Readers Question: The argument in Europe at the moment is whether the ECB should be able to buy bonds (new? old?) directly from governments as well as being able to buy old ones on the open market (“secondary market”?). Is it correct that in either case that the ECB would just the create Euros to buy the bonds? I am confused about when the central banks create money and when they use other reserves. I can already hear you asking me “Well where else would they get the money from?”, but talk of borrowing from China, and all the fuss over quantitative easing has left me just a bit confused.
The Central Bank can purchase bonds in two ways
- ‘Sterilised Bond Purchases’ This is when the Central Bank buys bonds without creating any new money. In this case, they use existing bank reserves. Therefore this policy is limited; they can only buy a limited quantity of bonds.
- ‘Unsterilised Bond Purchases. This is when a Central Bank (e.g. ECB) create money and use this newly created money to buy bonds.
- see also: unsterilised bond purchases
Bank of England and Quantitative Easing.
If you look at the Bank of England, they created over £200bn as part of their ‘asset purchase scheme’ and used this ‘newly created money to buy government bonds. They created money by simply increasing the amount of money (electronically) in their bank account. It is similar in principle to printing money and using that money to buy bonds from commercial banks.
Why Doesn’t ECB Create Money Electronically?
The ECB is very determined to keep inflation low. To the ECB, the most important thing is low inflation. They fear that pursuing quantitative easing (creating money) will cause inflation, either now or in the future. (see: Why printing money can cause inflation)
The ECB have bought a limited number of bonds, but they always say they will not use created money. Therefore, markets don’t give much credence to these bond purchases because they know the ECB intervention will be very limited. The ECB cannot prevent bond yields rising because they can only buy a limited quantity of bonds
Why the ECB should Be Willing to Create Money
1. The ECB are wrong to target only inflation. The problem facing the Euro zone is not inflation, but the real risk of prolonged recession and deflationary pressures (especially in south of Euro zone). Targeting inflation, in the current climate is the wrong objective.
2. No Lender of last resort. At the moment, bond markets don’t trust Euro zone governments because there is no lender of last resort.
The UK has a much larger budget deficit than Italy. Yet, bond yields on Italian bonds have jumped to over 7%, bond yields on UK bond have fallen. One reason is that markets believe the UK will not have a liquidity crisis. For example, if the UK government struggles to sell sufficient bonds one month, the market knows the Bank of England will intervene to buy bonds and create money if necessary. This lender of last resort is reassuring to markets.
However, Italy doesn’t have a lender of last resort. If Italy struggles to sell sufficient bonds one month, they would have to go to an EU summit and ask for help. The EU summit will probably ask for politically unpopular spending cuts, there will be a long drawn out argument, and they may get a bailout on conditions. But, the European bailout fund and procedure for bailing out countries is not exactly reassuring. The third biggest contributor to the EFSF is Italy. Markets will ask how can Italy bailout itself?
Therefore, if you’re an investor why take the risk of buying Euro zone bonds?
- In the current climate, if ECB intervention is to be successful, they need to create money. Otherwise they won’t be able to buy sufficient bonds to reassure markets.
- This is a simplification, there are other issues and complexities, but it does hopefully distinguish between a Central Bank buying bonds from its reserves and when a Central Bank creates money.