The miracle drug of quantitative easing, which prevented the financial crisis from becoming a repeat of Great Depression, helped us survive the years of famine, stabilized the markets following the shock of Britain leaving the EU and allowed the Government to spend money “protecting” its citizens from Covid’s ravages.
After £875bn in the UK alone and trillions in dollars of central bank money printing worldwide, the chickens have come home to roost, and not only in the inflationary crisis we are seeing today.
The public finances are also at risk, as the QE effect has changed from being supportive to deeply destructive, due to rising interest rates.
This is some technical. It requires some attention. However, the main point is relatively simple.
Officially, the purpose of QE is to lower market interest rates to stimulate the economy. However, in practice it has had the immediate effect of reducing government financing costs.
In the UK for example, interest payments on the Government’s debt fell during the pandemic, even though the Treasury borrowed hundreds of billions to pay for lockdowns and additional healthcare costs.
The tables have now turned with the resurgence of inflation. With it, the debt interest bills are going through the roof and eating into the government’s ability spend on other items. This severely limits the scope for tax reductions ahead of the elections.
As always, the EU is less transparent now that bills are beginning to arrive about the costs.
The German federal audit office warned that the German government might need to bailout the Bundesbank in order to cover losses from its various bond-buying programmes.
All the satellite central banks will operate under the umbrella provided by the European Central Bank. As it stands, all of them are essentially insolvent.
Bank of England analysis shows that the UK government alone spent £124bn of the QE windfall when it was positive. Now, the UK is choking from the consequences.
This amount represents the difference between interest received by the BoE on government bonds purchased through QE, and the low interest rate paid to the central bank on the cash that was deposited as reserves.
This difference was then transferred as profit to the Treasury, allowing for much higher deficit spending than would otherwise be possible. If there ever was voodoo financing, this is it.
The only difference between Europe and the United Kingdom is that the Government compensated the Bank of England for future losses if the program was reversed.
The Bank of England has revised its last estimate and the Bank Rate is now at a rate of about £30bn per year. It may even be higher, as the Bank Rate is still rising.
The flow of funds from Banks to Taxpayers has been thus reversed.
In Europe, there is a slight difference, as the indemnity was not available. In Europe, most central banks allowed governments to bank profits. However, losses are not recognized yet, and they simply accumulate on the central bank balance sheet.
In Britain, the Treasury immediately makes up any losses, while in Europe central banks have a negative net worth.
Even a central banking system cannot trade indefinitely with negative equity. As the German audit office has acknowledged, eventually the losses must be paid.
A bailout of this kind will provoke a strong political reaction. The fact that many Germans did not want the euro to begin with, and the fact that the German checkbook again effectively backstops the whole system only intensifies the feeling of grievance.
The “no bailouts” principles, which underpin the pact for stability and growth of the monetary union, are being pushed through with a real coach and horses.
The sums in Britain and Europe are so large that the debate about whether the central banks should have forced taxpayers to cover the losses has been reignited.
Politicians were happy to spend QE profits as long as it lasted. But now, the situation is different.
After all, QE has the simple effect of swapping long-term government bonds with a fixed coupon with short-term debts with variable interest rates.
It’s great when the short-term rate is lower than the longer term rates, because it lowers government financing costs. When the official policy rate is higher than long-term rates then you have a problem.
Some economists are increasingly pushing for a complete end to the payment of Bank Rates on reserves held by central banks. This is a popular argument. A higher Bank Rate is bad for millions of mortgage holders, businesses and struggling companies. But there’s one big beneficiary: profits from the commercial banking system.
It is a source of great outrage that banks don’t pass on all the benefits of a higher bank rate to their depositors. Instead, they use the money to rebuild their margins.
I have mixed feelings about this. Even if a small percentage of reserves are not paid, it could be considered a default. In reality though, money held by the central bank as reserves is similar to money in a current account.
People will complain if a bank increases the interest rate on a current account. However, they do not consider it a default.
If no interest is paid on the reserves, then the monetary policy will be rendered obsolete. The rate of interest on the reserves is the primary conduit through which policy changes are transmitted to the real economy.
Nobody would be in charge. Commercial banks will also try to compensate by increasing the difference between deposit and lending rates.
In any case, it is too late. If Treasury had hoped that it could limit the damage caused by the escalating debt servicing costs, then it would have been wise to give due notice when the Bank Rate was relatively low.
By introducing a sudden change to the markets when the official rate of policy is already approaching 6pc, you risk destabilizing the entire system.
QE was initially introduced as a magic wand, despite the fact that most of us were highly suspicious.
But it has only delayed the inevitable and proved that free lunches do not exist, no matter how much governments would like to think otherwise.