James Bevan: Why not just cancel sovereign debt?

At a recent get-together with trustees in Bristol, we discussed Quantitative Easing (QE) and one trustee asked why central banks cannot simply cancel the government debt that they own as a result of QE, and in so doing reduce government debt burdens, thereby paving the way for lower taxes and hopefully a boost to the economy.

At first sight, the policy would seem to offer something for nothing, but a central bank’s holdings of government bonds were purchased so that the central bank could give ‘deposits’ to the private sector. Or in the cases in which the central bank purchased the bonds in the primary markets, they were bought so that the government agencies could spend money in the real economies. This amounts to the same thing in a monetary sense and also from a monetary perspective. When the central bank acquired fixed income assets so that the private sector could acquire deposit assets, the two sides of the equation cannot be separated.

A fat slab of the funds received by the private sector will be saved (ultimately) in the form of deposits, or used to repay existing debts. Indeed, much of the increase in public sector indebtedness in Japan and elsewhere that the banking system took on during the QE phases can in fact be regarded as having ‘replaced’ private sector debt on the banking systems’ balance sheets.

However, this now retired private sector debt (which was an asset of the banks) had been matched either by domestic deposits or by banks’ offshore funding (i.e. their external liabilities) and when public sector debt was used to replace private sector debt, it will have left the liabilities side of the balance sheet ‘unchanged’. In consequence, the public debt that is now owned by the banking system is ultimately matched either by a customer deposit or an external liability.

At this point in may be helpful to think of the economy as a series of ‘T accounts’.

• The central bank holds as an asset the government bonds but the matching liability is the cash in circulation and the reserve deposits of the commercial banking system.
• The reserve deposits of the banking system are then an asset of the commercial banks and their matching liabilities are either customer deposits or their offshore borrowings.
• If we ‘miss out’ the middle part of this equation – i.e. consolidate the data – we again find that the banking system’s holdings of bonds are the matching assets to the banks deposit and external liabilities.  As a consequence of this logic, we can summarise the situation to say that the government bonds that the central banks now own are in effect “the assets” that correspond to the banking systems’ liabilities which are either in the form of liabilities to non-residents or deposit-type instruments owned by their own private sectors.

In the case of the former, it is quite possible and indeed feasible that the central bank could cancel its bond holdings, and at the same time reduce its own liabilities to the commercial banks (i.e. their reserves). The banking system could then simply default on its external liabilities but the ramifications of such a move might be “interesting”.  Countries such as Turkey, in which the banking system both owns a lot of bonds and owes a lot of foreign liabilities, could potentially adopt this route but we might reasonably expect some form of retaliation at that point.

More likely, and we’ve seen this before, the central bank could cancel its bond holdings, mark down the commercial banking system’s reserves proportionately, and thereby inflict heavy losses on commercial banks.  At that point, the banks could either write down the value of some of their customers’ deposits (likely causing chaos in the real economy) or the government would have to underwrite the deposits – but this would require the government to issue debt to fund this, taking the public sector debt ratio back up.

A final option might be for the central bank to write off its bond holdings but not to write down the value of the banking system’s reserve deposits. At this point, the central bank would of course take a hit to its capital structure, requiring re-finance via capital from the finance ministry, itself needing the issue of more government bonds.

So the plan could succeed if the banking system defaulted on its foreign debts with all the risks of retaliation, but a better plan for the central banks could be to consolidate their exiting bond holdings into a single zero interest ‘consol’ and leave them to fester quietly on the balance sheet for fifty years. Indeed, central banks probably should do this but only in exchange for reforms and real economic deregulation from governments to raise economies’ sustainable rates of productivity and real growth.  Such a genuine approach to economic recovery, rather than an accounting sleight-of-hand would have real merit.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla