On Saturday, we wrote that more and more people are starting to wonder if central banks like the Bank of England and The Fed can just “rip up” the debt that they’ve bought via Quantitative Easing, and reduce the national debt of these countries with the stroke of a key.Asking this question, and thinking about the implications of it, is the equivalent of taking the ‘Red Pill’ of economics. The Red Pill, of course, is what Neo took in the Matrix, and it exposed his mind to an entirely different view of the world that was far less comfortable than the one he inhabited. If you start thinking about the possibility that the central bank could just rip up a government’s debt, with few negative ramifications, then you might start thinking about government finances in a totally new way that makes you uncomfortable.
You might start to realise that this whole construct of a broke government, deeply in hock to the Chinese (and everyone else) is an illusion, that complete distorts the realities of sovereign finance.
But it’s too late. More and more people are taking the red pill, and thinking about this question.
Want proof? In her latest note, SocGen economist Michala Marcusen reveals the #1 question that clients are asking.
With each new round of QE coming with diminishing returns, a new question is emerging … Can central banks just cancel their government debt holdings?
For what it’s worth, Marcusen isn’t buying the idea that it can be done so easily:
A speech by FSA Chairman Turner on 11 October appears to have catalysed the recent debate when he noted that “…quantitative easing may be subject to declining marginal impact ‹…..›. So optimal policy needs to include a willingness to employ still more innovative and unconventional policies ‹…..›”. While Lord Turner (a potential candidate to succeed Mervyn King at the BoE when his term expires in June 2013) has publically distanced himself from the notion that central banks could just cancel their government debt holdings, the idea holds temptation for deflation hawks.
The initial argument is seductive; the government and the central bank both belong to the public sector so simple consolidation would net out the debt without any loss to the private sector (the loss would fall on central bank capital). With the Fed holding around 10% of Treasuries and the BoE 25% of Gilts, such a move could have a significant impact on the debt burden and alleviate the need for austerity. Furthermore, it would boost inflation thus reducing the risks of deflation. Both the Fed and the BoE see inflation as easier to fight than deflation.
Already concerned by the medium-term inflation risks of QE, we believe that such a policy move could prove a recipe for disaster. Central banks have long argued that QE is not debt monetisation due to its temporary nature, i.e. at some point in time the bonds will be sold back to the private sector. If the central bank’s government bond holdings are simply cancelled, this would amount to pure and simple debt monetisation (formally prohibited in the case of the ECB), and would in our opinion risk soaring inflation expectations as trust in the monetary system breaks down. In his latest edition of Popular Delusions, Memo to Central Banks, Dylan Grice issues a very clear warning on the dangers of debasing trust.
We’re not sure if Marcusen’s stance is right, but the point is clear, just based on the fact that this is the top client question right now: more and more people are escaping the prison of their minds!