Summary:  

We  studied  the  balance  sheet  of  the  ECB  and  its  evolution and  analysed the  growth  of  its  main  components on the assets and liabilities sides. We show that although non-conventional policies like  QE mechanically creates base money and generates seigniorage profits, they have a relatively small  effect  on  inflation  and  a  slightly  higher  effect  on  inflation  expectation  and  on the Euro  currency  exchange rate. We concluded that uncontrolled QE including debt cancellation would put the ECB at  risk of losing its credibility, even if it cannot technically go broke. 

Introduction 

The  outbreak  of  the COVID-19 pandemic  has  generated  a  widespread  and  simultaneous  shock  on  supply and demand across the world, with a severe impact on GDP growth. This “black swan scenario1”  has forced central banks and governments to move swiftly against the risk of a repeat of the great  depression.  Government spending was increased in order to maintain the productive capacity of the  economy, with massive programs helping firms to partially compensate the income losses experienced  by their furloughed workers,  and government  guarantees  to  preserve  their access  to  credit. With  European countries facing large amounts of government debt and an increasing public debt to GDP  ratio, the ECB (European Central Bank) hasstated that it would be ready to increase its asset purchases (known as Quantitative Easing, or Q.E) and therefore to monetize deficits. Debt cancellation scenarios,  which go a step further, are now being pushed forward by a minority of radical outsiders in the name  of  Modern  monetary  theory  (MMT).  Even  if  the  balance  sheet of  a  central  bank  often  does not 

necessarily portray its success, as it does not have the liquidity constraint faced by governments and  commercial banks, its financial strength can often reinforce its own credibility. This project will discuss  the role of the ECB, the implementation of its non-conventional monetary policy, and also the risks it is currently facing in the midst of a deep worldwide economic recession. 

1. What is a Central Bank and why does it exist? 

Historically,  central  banks  have  often  been  better  understood  by  their  functions  rather  than their  objectives. Central banks were generally the dominant issuers of banknotes, which in turn usually gave  them sufficient scale to be the preferred choice for government banking, and this scale also provided  the ability for a fraction of the issuance to be handed back to government (“seigniorage”).  

Many central banks were founded in times of economic turmoil, in an effort to restore price stability  and the credibility of banknotes after times of over issuance. In more modern times, the dominant  bank would often be a lender to customer banks in times of liquidity shortage and became a “lender  of last resort”. This was because it was in their commercial interest to do so, and the central bank  could not be declared bankrupt or have negative capital as it could use its money creation toolkit to  pay off its own debt.  

Overall, the Central bank acts as a “Bank of banks” with a mandate to warrant monetary stability by  controlled  inflation  (around  2% for  the  ECB  yearly),  and  also  to  promote  economic  growth  in the country (or countries) using its currency. Though many central banks such as the Federal Reserve (Fed) or  the  Bank  of  England  (BoE) have  this  dual  mandate,  the  ECB  has  a  single  mandate focused  on  inflation and financial stability.  

2. The Balance sheet of the ECB 

The consolidated balance sheet of the Euro area represents the ECB and the 27 NCBs (National Central  Banks) inside the Eurosystem. How does a Central Bank’s balance sheet work? It looks like the balance  sheet of a commercial bank, but with a huge difference: a central bank can create its own liabilities,  issuing its own currency. Hence the equivalent of its shareholder’s equity is somewhat conventional.  In a paper from 20082, William BUITER has proposed a stylised view of a balance sheet.   

At the top of the table are the liabilities and the shareholder equity (the ECB’s “net worth” or capital).  Firstly, the monetary liabilities (M in table), sometimes called base money, is the sum of currency in  circulation and balances or reserves held with the central banks by commercial banks. The central  bank also has non-monetary liabilities (O in table) which can be debt to the government, the domestic  private sector, or to international organisations like the IMF. The bottom of the table shows the assets  of the central bank: the central bank owns securities (D), which are treasury bills and government or  corporate bonds, private debt (L), which are loans to the private sector (essentially banks), and official 

foreign  exchange and  gold reserves  (R).  The  “conventional” equity  of  the  central  bank  (W)  is  determined as the value of assets minus the value of liabilities.  

In short, W = D + L+ R - M -O 

A simplified view of the evolution of the balance sheet of the ECB is presented in the table below. We have adapted the framework initially set out by W.BUITER.  

From the table above, we can see that the ECB balance sheet has quintupled since the end of 2006. The total value of assets of the ECB has gone from 1.2 to 5.3 Trillion Euros. Since the beginning of the  great financial crisis in August 2007, the Central Banks of G4 countries have expanded at a high pace,  which is reflected in the graph below.  

Asset side of the ECB’s balance sheet: securities and long-term lending 

As regards to the component of the balance sheet, the most obvious change on its assets side is the  emergence of long-term lending to credit institutions within the Euro zone, but also the vast increase  in the amount of securities owned by the bank. Monetary policy has evolved and new instruments,  such as TLTROS (Targeted Long-Term Lending Operations) and APPs (Asset Purchasing Program), are  now  part  of  the ECB’s quantitative easing  (QE)  toolkit: their main  purpose is  to provide monetary  accommodation. In  times  of  crises, TLTROS  operations  provides  long-term  funding  through  cheap  liquidity – currently with negative interest rates of -1% - provided by the central bank to commercial  banks, to ensure cheap credit is available (and distributed) for individuals and corporates. This reduces  the  cost  of  funding  of  the  commercial  banks, which  is  especially useful in times of  crisis.  It also  increases liquidity in markets and base money (M). In light of recent events, the ECB has created an  asset purchasing program called the Pandemic Emergency Purchase Program (PEPP), which aims to  stabilise the securities markets and to contain disinflationary pressures, according to Philip Lane, by  lowering levels of commercial and corporate debt and meet their demand  for liquidity to maintain  cash  flow. Latest numbers indicate  that  the ECB has bought more  than  3.3 Trillion euros worth of  securities through its asset purchasing programs, that include government debt as well as corporate  debt. The large increase in Gold and forex reserves on the Asset side between 2006 and 2020, going from 321 to 958 Billion, reflect large surpluses in the balance of payments of the Eurozone, which is a  sign of strength of the currency, as there is less demand for Euro creation. 

Liabilities side of the ECB’s balance sheet: QE and base money creation 

On the liabilities side of the balance sheet, reserve balances have gone from 177 Billion euros to 2.3  Trillion euros between 2006 and 2020. Central Bank base money (M) has been created through the  process of buying securities owned by non-financial institutions. The large growth on the asset side of  the balance  sheet is  reflected on  the liabilities  side, and  this expansion  shows  the money creation  effect of non-conventional policies such as Quantitative Easing. Most Central banks are often reluctant  to talk about the liabilitiesside of the balance sheet and often insist on the portfolio rebalancing effect  on the asset side. Asset purchases by the Central bank from non-bank investors create base money (M), while purchases from commercial banks do not.  

• The impact of QE on base money: 

⮚ Asset purchases from non-bank investors: 

Asset purchases made by the Central Bank from non-bank investors(non-financial entities like pension  funds  or  governments) create Central  bank base  money.  This  policy  is  usually called  Quantitative Easing (QE). The main mechanism for money creation is shown in the T-accounts below: the liabilities  of all three bodies are represented on the right-hand side of the table, and their asset side is on the  left-hand  side.  Firstly,  the  central  bank  buys  bonds  from  the  private  investors through  their  commercial bank and sends money to them: the private investors have less bonds and more deposits  on its asset side, whilst  the central bank has more bonds on its asset side. More money  therefore  appears on the deposit account of the private investors, on the liabilities side of the commercial bank:  this  means  base  money  has  been  created.  More  reserves  also  appear  on  the  asset  side  of  the  commercial bank and the liabilities side of the Central bank. We can see that the process occurred  entirely at the initiative of the Central Bank, and the commercial bank had to create more deposits  and was “forced” to create more reserves consequently. The same conclusion is valid when the central  bank  accepts  to  finance  fiscal  deficits,  whether  or  not  the  bonds  are  purchased  on the  primary  market. 

⮚ Asset purchases from Banks

The main difference when the assets are purchased from commercial banks is that the balance sheet  of the commercial banks remain unchanged. The bond asset formerly owned by the commercial bank is transferred to the central bank, and consequently is replaced by new reserves on the commercial  bank asset side. The following chart sketches QE flows when assets are purchased from commercial  banks: 

Increasing conventional equity in the ECB’s balance sheet: 

Between  2006 and  2020, the  conventional equity  in  the ECB’s  balance  sheet grew  from  64  Billion (5.6%) to 616 Billion euros (10.9%). This larger equity share, which is a rough indicator of the bank’s  solvency,suggests that the structure of the ECB’s balance sheet has grown stronger during this period. This is a direct consequence of the benefits of seigniorage, which we discuss in the next section.  

3. Opportunities and risks of a rapid expansion of the ECBs balance sheet: 

Seigniorage is at the heart of balance sheet expansion. The creation of base money by the central bank  is virtually costless, and with this money it can buy assets that generate revenue. The spread between  the cost of its assets and the cost of its liabilities generate a profit for the central bank, which is named  seigniorage, which  references  profits  from money  creation  made  by  lords  (“seigneurs”  in  French)  during medieval times. In countries with National central banks, including the euro area, most of these  central bank profits are distributed to national treasuries. In the case of the ECB, seigniorage profits  from quantitative easing are redistributed to treasuries of European governments. It should however be noted, as mentioned by the BIS5,  that central banks pursue national welfare rather than profits. Central banks are not investment funds, and their gains and losses belong to society.  

A  strong  balance  sheet  also  contributes  to  the  credibility  of  the  central  bank. Conversely,  a  weak  balance  sheet  of National  Central  banks  have  historically  been  the  hallmark  for  external  crises  in  emerging countries. For instance, when foreign exchange and gold reserves reach a low point because  of external imbalances, the central bank cannot guarantee the convertibility of the currency. At the  end of the process, the IMF may be needed to recapitalise the central bank. This is far from being the  context of the eurozone, partially because the euro is already a reserve currency (forming around 25%  of all central bank foreign currency assets).  

Many  risks are associated  to a  rapid expansion  of a Central  bank balance  sheet. Hence, like many  central banks, the ECB is aiming for a possible normalization of its balance sheet once the economic  storm, requiring massive intervention of central banks, is over. We can identify three main risks of  qualitative easing policies: a massive credit risk for the central bank, the resumption of inflation above  its yearly target, and a risk to the status of the Euro currency.  

Firstly, a credit risk arises from the securities portfolio owned by the ECB. One should be reminded of  the  tensions  that  erupted  when  the  ECB  bought  Greek  government  bonds  in  2011,  and  when  it  massively increased its holdings of Italian and Spanish government debt in order to provide them with  a backstop needed to defend the Euro currency (Mario Draghi’s phrase of “Whatever it takes” in 2012).  This risk has increased dramatically with the corporate sector purchasing program (CSPP), where the  ECB is exposed to the risk of default of private sector entities.  

Secondly, inflationary pressures are often associated with the expansion of base money. We studied  the statistical relationship between a) the size of the ECB’s balance sheet as a percentage of GDP and  b) core inflation/inflation expectations in the Eurozone. Long term data does not suggest that there is  a strong correlation between the balance sheet and core inflation indicators. 

However, the correlation between the size of the ECB’s balance sheet and inflation expectations (5- year inflation in 5 years) is slightly more significant. What seems troubling is that despite this massive  expansion, inflation expectations remain well below the 2% inflation target set out by the ECB. It is  therefore not clear that QE generates inflation. 

Lastly,  as  shown  in Graph  4 below, there  is  a  more  significant  impact  of  the  ECB’s  balance  sheet  expansion on the exchange rate of the Euro against the US dollar. Between 2014 and early 2020, the  balance sheet of the ECB has continued to grow and European interest rates have shrunk to very low  or even negative levels, while the FED started to taper its balance sheet. The Covid-19 pandemic has  brutally interrupted this long-term trend. 

Conclusion: QE as the ECB’s method of maintaining financial stability in the Eurozone without  losing its credibility. 

In this research project we studied the balance sheet of the ECB and its massive expansion since the  great  Financial  crisis,  and  the  ECB’s  use  of  APPs  through  non-conventional  monetary  policy  like  quantitative easing. We checked the impact of balance sheet expansion on core inflation indicators,  inflation expectations and the level of the Euro currency. We concluded that lower interest rates and  the ECB’s use of non-conventional policies (increasing base money in the economy) did not have much  of an effect on inflation, but there were bigger correlations with inflation expectations and the Euro Dollar exchange rate. They have also been efficient tools to reduce the level of financial tensions (or  the level of systemic stress6) recently. This may lead to the wrong conclusions: if printing money is  free for the ECB, coming together with the full benefits of seigniorage, why not cancel the government  debt owned by the ECB, as suggested by MMT economists?  

Paying attention to the structure of the balance sheet gives an inkling of the risks attached to such an  option.  Our  research  shows  that  this  would more  than  likely to result  in  central  bank  technical  insolvency (negative  equity)  and  uncontrollable  deficit,  causing  massive  debasement  of  the  Euro  currency, calling off de facto any future QE program and resulting altogether in a loss of credibility,  with potentially an inflation spiral at the end point. The use of “Helicopter money” would be a bridge  too far that would put the European project at risk. Through policies of Quantitative easing, the ECB  can provide an easing of  financial conditions and ensure that  the economic downturn is not made  worse by a credit squeeze, and also achieve its single mandate of keeping a low yearly inflation rate.  Overall, the ECB cannot technically go broke but can severely damage its credibility if it loses control  of inflation and its own currency, the Euro.  

References

1. N.TALEB, “The black swan: the impact of the highly improbable”, 2007. 

2 Buiter, Willem, Can Central Banks go broke? CEPR Policy insight No.24, May 2008.

3. Courtesy of Jean Pierre Landau, former Vice-Governor of the Banque de France

4 HSBC global research, 29 June 2020. US bonds- the QE quandary. Three common misconceptions

5 Bank for International Settlements (BIS Paper n71) – Central Bank Finances – David Archer and Paul Moser Boehn (April 2013) – The diagram above is extracted from the same paper.  

6 See Philip Lane’s blog on the ECB website dated 22 June 2020.