Finnish crisis researcher Tuomas Malinen has for some time been predicting the collapse of the Western financial system, starting with the melt-down of the European Central Bank. Malinen, an associate professor of economics at the University of Helsinki, offers his views on his substack and elsewhere. He correctly warned in early/mid 2021 of coming inflation, which would present central bankers with severe challenges.
Among other things, by raising interest rates (to counter inflation), the banks necessarily cause the value of bonds to drop. However, a lot of the assets of the central banks consist of medium and long term bonds, especially those issued by sovereign governments. We have come to the point where some central banks are technically insolvent: the current cash value of their liabilities exceed their assets.
Is that a problem? Most authors I found did not seem to think so. For a normal private bank, as soon as the word got out that it was insolvent, customers would rush to withdraw their funds, in a classic “run on the bank”. Customers who waited too late to panic would simply lose their money, since there would not be enough assets on the bank’s balance sheet to cover all withdrawals.
However, no one seems to be in a hurry to beat down the doors of the Fed and demand their money. Most of the liabilities of the Fed are (a) paper currency in circulation, and (b) “Reserve” accounts of major banks at the Fed.
Bandyopadhyay, et al. note that negative equity in central banks (including those of smaller countries) is not uncommon; at any given time, about one out of seven central banks worldwide in the 2014-2017 timeframe suffered operating losses, some of which were large enough to wipe out their capital. However, most central banks are owned by, or have some other synergistic relationship to , the governments of their respective countries. For instance, there is a standard contractual relationship between the Bank of England (BOE) and the British government. Thus, when the BOE recently fell into arrears, the government provided them with additional funds. This was apparently a routine non-event. (I don’t know where the government came up with those additional funds; did they just issue more bonds, which in turn were purchased by the BOE?)
The Fed, as a privately-owned public/private hybrid, technically has a more arms-length distancing from the U.S. Treasury. For instance, the Fed is not supposed to buy government bonds directly from the government. Rather, the government sells them to large banks, who in turn sell them to the Fed (if the Fed is buying). It is possible for the U.S. Treasury to transfer funds to the Fed to recapitalize it; but for now, the Fed is just booking losses as a “deferred asset”. Voila, the magic of central bank accounting. The presumption is that sometime in the future, the Fed will receive enough net income to overcome these losses.
The biggest debate is over the fate of the European Central Bank (ECB). Its relation to sovereign governments is even more arms-length; it is difficult to see all the European countries, with their own budget issues, agreeing to cough up money to give to ECB. As Malinen sees it, this likely leads to the “deferred asset” accounting scheme to handle negative equity for the ECB. He worries, “Will the markets or the banks trust the ECB after losses starts to mount forcing the Bank to operate with (large) negative equity? We simply do not know.” This is a weighty issue. As we noted earlier, “money” is in the end a social construct, an item of trust among parties for future payments of value. Central banks are the lenders of last resort, the source of money when it has dried up elsewhere; they regularly have to step into financial liquidity crises to inject more money to keep the system going. If people stopped accepted the keystroke-created money from central banks, the whole economy could freeze up.
A more sanguine view of central bank negative equity issues from MMT proponent Bill Mitchell. In his “Central banks can operate with negative equity forever” Mitchell heaps scorn on the very idea that central banks could run into solvency problems. He states that a “government bailout” is an inconsequential paper operation, merely transferring money from the left pocket to the right pocket of the government/central bank joint entity (as he views it). Furthermore, central banks have the capability of creating money out of thin air, so they can always meet their obligations and therefore can never be deemed insolvent:
The global press is full of stories lately about how central banks are taking big losses and risking solvency and then analysing the dire consequences of government bailouts of the said banks. All preposterous nonsense of course. It would be like daily news stories about the threat of ships falling off the edge of the earth. But then we know better than that. But in the economic commentariat there are plenty of flat earthers for sure. Some day, humanity (if it survives) will look back on this period and wonder how their predecessors could have been so ignorant of basic logic and facts. What a stupid bunch those 2022 humans really were.
Are there any historical events of central governments running out of money?
If the reason CBs don’t is because their governments can just create money…. but too much of that leads to hyperinflation. Can we say that hyperinflation crises like Zimbabwe are actually “insolvent CB” problems except that CBs printed too much worthless money? Or is that a different mechanism?
Yes, as I understand it, the government/CB can create so much money that it leads to hyperinflation. That puts a bunch of local currency (whether paper bills or bank entries) in circulation. So I think technically as long as a country issues its own currency (the Eurozone is huge exception) , the government can technically never run out of money.
The problem comes in when people no longer value the “money” that is being created. Black markets spring up where transactions are in, say, dollars. Also, foreign trade partners stop accepting payments in the local currency, so said country needs to come up with dollars or Euros. So there seems to come a point when issuing all that currency ceases to have a positive effect, and they have to fall back and regroup. Maybe come crawling to an international institution for some hard money loans in exchange for knocking off the money printing.
Can Western governments exercise enough self-restraint to keep the deficit spending down, enough to avoid high inflation? So far, up through 2020, they mainly have, I think.
There is debate over the genesis of the current inflation. Some if it is supply chain issues. But I think a large factor is the trillions of dollars that were created by the govt/CB out of thin air and injected into people’s wallets. This was a very popular policy, so it remains to be seen how it evolves from here. If we get a mild recession later this year, will the floodgates open again?
IMHO, dumping reserves seem to be a pretty effective mechanism for indicating you no longer have any confidence in a government/society’s decisions or functions.
And the significant increase in precious metals holdings by foreign governments (i.e. India and China) over the last several years would indicate that confidence in our ability to keep a functioning government (much less pay our substantial debts) is poor indeed.
We face incredible burdens in order to maintain the standard of living that cheap and available resources provided us as a society. And continuing to incinerate resources at the rate we do for grossly superfluous consumption is not remotely sustainable. For a whole variety of reasons.