Now you see them

EVERYBODY would like a rich uncle to help them when times are hard. And that is the role central banks have been playing in recent years, easing monetary policy at a time when economic output is below trend and the scope for fiscal stimulus has been reduced.

The most controversial aspect of this support has been “quantitative easing” (QE), the creation of money to buy assets, mostly government bonds. Central banks resorted to this expedient in the depths of the crisis as interest rates approached zero. The role of QE was to provide liquidity to the system and to ensure that long-term rates did not rise too far.

The policy had the useful side-effect, as far as governments were concerned, of providing a willing buyer for their bonds at a low interest rate. To be fair, central banks did not buy in the primary market: that is, when the bonds were issued. But the fact that they were buying in the secondary market gave an incentive for private-sector buyers to stump up.

The unanswered question was how the central banks would ever unwind these positions. The Federal Reserve owns some $2.3 trillion of Treasury bonds; the Bank of England has £375 billion ($624 billion) of gilts. Any sign that central banks were selling their holdings, or not reinvesting when bonds mature, might cause the bond market to panic. When the Fed hinted at tapering last year—merely reducing the amount of bond purchases—yields rose by more than a percentage point.

Sir Mervyn King, when head of the Bank of England, displayed a certain insouciance on this question. In February 2012 he told the press: “I have absolutely no doubt that when the time comes to reduce the size of the balance-sheet that we’ll find that a whole lot easier than we did when expanding it.” Whether he passed his cunning plan on to his successor, Mark Carney, is not known. But Mr Carney recently revealed that the Bank did not expect to unwind all its gilt holdings; post-crisis, central banks will have to have a much bigger balance-sheet to cope with the liquidity needs of the banks.

This is a perfectly respectable argument and seems likely to be replicated elsewhere. In a paper for the Peterson Institute, Joseph Gagnon and Brian Sack argue that “the Fed should not shrink its balance-sheet all the way back to a size that would have been considered normal prior to the global financial crisis but should instead leave a larger amount of liquidity in the financial system on a permanent basis.”

Nevertheless, it is worth reflecting on the road that has been travelled, paved all the way with good intentions. When QE was first announced, it was the equivalent of emergency surgery. Then, further rounds were needed to help the economic patient recover. The third step was for the Bank of England to hand back to the Treasury the interest it earned on government bonds, in the name of good accounting. And now what was originally a temporary arrangement has been turned into something more permanent.

All along, the authorities have denied that this process represents “monetisation” (the monetary financing of government debt), which is something of a taboo in central banking. But the cumulative impact is similar. The British government has in effect ended up with an interest-free loan from its central bank, financed by money creation. The debt has not been formally cancelled, but it might as well have been.

The obvious response is: where is the harm? Previous instances of massive monetisation—in Zimbabwe, say, or Weimar Germany—had led to hyperinflation. This time round inflation is low and falling. If the authorities had not used QE, the alternative might well have been a deeper recession, higher unemployment and a lower standard of living. Set in that context, worries about the theoretical risks of QE seem like a luxury we cannot afford.

But another reason why monetisation has always been frowned upon is that it is an easy option. Why should governments finance spending with unpopular taxes or borrow from suspicious bond investors when they can get the money from a friendly central bank? The process makes democratic leaders less accountable; by boosting asset prices, which are mostly owned by the rich, it may well have led to a rise in inequality, without the sanction of any vote. Perhaps in ten or 20 years’ time, recent events will be seen as the moment the world crossed a line.

^{Economist.com/blogs/buttonwood}