Central Bank Direct Lending Does Not Add Much To Policy Space

A new front has opened up in the "Helicopter Money" debate: the belief that direct lending by the central bank somehow constitutes "helicopter money," and that it opens up new space for policy action. In my view, it just creates another way for central bank-focused mainstream economists to discredit monetary policy further, and for the central bank to lose money.

S W-L on the BoE TFS

Professor Simon Wren-Lewis discusses the new Term Funding Scheme (TFS) of the Bank of England (BoE) in "Negative rates, helicopter money and the Bank of England."

He recognises the complaint that negative interest rates punish savers (which is why some non-mainstream economists view the effect of low interest rates on the economy as being ambiguous). He argues:

We normally think about monetary policy as changing the [emphasis S W-L] interest rate. If rates are cut, that benefits borrowers but is bad for savers. But suppose the central bank gave money [emphasis mine - BR] to private banks, on condition that this money was passed on in the form of lower rates to borrowers. If it did this, but did not change the [emphasis S W-L] interest rate, that would be helping borrowers but not hitting savers. The Bank introduced such a scheme yesterday, called the Term Funding Scheme (TFS). What is more, this subsidy for borrowers is financed by creating money. Eric Lonergan argues that the ECB is doing something similar, and if there is any insight in this post I owe it to him (but if there isn’t it is my fault not his!).

(I will discuss the Eric Lonergan's arguments below.)

I will immediately note that I am not an expert on the TFS, but based on the descriptive comments of the BoE, the name of the programme describes exactly what it is: a scheme in which the BoE lends money (reserves) to banks for a period of time to counterparty banks.

Although we often say that banks "give" loans to their clients, this is not the usual usage of the word "give," as in a gift.  The usual conception of "helicopter money" is that the central bank hands out gifts of money -- there is no obligation to pay the money back. A loan has to be paid back, so it does not match up with the usual usage of "helicopter money".

In Simon Wren-Lewis' conception, the borrowing banks are going to promise that they will narrow their lending spreads in return for accepting the low interest term funding. In other words, the entire premise is based upon the good faith of modern bankers -- good luck with that.

Realistically speaking, it would be suicidal for a bank to narrow its lending/borrowing spread across its entire balance sheet in return for a bit of cheap term funding. The only reasonable outcome would be that certain borrowers would get better lending terms from the bank, up to the size of the programme. Realistically speaking, this is just going to be a subsidy for a handful of borrowers (assuming that the banks do not just pocket the gains from a slightly lower funding cost on some borrowing).

This is a form of a directed subsidies towards some borrowers. Such a policy was standard practice when "industrial planning" was in vogue; whether it will survive challenges from the idiotic "free trade" treaties that nations have signed is an open question.

Furthermore, such policies already exist -- and are completely ignored in mainstream models. Developed countries generally allow corporate borrowers to deduct interest expense on taxes (and in the United States, household mortgage interest), while most owners of bonds hold them in tax-advantaged vehicles (pension funds, etc.). The economic cost of borrowing is at the after-tax rate of interest, while savers receive the pretax rate. This effect is completely ignored in mainstream models.

This is another wonderful illustration of the myopic nature of mainstream economic analysis. A tiny programme run by the central bank that will affect a handful of borrowers allegedly creates new policy space, while a similar policy run by Her Majesty's Treasury that encompasses the entire corporate sector is completely ignored.

Not a New Policy, Just a Dangerous One

When I first wrote this article, I believed that the TFS was a  form of unsecured lending by the central bank. (Oops -- see comment below). Unsecured lending adds a third option for central bank operations, on top of:

1. outright purchases of assets (typically fixed income); and
2. lending against assets (repurchase agreements or "repos", or discount window operations).

(Accountants might argue that repos are not loans, and they may or may not be correct according to GAAP. From an economic point of view, they are collateralised loans.)

(UPDATE: This article had been written when the programme was announced, but publication was delayed as I was driving across Northern Ontario last week. I could not find many details on the TFS, and I assumed that it was unsecured lending. As Nick Edmonds pointed out in comments, this is not the case -- TFS loans are indeed secured in a conventional fashion. As a result, this programme is not particularly novel, and only of interest to British banks.)

However, this third method is really just a variant of lending against collateral -- in this case, the value of the collateral is zero. Does this add to policy space? Not really. Any bank that lacks unencumbered assets that are eligible for rediscounting or repo operations is a bank that is already hurtling towards oblivion.

It is also bad policy. Although central banks are indeed banks, they live a sheltered life. They do not have teams in place to work out defaults. (I argued in my article on "Overdraft Economies" that it would be a good idea if central banks did have such credit expertise, but even then, it should take the form of secured lending.) Lacking lending expertise, they need to stay at the front of the line of creditors, by only lending against top quality collateral. Let the private sector fight over the scraps in a liquidation event.

One might argue that a central bank cannot go bankrupt, so who cares about credit losses? This ignores the reality that central banks are somewhat unaccountable, and if they lend billions to a chupacabra ranch operator who then hightails it with the cash, that represents a real transfer of wealth that could have gone to citizens with slightly more legitimate needs. Elected politicians are the ones with the mandate to make such distributional decisions.

Eric Lonergan on TLTRO's

Eric Lonergan writes:

The ECB understands this [the ineffectiveness of lowering the policy rate - BR]. That is why it turned its focus to the other interest rate – the rate at which it lends to banks under its latest TLTRO programme. Disguised behind horrible acronyms, TLTROs are far more radical than QE, OMT, or SMP programmes. TLTROs are also so obviously legal that the German media barely bothers to mention them.
Here’s why TLTROs are hyper-radical – and will work. What are Targeted Long-term Refinancing Operations? They are loans which the ECB makes to banks at a duration and interest rate of its choosing, for specified purposes. With every TLTRO the ECB chooses the interest rate, the duration of the loan, and potentially, the credit risk. Why is this potentially more important than all other monetary tools? Because the ECB is never out of ammunition with a TLTRO. Just cut the interest rate further, extend the duration, and extend the scope of the lending. For example, the ECB could make 20-year TLTROs at -5% interest rates, available for durable goods purchases, in an amount up to 10% of GDP. Would it work? Just watch the share prices of automakers!

There's a few problems with this argument.

• It assumes that there are creditworthy borrowers. Even if a loan can be rediscounted at the central bank, the lending back (or securitisation) eats credit losses first. Furthermore, we would need to find borrowers who are willing to invest (or at least borrow to consume). Given the amount of private financial capital that has been desperate to find investment opportunities, there is not a whole lot of pent up demand for borrowing. As a result, announcing a negative discount rate on a particular class of loans will not necessarily create much new demand for credit.
• This is not exactly helpful for savers. A certain class of loans will drop to an interest rate of -5%, well below the benchmark policy rate. That eliminates a certain amount of assets that could have been bought as bonds or securitisations by savers in the bond market. If the central bank extends this policy, the aggregate yield on assets available to savers will converge towards the "special" financing rate.
• The effectiveness of the policy is predicated upon the central bank being able to allocate credit in a fashion that is superior to the private sector. Given that the brain trust at the ECB drove the euro area periphery into a depression -- a feat that many thought was impossible in the modern era -- this seems like wishful thinking of the highest order.
• Narrowly focused sectoral subsidies is an inducement to create bubbles. As the Greenspan/Bernanke Fed figured out the hard way, cleaning up after a burst bubble is hardly a cost-free exercise.

Admittedly, given the disastrous design of the euro area, any form of disguised fiscal policy is better than the policy stance that is in place. This offers us no insight into the operation of less deranged monetary systems in place in the other developed economies.

(UPDATE: Eric Lonergan questioned the idea that there could be credit risk with a 20-year loan at -5% interest. It is possible that he intended to write a 20-year loan, with a -5% annual coupon (with the coupon based on the initial principal balance), with the negative coupon reducing the principal balance. That is, there would be no repayment by the "borrower" at any time (since the principal balance is $0 in 20 years). However, this would not be a -5% interest; it is effectively -100% interest -- the "loan" generate no repayment cash flows. Such a structure has a NPV of $0 at any discount rate (above -100%), and would have to be immediately written down to $0 under any accounting convention. Since the loss is immediate and automatic, one could debate whether this should be considered a "credit loss." Nevertheless, it would represent an income loss to the central bank, and would raise the exact same political problems as a "normal" credit loss.)

(c) Brian Romanchuk 2016