by
Philipp Bagus
Both the Federal Reserve (Fed) and the European Central Bank (ECB)
are owners of the printing press. They produce base money. On top of the
base-money production, the fractional-reserve-banking system can
produce money out of thin air. Both central banks produce money in order
to finance their respective governments. As a result of their money
production, prices will be higher than they would have been otherwise.
All money users indirectly pay for the government deficits through a
reduction in purchasing power and the reduced quality of their money.
While the ECB's and Fed's functions (to provide liquidity to the
banking system in times of crisis and to finance the government together
with the banking system) are the same, there exist small differences
between them. In the so-called open-market operations (another term for
active manipulation of the money supply) the central banks produce or
destroy base money.
There are two ways central banks produce base money. By tradition,
the Fed uses the produce-money-and-purchase approach (PMP). Normally,
the Fed produces money in their computers and uses it to buy US
Treasuries from the banking system. In exchange for the US Treasuries,
the Fed creates money on the account that the selling bank holds at the
Fed.
The ECB, in contrast, uses the produce-money-and-lend (PML) approach.
It produces money and lends it to the banking system for one week or
three months. The preferred collateral for these loans to banks is
government bonds.[1]
As a result of PMP and PML, banks receive new base money. They hold
more reserves at their account at the central bank. The additional
reserves mean that they can now expand credit and create even more
money.
For governments, the mechanism works out pretty well. They usually
spend more than they receive in taxes, i.e., they run a deficit. No one
likes taxes. Yet, most voters like to receive gifts from their
governments. The solution for politicians is simple. They promise gifts
to voters and finance them by deficits rather than with taxes. To pay
for the deficit, governments issue paper tickets called government bonds
such as US Treasuries.
An huge portion of the Treasuries are bought by the banking system,
not only because the US government is conceived as a solvent debtor,
thanks to its capacity to use violence to appropriate resources, but
also because the Fed buys Treasuries in its open-market operations. The
Fed, thereby, monetizes the deficit in a way that does not hurt
politicians.
But what about the interest paid on the Treasuries? The US government
has to pay interest on the bonds to their new owner, the Fed. The Fed
receives the interest, which increases the Fed's profit. Who receives
the Fed's profit? The bulk of the Fed's profit is remitted back to the
US government at the end of the year.
But what about the principal on the bonds? What happens when the bond
must be paid back? At the end of the term of the bonds, the government
would have to pay its holders. The trick here is just to issue a new
bond to pay for the maturing one. Thus, the debts must never be paid but
keep getting monetized. Figure 1 shows how the Fed finances the US
deficit:
Figure 1: How the Fed finances the US government
The ECB finances deficits in a more subtle way. Only in the
sovereign-debt crisis did it start to buy government bonds outright.
Normally, the ECB lends to banks against collateral. Banks buy
government bonds because they know it is preferred collateral at the
ECB. By pledging the bonds as collateral at the ECB, banks receive new
reserves and can expand credit. As the government bonds are still owned
by banks, governments have to pay interest to banks. Banks, in turn, pay
interest on the loans they receive from the ECB, which remits its
profits back to governments.
Thus, the system is similar to the Fed, with the difference that
normally some of the interest payments leak out to the banking system
that pays lower interest rates on its loans than it receives on the
bonds. Another important difference is that there may be a
redistribution between governments if eurozone governments run deficits
of different sizes. In my book
The Tragedy of the Euro
I explain that the Eurosystem resembles a tragedy of the commons.
Several independent governments can use one central-banking system to
finance their deficits and externalize the costs in the form of a loss
of purchasing power of the Euro onto all users of the currency. The
incentive is to have higher deficits than other eurozone governments in
order to profit from the monetary redistribution. The flow of the new
money is shown in figure 2.
Figure 2: How the ECB finances Euro area governments
Is the difference between the Fed's and the ECB's manipulation of the
money supply essential? The Fed buys government bonds outright, while
the ECB accepts them as collateral for new loans to the banking system.
Economically, the effects are identical. The money supply increases when
the Fed buys government bonds. When the ECB grants a loan with
government bonds pledged as collateral, the money supply increases as
well. In the case of the Fed, the money supply increases until the Fed
sells the bond. In the case of the ECB, the money supply increases until
the ECB fails to roll over (renew) its loan to the banking system.
There exists a legal difference. The Fed integrates the government
bonds on its balance sheet. The ECB does not do so as bonds remain
legally the ownership of the banks. Because the ECB does not publish the
collateral provided for its loans, we do not know how many Greek
government bonds, for example, are provided as collateral for ECB loans.
The Fed is more transparent in this respect.
In both cases, government deficits are effectively monetized. That
means that the ECB was bailing out Greece even before May 2010. It did
not have to buy the Greek bonds outright; it only had to accept them as
collateral. If the ECB had not accepted Greek bonds, Greek debts could
not have mounted to such an extent. The Greek government would have had
to default much earlier.
Aside from this more direct monetization, there is also a
monetization going on that is often neglected. Market participants know
that central banks buy government bonds and accept them as the preferred
collateral. Banks buy the bonds due to their privileged treatment
ensuring a liquid market and pushing down yields.
Knowing that there is a very liquid market in government bonds and a
high demand by banks, investment funds, pension funds, insurers, and
private investors buy government bonds. Government bonds become very
liquid and almost as good as base money. In many cases, they serve to
create additional base money. In other cases they stand as a reserve to
be converted into base money if necessary. As a consequence, new money
created through credit expansion often ends up buying liquid government
bonds, indirectly monetizing the debt. (Another main holder of
government debts is other foreign central banks.)
Imagine that the government has a deficit and issues government
bonds. Part is bought by the banking system and used to get additional
reserves from the central bank, which buys the bonds or grants new
loans, accepting them as collateral. The banking system uses the new
reserves to expand credit and grant loans to, for example, the
construction industry. With the new loans, the construction industry
buys factors of production and pays its workers. The workers use part of
the new money to invest in funds. The investment funds then use the new
money to acquire government bonds. Thus, there is an indirect
monetization. Part of the money created by the
fractional-reserve-banking system ends up buying government bonds
because of their preferential treatment by the central bank, i.e., its
direct monetization.
The process is shown in figure 3:
While it is an intricate system at the first sight, one that many
common citizens fail to understand, the system boils down to the
following: The government spends more than it receives in taxes. The
difference is financed by its friends from the financial system,
accommodated by central banks. Money production sponsors politicians'
dreams, thereby destroying our currencies. The population pays in the
form of a lower purchasing power of money.
For governments it is the perfect scheme. The costs of their deficits
are externalized to the users of the currency. The debt is never paid
through unpopular taxes but simply by issuing paper that says,
"government bond."
Notes
[1]
Traditionally central banks have used both ways to finance government
debt. America's Federal Reserve System places emphasis on the purchase
of government bonds in its open-market operations. It also accepts
government bonds as collateral in repurchase agreements. Repurchase
agreements and other loans in which government bonds were accepted as
collateral rose in importance during the financial crisis of 2008. The
European Central Bank, on the contrary, has put more emphasis on
accepting government bonds in collateralized loans in its lending
operations to the banking system. Only during the sovereign-debt crisis
of 2010 did the ECB started buying government bonds outright. On these
central-bank policies in the wake of the financial crisis, see Bagus and
Howden (2009)
and Bagus and Schiml (2010).
