obligations are denominated in a foreign currency (and therefore cannot be inflated away via growth in the money supply).
Central banks can go broke and have done so historically, albeit mainly in developing countries. Central bank insolvency may become an issue again, even in advanced industrial countries, if central banks were to assume too many foreign-currency denominated liabilities in an attempt to support or bail out private banks and other financial institutions deemed to be too large or too interconnected to fail.”
The Fed’s foreign exchange swaps don’t quite fit that category yet, but they sure seem like a step in that direction.