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Central Bank Interventions - Are there any limits?

This article was published in Innherji, a leading business publication in Iceland, on March 27th.

In this article, we will briefly discuss the situation of foreign central banks. Although the current situation in Iceland is not described here, Icelanders are, of course, no strangers to interventions in the banking system, considering that the most significant banking crisis in the world happened here in relation to the size of the economy. This discussion concerns the world as a whole, as the world's economies have never been more interconnected.

A lot has been happening in the financial markets in the past few weeks, and there has been particular discussion about the intervention of authorities in troubled banks. Central banks on both sides of the Atlantic have intervened, provided guarantees to banks in trouble, and increased access to cash in US dollars. It is only a few months since the Bank of England intervened in the UK's bond market when pension funds encountered difficulties with so-called Liability Driven Investments (LDIs). The Bank of Japan has been conducting repurchases on the Japanese government bond market without interruption since 2016 (yield curve control), and its balance sheet has grown by 560% since the 2008 financial crisis. There is now discussion about whether all deposits in the US banking system need to be federally insured to withstand customer withdrawals from smaller banks to larger ones.

In this light, one can ask if there are any limits to how far one can go to save the financial system. The concept of too-big-to-fail was frequently used in the 2008 financial crisis. It referred to systemically important financial institutions that were rescued because the cost of their failure was deemed too high for the financial system. At that time, the United States and European countries took on large debts financed by issuing new money printed by the central banks of the respective countries. These debts enter the central banks' balance sheets (FED and ECB) as assets. From the start of the 2008 financial crisis until its peak in 2022, the FED's assets increased by 8,000 billion US dollars or about 900%!

Source: https://fred.stlouisfed.org/series/WALCL

Looking at the statements of the central bank governors of these countries, there have repeatedly been declarations that the balance sheet of the central banks will be reduced again. From April 2022, the FED reduced its balance sheet by 620 billion dollars (a 7% decrease from the peak). The first three weeks of March brought news when the balance sheet increased again by 400 billion dollars, which were loans and measures to assist US banks in the impending liquidity crisis in the United States.

Therefore, it is clear that central banks have achieved minimal success in reducing their balance sheet, and new rescue measures are starting to enlarge it again. We always hear the same declarations that these are temporary measures, but history clearly shows this is untrue. The economist Milton Friedman once said that nothing is as permanent as a temporary government program, which is very accurate in this case.

The cost of interventions of this kind can be presented in various ways. Firstly, one can look at the direct cost of government intervention in banks through guarantees and purchases of illiquid assets from troubled banks. There are examples where investments of this kind have yielded returns, but overall this is a cost that typically falls on taxpayers. For example, the direct cost of the US government's rescue operations in the 2008 banking crisis has been estimated at nearly 500 billion dollars [1].

One indirect cost of such interventions is the increased amount of money in circulation. US dollars in circulation increased by 40% in 2020 – 2021. Those who subscribe to the Modern Monetary Theory (MMT) consider increased money printing to be of little consequence as they argue it does not lead to inflation. If the calculation was that simple, one might wonder why states collect taxes from their citizens at all.

One can mention the moral hazard that interventions and state guarantees pose to banks and their managers. When banks become systemically important, we have seen numerous examples of them being rescued. These precedents could increase risk-taking, which in turn creates more systemic risk. The banking system plays a vital role in mediating capital in the economy while managing the public's savings. Therefore, these risks must be particularly guarded against in the case of banks.

Finally, interventions in the banking system make the execution of monetary policy much more challenging. If we look at inflation in the United States (currently about 6%) and Europe (8.5%), it is still quite high and persistent. However, the current banking crisis has fundamentally changed investor attitudes towards interest rate developments on both sides of the Atlantic, as expectations of interest rate hikes have almost completely receded. Instead of expecting ongoing rate hikes and high-interest rates throughout 2024, it is now expected that we are at the peak of the interest rate cycle, and within a few months, interest rates will start to fall again. While the current banking crisis is likely to reduce inflationary pressure in the short term, an increase in the amount of money in circulation can stoke inflation over the long term. Hence, the current banking crisis and associated interventions may make it harder for central banks to adhere to their monetary policies.

Foreign central banks are now caught between a rock and a hard place as they decide how to respond to the current situation. Will they focus on rescuing the banking system with rescue measures, or will they maintain a strict stance in order to get a handle on inflation, potentially creating more problems in an indebted system?

To put debt development into context, the United States national debt has risen from 30% to over 120% of GDP over the last 40 years. Now, the banking system has once again started calling for interventions, increasing the burdens on the taxpayers of the respective countries. This will happen either by cuts in other government spending or by continued money printing and debt increase. Such actions depreciate the currency of the relevant countries, leading to associated inflation and a decline in purchasing power.

After a long history of increasing debt accumulation and interventions, policymakers always choose to print money instead of showing restraint in management, then act as if it has no significance. However, the reality is that the increased debt burden is passed on to future generations, who will have to deal with the consequences of this reckless debt increase. Is this a fair arrangement?

Guðlaugur Steinarr GíslasonCIO - Founding Partner