The author is an FT Contributing Editor
In July 1694 an Act of Parliament gave William and Mary the right to levy a tax on shipping and beer. In return, they were to use this income to repay a group of people who would lend them £1.2million. It was the law that chartered what would become the Bank of England. The preamble gives the bank a purpose: the money must go “in pursuit of the war against France”.
This is no longer the Bank’s statutory objective. But that first £1.2million loan to William and Mary is still treated by economists and policymakers as a definition. Whether to continue against France or against inflation, central banks are buying and selling sovereign debt. All other trumps are considered political or, worse, no Ordinary: embarrassing panic buys to get off the balance sheet as quickly as possible.
Over the past two weeks, gilts swooned, then a Fed governor said Treasury markets were “working well” — two of the most terrifying words in the markets. It’s possible we’re asking too much of sovereign debt, and there, in that original act, there’s an option that we keep pretending doesn’t exist: central banks can buy anything we tell them.
In 1694, Parliament prohibited the Bank from trading in its own shares or any kind of goods. But the Bank could take property as collateral for a loan, and it could buy bills of exchange, a kind of check for commercial goods, cashable at a bank in another city. The Bank, as it was originally imagined, did not just lend to the crown. It had a direct link with the private economy through its own balance sheet.
This link was still strong in the 19th century, when economist and journalist Walter Bagehot wrote his rules for central banking; the Bank had more private securities on its banking department’s balance sheet than public securities. Bagehot did not order a panicked central bank to suddenly buy new things, but to buy After of what he already knew how to buy.
There is a more recent tradition of economists examining how the Bank made gilt markets deep and liquid, giving Britain deep pockets for wars, creating safe assets and a new source of paper money for the steps. This £1.2million loan to William and Mary is now seen as the act that created modern finance, an immaculate conception. But in Bagehot’s time, the Bank was equally important – and equally admired, among American financiers – for the way it bought and sold private debt.
It was the skill with private securities that Paul Warburg, architect of the Federal Reserve, wanted to copy from the Bank. But wars produce sovereign debt, and the Fed stepped in during World War I to help create and sustain the Liberty Bond market. It did the same during World War II, keeping Treasury market yields low.
By the time the Fed informed the Treasury Department in 1951 that it was done with helping, the shift from its balance sheet to Treasuries was already nearly complete. The Federal Reserve – and the BoE and the European Central Bank – now have more admirable missions than fighting France. And they claim the power to make independent decisions. But they are completely, abjectly dependent on their own governments for the only assets they really feel comfortable buying.
There are defensible reasons for keeping everything but sovereign debt off a central bank’s balance sheet. More importantly, it insulates central bankers from politics. They can’t be blamed on who benefits from a treasure trove or gold auction – that’s for lawmakers to worry about. And the sovereign debt markets of the big rich countries are deep and liquid, which makes it easier to intervene. The problem with both of these arguments is that since 2008 they’ve been taken to comical extremes. It was easy to see the comedy, but we should talk more about the end.
Quantitative easing, for example, has massive distributional consequences – it increases the value of homes and financial assets. It is not because you buy a treasure that you commit an apolitical act. And sovereign debt markets are deep and liquid in part because central banks have spent the last century making them that way – holding auctions, worrying about market bottlenecks, eliminating everything that could prevent a government from borrowing.
We now expect sovereign debt to do everything. It continues to fund the government and, in theory, should send a price signal about debt sustainability. It is also the political trump card of the central bank, which has a massive portfolio, dampening price signals. Sovereign debt must also remain liquid as a safe asset for private wallets, which can become difficult when a central bank holds so much of it. And we’re stuck with this system because we’ve all kind of forgotten half of what a central bank could do.