Like Greek bonds. Dumb question of the day.
"Because risky assets are risky!" is not the answer.
Other things equal, I would prefer to hold a safe asset than a risky asset, because I don't like risk. But other things are not equal, precisely because other people don't like holding risky assets either. So risky assets are priced at a discount to safe assets, and so yield a higher expected rate of return than safe assets, and so some people are willing to hold some risky assets, despite their risk, and despite their risk-aversion. Every asset, even the most risky, is held by someone.
Those people who are relatively less risk-averse will hold relatively more relatively riskier assets; and those people who are relatively more risk-averse will hold relatively more relatively safer assets. It's all about comparative advantage, or comparative willingness to accept risk.
Do central banks have a comparative disadvantage at holding risky assets? Are central banks the widows and orphans of financial institutions?
We could ask the same question about illiquid assets. Why shouldn't central banks buy illiquid assets? "Because illiquid assets are illiquid!" is not the answer. Other things equal, I would prefer to hold a liquid asset than an illiquid asset, but other things are not equal, precisely because other people don't like holding illiquid assets either.
Do central banks have a comparative disadvantage at holding illiquid assets? That just sounds weird, because central banks themselves produce the most liquid assets of all.
You can make a case, as I did once, that central banks should sometimes actually prefer holding risky assets, even if other things were equal. But let's set that case aside. And you can make a case, in a liquidity crisis, that central banks should actually prefer holding illiquid assets, even if other things were equal. But let's set that case aside too.
As a purely benchmark case, we could imagine central banks holding the market portfolio of assets, with the same mix of safe and risky, and liquid and illiquid assets, as the average holder of assets. Starting at that benchmark, what are the arguments why central banks should move in one direction rather than the other?
What should make central banks relatively more averse to risk and illiquidity than the average holder of assets?
Again, "Because risky assets are risky, and illiquid assets are illiquid!" is not the answer. (So don't even think about saying that in a comment.) And "Because central banks are banks!" is not a good answer either, because they aren't, and because central banks seem even more risk-averse and illiquidity-averse than banks that really are banks.
And remember, the biggest asset that a central bank owns does not even appear on its balance sheet: that's the expected present value of its future seigniorage profits from printing money. (Background reading: my old post on why central banks hold any assets at all.)
I was thinking about the ECB and Greek bonds. Why not buy risky Greek bonds, at a market discount to safe bonds? Why not just buy the market portfolio of government bonds, if you want to do QE? And why just government bonds, and why just bonds? And then reading the latest missive from the Bank of Canada about its haircut policy. And realising I had no theoretical framework to even begin to answer these questions.
If I buy a Greek bond, am I bailing out the Greeks?
What is it about dumb questions like these? Why aren't they the first questions that get asked and answered?
Worthwhile Canadian Initiative 
Nick Rowe: “Min: You don’t understand it correctly.
Start here (second diagram): http://en.wikipedia.org/wiki/Deadweight_loss”
Thanks. 🙂 I was acquainted with the concept of deadweight loss, but that article had some information that was new to me.
However, deadweight loss is not my concern. I do not have time in the near future to go to the library and find Friedman’s book. So I cannot address his argument directly. Maybe I am getting the wrong idea from other sources.
My first concern is the use of the metaphor of a tax, which may or may not be applicable. My second is the impression that important variables are being left out or swept under the rug. (To use a metaphor, myself. ;)) It is as though the optimal number of cookies was being calculated based upon the total capacity of children’s stomachs. Other things are important besides the children’s desires for cookies.
Oh, yes. My third concern has to do with evidence. Where is the evidence that people are holding less currency than they should? Are they attempting to hold as much as they can by burying it in the back yard, for example?
Min: take that second diagram in Wiki, put M/P (real stock of currency) on the horizontal axis, and i (the nominal interest rate) on the vertical axis, and draw the Marginal Cost curve horizontal at roughly zero (ignoring the central bank’s printing and admin costs). Empirically the money demand curve does slope down (we hold more money when the opportunity cost of holding it falls), so if the monopoly central bank sets i above marginal cost, we get a deadweight cost triangle.
@ Nick Rowe
Thanks. You have adapted Friedman’s argument to modern practice, I guess. But my second concern, that of leaving out important variables, remains. Also:
Nick Rowe: “If you tax holding currency, people hold less currency than where marginal benefit = marginal cost.”
By “tax holding currency” you mean have inflation, right? Empirically, during periods of inflation, people tend not to hold on to money. I suppose that you identify when marginal benefit = marginal cost, people are indifferent to holding currency. But then they try to get rid of it when they hold more currency than the Goldilocks amount, not when they hold less.
As for Gesell, his money did have an explicit tax on holding currency. But that was considered a welfare enhancement, not a welfare cost. We cannot simply say that the optimal amount of money in an economy is that amount such that people, on average, are indifferent to holding it or not.
Nick,
“Why shouldn’t central banks buy risky (and illiquid) assets?”
When a central bank actively buys and sells assets, do they become less risky and more liquid – I think so. Can a central bank eliminate the risk associated with any asset – I think to a point it can. Obviously people and may goods have fixed lifetimes. A steel hammer left to rust will turn to dust and scatter in the wind.
And so maybe the question should be – should any asset bear risk?
I know Nick thinks any seignorage will EVENTUALLY be spent by government, even though, at its most basic, it’s money that will NOT be spent by government. Buy peoples tax bills (or a portion of). payroll taxes? How do you suck money out? If the default rate is 100% (for illustrative purposes) that wouldn’t be hard at all. Plus, it avoids the fact that seignorage is impossible at the ZLB.
oops. wrong blog post. meant for what assets risky assets cb should own post
Nick,
I’m confused by the harshness of your response here. I point out that you are hiding fiscal policy in monetary policy and you respond with some ad hominems followed by “…so that central banks are forced to print more money to cover their losses”. What I’m saying is pretty orthodox and, (to me), should be clear to most readers. Perhaps I’m not clear enough.
Let’s try again.
Your proposal is (almost) isomorphic to the following:
Suppose you want the CB to purchase 1/3 of all private sector assets. To do this legally, you can:
1. Have the Treasury make a lump sum payment of 1/3 of the value of the asset to the owners.
2. The payment is financed by selling government debt.
3. The CB buys the government debt with QE.
4. The Treasury institutes a capital income tax equal to 1/3 of all capital income.
5. Proceeds of the tax are used to redeem the government bonds held by the CB.
This is almost what you want, except that
– Because we tax the capital income rather than buying the asset outright, we avoid the ethical problems of bureaucrats sitting on executive boards — e.g. we limit govt. control of the private sector to receiving the dividend/coupon, and not running the company. This is a good thing.
– It is legal.
Note that here the fiscal and monetary components are clearly defined. It’s not something that the CB can do on its own, and for good reason.
This should be enough to convince the casual reader that your proposal has embedded in it a fiscal component — something I see repeatedly here. Don’t get angry. That does not make me a deranged lefty or whatever.
Now we can have a more fruitful discussion of whether this would work to stimulate the economy. I’d be in favor of it if it had redistribution as well — e.g. don’t give the lump sum payment to holders of the asset, but distribute it progressively.
I really like the capital income tax, and have advocated for it before. If you believe that the market clearing interest rate is negative, then this can be raised to zero by a high enough capital income tax. I don’t understand why there are repeated calls for lower real wages if we really believe there are excess savings demands.
Oh, and if you only want the CB to buy asset class X, then make the lump sum payments to holders of that asset class and only tax the capital income of that class. This generalizes to whatever you want to do. It’s still a combination of fiscal and monetary policy, though.
rjs: you accuse me of semantic legerdemain by “hiding fiscal in monetary policy”, and miss the point of this post, and wonder why I get pissed?
Not every question is: “should we use monetary or fiscal policy to stimulate the economy?” And this one isn’t. This is not a post about monetarists vs fiscalists. And I don’t give a damn about whether you call it “fiscal policy”. That is a mere semantic argument.
We have these things called “central banks” that, in most countries, are owned by governments but are to a greater or lesser extent treated as independent of the rest of government. They have their own set of books, with their own assets and liabilities.
So we might want to ask some basic questions like:
Why do central banks need assets?
If they do need assets, what sort of assets should those be? Should they only include safe and liquid assets? Why?
And “they must only hold government bonds, because if they held anything else they would be doing fiscal policy not monetary policy! And that would be against the law!” is not a good answer to those questions. It’s not an answer at all. It’s pure semantics. And then you accuse me of playing semantics by “hiding fiscal in monetary policy”.
“Because it would be risky if they held anything other than government bonds!” is a better answer.
Yes, if we consolidate the central bank’s asset sheet with the rest of the government, we cannot see the difference between the central bank holding risky assets and the rest of the government holding risky assets. But for some reason central banks have their own set of books, and are run at least semi-independently of the rest of the government. If you think that independence is a pure fiction, then it doesn’t matter at all whether it is central banks or the rest of government that holds the risky assets. So we still don’t have an answer to my question.
Plus, there are some central banks, like the ECB, that stand alone, and don’t really have a federal government.
“Plus, there are some central banks, like the ECB, that stand alone, and don’t really have a federal government.”
Yup, this is the point. The ECB is not a real central bank because it cannot buy risk-free assets. There are no risk-free assets denominated in Euros.
So the ECB conducts fiscal policy (because it can’t avoid it), and as a result it’s telling Greek Women that they need to retire later, it’s telling Greek Unions that they need to scale back their wages, it’s telling the Irish government what kinds of surpluses it needs to run. You know, that kinda sounds like fiscal policy, doesn’t it?
Now these are things that creditors do all the time. These are also things that Governments do all the time. But governments have to conduct transfers, and — we hope — they exert their authority with some form of democratic accountability.
Now you — not me — want this new fangled thing called ‘Central Bank Independence’ — in which a bunch of unelected economists get to dictate things to the rest of the economy.
Fine, as long as the legislature tightly controls what they are and are not allowed to do.
They are not allowed to conduct transfers, which means that they can’t do fiscal policy. This is a good thing, because they can’t set the terms of the transfer, either. Because they can’t do fiscal policy, the electorate is OK with them being unaccountable and unelected.
As soon as they start doing fiscal policy, as soon as they become a quasi fiscal-monetary agent, then they either lose their independence to elected bodies, or they (God help us) become like the ECB.
You mentioned forex pegs and buying gold (really a forex peg when CBs invested in gold). Wanna know why none of those CBs were independent? It’s because they bought those risky assets. You can’t do all three: maintain a peg, have an independent monetary policy, and have an independent fiscal policy — for purposes of pure logic/accounting.
For purposes of living in a democratic society, you cannot have unelected central banks conducting fiscal policy (which is why the ECB is so hated and europe is so messed up). That’s why the CB can’t buy risky assets.
RSJ,
“For purposes of living in a democratic society, you cannot have unelected central banks conducting fiscal policy (which is why the ECB is so hated and europe is so messed up). That’s why the CB can’t buy risky assets.”
But you can have a fiscal authority sell risk assets while maintaining democratic accountability. In fact, that could cure a lot of what is wrong in Europe.
Sure, if the EMU wants to create a single government or otherwise unify, then should do that with a european treasury, with a euro-income tax and a european ECB. Then all “bailout” functionality shifts out of the ECB and into the Treasury side of things, and the job of the ECB is to set euro-wide interest rates, rather than determine how much Greek janitors should get paid.
I blame the current faults of the EMU squarely at the feet of the monetarists who really thought all you needed for cyclical demand management was an interest rate policy as set by the central bank. So they created a monetary union with a central bank and no treasury. But of course fiscal policy is always central in a crisis and so fiscal policy sneaks back into the only institution available, the central bank, creating a type of franken-bank monster. The whole notion of the ECB demanding concessions about how much Greek janitors get paid before it stops providing liquidity to Greek banks is so offensive you want to kill the monster but its the only institution there to conduct the fiscal transfers necessary. If this is an example of anything, it’s a cautionary tale about what happens when you don’t plan for fiscal policy in times of crisis.
RJS,
No. Creating a single government to unify the members of the EMU would create more problems than it solves – different languages, social norms, education systems, legal systems would need to be melded together. Each member of the EMU has a Treasury that can sell risk assets to it’s own populace and that really is enough.
Nick:
If we decide the central bank should invest in risky assets as part of its normal operation, what’s the stopping rule?
Say the CB starts buying an index fund in addition to government debt. What stops us from repeating your argument and asking “well why shouldn’t the central bank buy individual stocks?”. And so on, until we reach the point of the CB making individual home loans.
One stopping rule you’ve alluded to is the idea that index funds are a sort of “neutral” investment. But there is at least some basic level of economic calculation involved in choosing a fund. It’s not a lot on a per-$ basis, but multiply that over the size of a CB balance sheet and you’re talking real distortions.
NIck,
There are collateralization requirements in the US, of course — interestingly, they claim assets like gold and SDRs as backing physical currency instead of all-Treasury /mortgage bonds. Line 7 http://www.federalreserve.gov/releases/h41/Current/ Might this just possibly suggest that gold and SDRs are senior assets?
But at the end of the day, there is no deliverable for the FRN liabilities, and the Fed has never shrunk its balance sheet by any noticeable level — i.e. engaged in net selling — so who cares what they have on the balance sheet?
At worst, they could maintain a liquid high-quality trading balance of some 10% of assets. The other 90% of the Fed’s balance sheet could be a 1oz gold coin that they value at $3.7 trillion.
Hey, they still value the gold at $42, why not just call it whatever price they like?
I had been under the impression the CB buys risky and suddenly illiquid assets mostly to stop the vicious cycle of mark to market losses, margin calls, forced selling that comes with a panic. Especially when credit default swaps on trading banks threaten contagion. During the ’08 panic, dealers could rationalize distresses prices of CDOs and derivatives thereon only by forcing literally impossible correlations into their models. But they could not buy these assets and keep their jobs.
Every party has to de-lever. Every party is marked to market. Except the Fed. So in some ways a shrewd fed can pick off the market, since the regular market bid is zero.
Maybe this is the last resort/ stabilizing function Nick mentioned above.