VoxEU Column Monetary Policy

Fiscal dimensions of central banking: the fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 2

The last column in this series on fiscal aspects of central banking reviews the differences in fiscal backing for the Bank of England, the US Federal Reserve, and the European Central Bank.

The Bank of England

When the Bank of England gets around to making outright private asset purchases, it will do so with an indemnity provided by Her Majesty’s Government to cover any losses arising from the use of the Facility. This is as it should be. In principle, a central bank should only take the credit risk of its sovereign – the state. If its monetary, liquidity, or credit-easing operations expose it to the credit risk of the private sector, it ought to do so with a full indemnity (guarantee for any losses) from the Treasury.

The Bank of England has a full indemnity for outright purchases of private securities, but not for the private credit risk it assumes through repos and other forms of collateralised lending to banks where the collateral offered consists of private securities. I believe the UK Treasury should insure the Bank of England – for free – against all losses incurred as a result of the Bank of England taking private credit risk on its portfolio.

The Fed

The Fed does not have a full indemnity from the US Treasury even for its outright purchases of private securities. It has no guarantee or indemnity for private credit risk assumed as a result of its repo operations and collateralised lending.

For the Fed’s potential $1 trillion exposure to private credit risk through the Term Asset-Backed Securities Loan Facility, for instance, the Treasury only guarantees $100 billion. They call it 10 times leverage. I call it the Fed being potentially in the hole for $900 billion. Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG, and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the Federal Deposit Insurance Corporation, and the US Treasury jointly.

I consider this use of the Federal Reserve as an active (quasi-)fiscal player to be extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US.

There are two reasons for this. First, it undermines the independence of the Fed and turns it into an off-budget and off-balance sheet special purpose vehicle of the US Treasury. Second, it undermines the accountability of the Executive branch of the US Federal government for the use of public resources – taxpayers’ money.

As for the Fed’s independence (whatever independence remains), first, even if the central bank prices the private securities it purchases appropriately (that is, there is no ex ante implicit quasi-fiscal subsidy involved), it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player or a debt collector. The ex post transfers or subsidies involved in writing down or writing off private assets are (quasi-)fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.

The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withhold. The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around $170 billion with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns’ balance sheet has been hidden in some SPV in Delaware.

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of taxpayers’ resources that it entails threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.


The ECB has no fiscal backup. There is no guarantee, insurance, or indemnity for any private credit risk it assumes. This huge error and omission in the design of the ECB and the Eurosystem threatens to make the ECB significantly less able than the Bank of England and the Fed to engage in unconventional monetary policy, including quantitative easing and credit easing.

The exposure of central banks to private sector default risk applies, of course, not only to central banks making outright purchases of private securities. It applies equally to central banks that make loans to the private sector using private financial instruments as collateral. Repos are an example. The Eurosystem has taken private sector credit risk onto its balance sheet ever since it was created. It now accepts a vast collection of private securities as collateral in repos and at its discount window (just about anything issued in euro and in the Eurozone that is rated at least BBB-).

The Eurosystem has already taken some significant marked-to-market losses on loans it made to eligible Eurozone counterparty banks against rubbish ABS collateral. In the autumn of 2008, five banks (Lehman Brothers Bankhaus AG, three subsidiaries of Icelandic banks, and Indover NL) defaulted on refinancing operations undertaken by the Eurosystem. The amount involved was just over €10 billion, and over €5 billion of provisions have been made against these impaired assets, because the mainly ABS dodgy collateral is, under current market conditions, worth rather less than €10 billion.

Any losses incurred as a result of these defaults are, like all losses incurred by the Eurosystem in the pursuit of its monetary and liquidity operations, to be shared by all 16 national central banks in proportion to their shares in the ECB’s capital. But while the Eurosystem as a whole shares any losses incurred by its individual national central banks, there is no mechanism for recapitalising the Eurosystem as a whole.

The ECB/Eurosystem is not yet hurting financially, however. The Eurosystem’s income from monetary policy operations was probably around €28.7 billion in 2008. A high degree of price stability and large denomination notes (including €500 and €200 notes, while the best the US can come up with is a $100 bill) make the euro the currency of choice for tax evaders, tax avoiders, money launderers, and other criminal elements everywhere. This makes for massive seigniorage revenue for the ECB and the Eurosystem.

The combination of the obvious willingness of the ECB/Eurosystem to take serious private sector credit risk through collateralised lending to banks and its unwillingness to consider outright purchases of private securities or to engage in unsecured lending to the banking sector is difficult to rationalise.

Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission.

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