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No, Brad DeLong, There Is No Draghi Claus

Author: Benn Steil, Senior Fellow and Director of International Economics
December 8, 2011
Forbes Online


'Tis the season for miracles, so perhaps we shouldn't be surprised to find even tenured economists believing in them. Here's my favorite, from Berkeley blogger Brad DeLong: a central bank can buy as much debt as it wants at whatever price it wants, and any losses it takes on its portfolio just disappear! Really. The European Central Bank "taking losses on its PIIGS bonds," he writes, "is a nothingburger."

Yes, a nothingburger! And those Europeans still seem to think that Portugal, Italy, Ireland, Greece, and Spain have a debt problem. What idiots. Don't they know about Draghi Claus?

"If you go to a central bank and say 'I want to pull my money out', DeLong explains, "the central bank says 'OK'. It then prints up a number of banknotes. It then hands the banknotes to you. It doesn't need to sell assets to give you your money."

European debt crisis? What crisis? The ECB can just print it away.

Ok, I hate to play Scrooge here, but someone needs to drag DeLong from his egg nog. What if people don't want banknotes anymore either? What if they want bonds – or Swiss francs? Now the game is up.

Let me explain. Suppose a central bank with zero capital issues $1,000 of currency and buys $1,000 of bonds. Now, what if those bonds turn out to be worthless, so its capital is -$1,000?

Well, as long as people are happy to continue holding that currency, then the central bank can keep going forever. The economy may stay in a slump, but the central bank will be fine.

What, though, if people no longer want $1,000 of currency? Suppose the central bank had issued the currency during a financial panic – a "flight to quality," a time when people wanted to hold a lot more cash. The central bank might have issued the currency during a time of near-zero interest rates, when the cost to people of holding extra currency was nothing.

Once the panic eases, people will no longer be happy holding lots of non-interest-bearing currency. They will want interest-paying assets instead.

To soak up the unwanted currency, the central bank has to sell bonds. But what if its bonds are worthless? Then unless an outside patron provides the central bank with an infusion of new, valuable assets that it can sell to soak up the excess currency, the unwanted currency has to stay outstanding.

There is only one possible outcome from leaving the unwanted currency in circulation. Inflation. This is, of course, reflected in the history of central bank financing of government deficits.

However childlike DeLong's claims, it is true that a central bank can carry negative capital – for a period. The value of the central bank's assets must ultimately be equal to the value of its liabilities; there is no getting around that. But one of the central bank's liabilities right now benefits from an unusually low interest rate. The present value of that interest premium counts as an asset, allowing conventional measures of "capital" (the residual claim in liabilities) that ignore it to be negative.

The present value of the interest spread on outstanding money is therefore an asset of the central bank that needs to be counted. But it is an asset of finite value – conventionally measured capital can be negative, but not infinitely so.

The central bank's capital can only be negative to the extent of the minimum amount of non-interest-bearing currency that people are willing to hold. If the central bank's negative capital is any greater than that, it will be unable to soak up money when the time comes – as it must. And when people see that eventuality in the future, they run now. This is what causes currency collapses and hyperinflations.

To put this in a real-world context, the ECB has €81 billion in capital, which is roughly equivalent to the losses it would bear on a 25% write-down of PIG debt – that is, just the debt of Portugal, Ireland, and Greece; forget about the vastly larger Italy and Spain. The ECB therefore needs a credible guarantee that it will be recapitalized should such losses materialize. Its reluctance to wade deeper into the muck of bailing out PIIGS is not difficult to fathom – Germany must ultimately provide this guarantee, though it is not yet willing to do so.

The U.S. Federal Reserve has taken far greater risks with its balance sheet, buying up $1.3 trillion in mortgage securities between September 2008 and July 2010 – something few would have found imaginable before Lehman. It could do so because the market knows that the U.S. Treasury ultimately stands behind its balance sheet. The ECB, having no nation behind it which considers it central to its nationhood, cannot afford to be so bold – or reckless, as the case may be; its assets could be the only thing standing between its status as the supplier of 27% of the world's monetary reserves and outright liquidation.

So, no Virginia, no Brad, I'm sorry – there is no Draghi Claus.

Benn Steil is director of international economics at the Council on Foreign Relations and co-winner of the 2010 Hayek Book Prize for Money, Markets and Sovereignty.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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