The writer is an FT contributing editor
In July of 1694 an act of parliament gave William and Mary the right to levy a tax on shipping and beer. In return, they had to dedicate that revenue toward paying back a group of people who would lend them £1.2mn. This is the act that chartered what would become the Bank of England. The preamble gives the bank one purpose: the money is to go “towards carrying on the War against France”.
That is no longer the statutory goal of the Bank. But that first £1.2mn loan to William and Mary is still treated by economists and policymakers as definitional. Whether to carry on against France or inflation, central banks buy and sell sovereign debt. Any other assets are seen as either political or, worse, not normal: embarrassing panic buys to be shed from the balance sheet as quickly as possible.
In the past two weeks gilts had a swoon, and then a Fed governor said that treasury markets were “functioning well” — two of the most terrifying words in markets. It’s possible that we’re asking sovereign debt to do too much, and right there in that original act there’s an option we keep pretending doesn’t exist: central banks can buy whatever we tell them to.
In 1694, Parliament forbade the Bank from trading in its own stock, or in any kind of merchandise. But the Bank could take goods as security 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 originally imagined, did not just lend to the crown. It had a direct connection to the private economy through its own balance sheet.
That connection was still strong in the 19th century, when economist and journalist Walter Bagehot composed his rules for central banking; the Bank had more private securities on the balance sheet of its banking department than it did government securities. Bagehot didn’t instruct a central bank in a panic to suddenly buy new things, but to buy more of what it already knew how to buy.
There’s a more recent tradition of economists looking back at how the Bank made gilt markets deep and liquid, giving Britain deep pockets for wars, creating safe assets and a new source of paper cash for markets. That £1.2mn loan to William and Mary is now seen as the act that created modern finance, an immaculate conception. But in Bagehot’s day, the Bank was just as important — and as 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 the first world war to help create and prop up the market for Liberty Bonds. It did the same during the second world war, holding down yields in the treasury market.
By the time the Fed informed the Treasury Department in 1951 that it was done helping out, the shift on its balance sheet toward treasuries was already almost 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 feel truly comfortable buying.
There are defensible reasons for keeping everything but sovereign debt off a central bank’s balance sheet. Most importantly, it insulates central bankers from politics. They cannot be blamed over who gets the benefit of a treasury or a gilt auction — that’s for lawmakers to worry about. And the markets for the sovereign debt of large, rich countries are deep and liquid, making it easier to intervene. The problem with both of these arguments is that since 2008 they have been dragged out to comic extremes. It has been easy to see the comedy, but we should talk more about the extremity.
There are massive distributional consequences to quantitative easing, for example — it raises the value of homes and financial assets. Just because you’re buying a treasury doesn’t mean you’re committing an apolitical act. And markets for sovereign debt are deep and liquid in part because central banks have spent the last century making them that way — running auctions, fretting about market bottlenecks, clearing everything out of the way that might prevent a government from borrowing.
We now expect sovereign debt to do everything. It still funds the government, and in theory should send a price signal about debt sustainability. It is also the policy asset for the central bank, which sits on a massive portfolio, damping price signals. Sovereign debt also has to remain liquid as the safe asset for private portfolios, which can get difficult when a central bank is sitting on so much of it. And we’re stuck with this system because we all somehow forgot fully half of what a central bank could do.
