July 30, 2006
Central Bankers as Portfolio Managers
Robert Blumen July 30, 2006
As if fighting inflation, smoothing out the business cycle, and saving the world from economic crises were not enough, central banks are being advised to include another objective in their mission: the purchase and management of stock portfolios. The Washington Post reports that former Treasury Secretary (and soon-to-be-former president of Harvard University) Lawrence Summers "is advising some of the world's biggest holders of U.S. Treasury bonds that they ought to find much better ways to invest their money." Summers says that by holding large portfolios of US Treasuries, central banks are passing up more lucrative investments in the stock market. To make sense of this proposal (if indeed it makes any sense), it is first necessary to understand how central banks came to hold so many reserves, and why the majority of their reserves are currently held in the form of US government debt. From there, Summers’ proposal is a small and apparently logical step. The great Austrian economist and critic of government intervention, Ludwig von Mises, explained the tendency of economic management to evolve in small and seemingly logical increments into a regime of complete central planning. The progression of central banks from their origin as repositories of gold created to bail out bankrupt fractional reserve banks into active portfolio managers perfectly illustrates the Misesean critique.
Origin of Foreign Dollar Reserves
The present circumstances are a matter of both accident and design, the residue of a failed monetary experiment. The Bretton Woods System was put in place after World War Two as an effort to avoid the rigors of the classical gold standard. It derives its name from the location of a Vermont resort where the agreement was drafted between the finance ministers of the world’s major economic powers. As Orlin Grabbe in his excellent article on the rise and fall of this system, explains,
After a postwar transition period, currencies were to become convertible. That meant, to anyone who was not a lawyer, currencies could be freely bought and sold for other foreign currencies. Restrictions were to be removed, and hopefully eliminated. So, in order to keep market exchange rates within 1 percent of par value, central banks and exchange authorities would have to build up a stock of dollar reserves with which to intervene in the foreign exchange market.
Page 1 of 9
July 30, 2006
The Bretton Woods agreement, if adhered to, precluded sustained inflation on the part of member nations. The values of other currencies were pegged to the dollar, which was pegged to gold.
Foreign central banks did for a period of time accumulate dollar reserves, which were thought, as per terms of the agreement, to be convertible to gold at the fixed rate of $35 per ounce. And for a time, foreign treasuries were able to demand gold in exchange for dollars at the official price. But this was not compatible with the guns and butter policies pursued by the US Federal government. The US ensured its ultimate default on the gold convertibility clause by vastly inflating the supply of dollars far beyond its gold reserves, valued at the official price. Grabbe continues,
[by the 1960s] European countries began to add up the total stock of U.S. dollars in foreign official hands and compare them to the total U.S. gold supply. They began to realize that the United States could no longer keep its part of the Bretton Woods agreement to convert dollars into gold at $35 per ounce. By 1960 total foreign dollar claims on the United States were greater than the total value of the U.S. gold stock when gold was valued at $35 per ounce. If all foreign official dollars were turned in for gold at the same time, U.S. gold would run short. The United States would either have to turn away dollar-holders or increase the dollar price of gold.
The Bretton Woods system ultimately collapsed as the US default option by “closing the gold window”, that is, suspending its redemption commitment. The convertibility rule that might have provided some kind of a check on US inflation was gone. The world was on a dollar standard, but the dollar itself was a floating abstraction with convertibility only to itself. To call the resulting international monetary arrangement a Frankenstein monster would be a great injustice to monsters. Two generations removed from a gold standard, central bankers no longer view gold as money, but as a portfolio asset. While this transition has been implied rather than consciously chosen, its significance cannot be overstated. Gold convertibility did not consist of the exchange of one asset (dollars) for another asset (gold) at a fixed price; rather it was the equivalence of two different representations of the same thing: money. The paper form was originally a convenience over the transportation of physical gold, in the same way that a check is not an asset but a means of transferring assets that are held in the checking account.
Reserve Assets After Bretton Woods
Central banks did not set out to accumulate dollars per se, but as an asset that could be converted into the ultimate means of payment, gold. Nevertheless, after the breakdown of the exchange rate regime, central banks around the world were left sitting on large piles of dollars that they had accumulated under the assumption that they were as good as gold. The large dollar holdings of non-US central banks were in this sense accidental. Richard Duncan in his book The Dollar Crisis picks up the story from this point:
Page 2 of 9
July 30, 2006
International reserve assets expanded at a relatively slow pace before 1970 and at a very rapid pace afterwards…It is extraordinary to note that the world’s reserve assets increased more in the four years between 1969 and 1974 as the Bretton Woods system collapsed than during all preceding centuries combined. During the 20 years from 1949 to 1969, the world’s reserve assets increased by 55%. During the next 20 years, they expanded by 700%. Altogether, between 1969 and today, international reserve asset have increased approximately 20-fold. Prior to 1970, gold has comprised the majority of total reserve assets and had been the foundation stone of the Bretton woods system. Afterwards…the role of gold diminished rapidly as foreign exchange become dominant within reserve holdings. By the end of 2000, gold represented only 2% of total reserves. This shift is particularly significant because all the major international currencies also ceased to be backed by gold after 1970. Consequently, as time passed, the world’s reserve assets were not only no longer comprised of gold, they became comprised primarily of currencies that were also no longer backed by gold. Paper money replaced gold as the foundation stone of tie international monetary system.
In the last five years, central banks of countries with which the US runs a trade deficit have accumulated staggering quantities of US Treasury debt.1 As of the end of 2005, the Bank of Korea held $210Bn, the Bank of Japan $828Bn and the Bank of China over $818Bn, rising to $875Bn by the end of March. These reserves are held mostly in US Treasury debt and other quasi-governmental securities such as mortgage-backed bonds issued by the government-sponsored entities Fannie Mae and Freddie Mac. Through their ownership of US government debt, foreign central banks are now major participants in financing the US budget deficit. Dollar reserves held by central banks under the Bretton Woods system provided the bank with ammunition to maintain the fixed exchange rate for its national currency against the dollar that was the cornerstone of the system. If foreign buyers would not pay dollars for the currency at the pegged exchange rate, then the central bank could step in. Dollar reserves could be used to purchase the national currency if the exchange rate threatened to fall more below its pegged rate. But post-Bretton Woods, what purpose would these reserves serve? Why should central banks hold them at all? For example, should the central banks have at this point contributed the dollars to the budgets of their national governments, which then could have spent them on imported goods from the US? In spite of the failure to achieve their stated objective, government agencies rarely respond “game over”, shut down, and return their resources to the private sector; instead, a new reason is found for their continuation. Several reasons for holding reserves have found favor, and these will be described below. After the default of the US on its promise of gold convertibility, other nations dropped the official claim of dollar convertibility. Unofficially, however, the fiat dollar had
BIS 76th Annual Report, p. 83.
Page 3 of 9
July 30, 2006
established itself as the largest and most liquid international means of payment, and as such it continued to function in some respects as the gold-backed dollar had done under the prior agreement. With the fiat dollar's acceptance as the international standard, some central banks have felt it prudent to hold a quantity of dollar reserves to prevent an imminent fall in their currency’s exchange rate. Debt defaults accompanied by a currency exchange rate collapse typically have occurred when a country has accumulated excessive levels of dollar-denominated debt when repayment prospects have come into question. For this reason, the presence of dollar-denominated assets on a central bank's balance sheet gives a country some credit-worthiness in the eyes of foreigners. While the bank has dollars to sell, it can purchase the country’s own currency with dollars on the foreign exchange market to maintain the exchange rate. A series of currency crises in the 90s affecting mostly developing nations has reinforced this trend. In such a crisis, the exchange rates of a particular currency would collapse against the dollar when the ability to repay dollar-denominated debt payments came into question. In the wake of these incidents, chastened central bankers have accumulated large precautionary “war chests” of dollar reserves. More recently, a nearly opposite reason for the accumulation of reserves has gained credibility among developing nations, especially Asian. Policy makers in these nations that have embraced a mercantilist ideology have found the accumulation of reserves helpful in the implementation of their policies. Mercantilism is the economic theory that exports are more desirable than imports. Policy makers under the influence of this theory believe that they best way that a government can promote economic growth by subsidizing domestic export industries, even unprofitable ones, at the expense of domestic consumers. The implementation of a mercantilist policy is improved by a deliberate policy of having a below-market exchange rate. Lowering the exchange rate of a currency against foreign currencies makes the country’s exports cheaper to foreigners and makes other nation’s imports more expensive within the country, thus achieving the goal of promoting exports. Several developing nations have implemented what economist Nouriel Roubini has called the Bretton Woods II system – a policy of quasi-fixed below-market exchange rates enforced by central bank intervention to prevent the exchange rates from adjusting upwards to their market values. To carry this out requires continued intervention by the central bank. In trading with the US, for example, Chinese exporters are constantly acquiring dollars from American firms, and seeking to exchange those dollars for the Chinese Renminbi in order to pay their local suppliers and employees. Over time, the supply of dollars and the demand for Renminbi would push Renminbi's exchange rate higher, in terms of dollars. To prevent this, the Bank of China bank must purchase dollars and sell Renminbi.
Page 4 of 9
July 30, 2006
As the central banks of China and other Asian nations carried out their policy of quasipegged below-market exchange rates, they have accumulated a vast fund of US dollars. The reserves were acquired not because the central bank saw any good reason to fund the bottomless pit of debt that is the US government, but as a necessary consequence of their trade policy. There would be no way for the central bank to unload its dollar reserves without defeating their original purpose. Stuck with their dollars, central banks have nothing better to do than to buy US Treasury debt that at least pays them a minimal rate of interest.
Central Banks as Hedge Funds
As discussed, the desire to allocate capital to credit markets and earn a prospective rate of return did not play a role in the accumulation of what have become in essence large bond portfolios. Nor did central banks start out with the idea that they would become portfolio managers. Their large holdings of reserves came about for other reasons entirely. While the original rationale for central banks reserves no longer applies, the large accumulated holdings of reserve assets and the political impossibility of any government institution voluntarily giving up its ill-gotten gains makes the next step nearly inevitable. The view that central banks should seek the highest return on their assets is increasingly driving discussions of central bank policy. This was the rationale behind the Bank of England's 1999 decision to sell a portion of its gold reserves. The proceeds of the sale were, according to UK Chancellor of the Exchequer Gordon Brown, to be used for the purchase of government securities denominated in dollars, euros, and yen.2 In the opinion of central bankers, gold as an asset lags in comparison to debt securities because it sits in vaults and does not pay a yield. This refrain has been echoed within the world of central banking, as a substantial number of Western European central banks in addition to the Bank of England have participated in a sell-off of gold reserves over the past six years. The Swiss central bank, for example, sold over 1000 tons, or around half of its reserves. The stated purpose of most of these sales was to invest the proceeds on interest-paying securities, “diversified” among the world’s major fiat currencies. Summers’ proposal then is part of the movement of central banks from accidental portfolio holders to active asset managers. In this light, for banks to swap bonds for stocks is nearly obvious. Summers first calls attention to the poor returns to be expected from holding US Treasuries. While Summers estimates the return on foreign holdings of US Treasuries to be a small but positive number (around 2%), a politically unbiased calculation of the inflation rate indicates that that the return on US Treasuries, in dollars, is probably As of this writing all of those currencies have depreciated substantially against gold in the time since the sale. By some estimates, the UK has lost over £2 billion on the sale compared to the value of the gold that it sold.
Page 5 of 9
July 30, 2006
negative. This computation does not take into account possible losses for non-US bond holders due to a fall in the dollar’s exchange rate against their currency. A single day’s movement in the dollar against other currencies could wipe out an entire year’s nominal return. Summers then offers the more attractive prospects accruing to equity shareholders. According to Summers,
[the equity holdings of central banks would earn] an annual return of 5 percent -- a conservative estimate for the long-run yield on a sensible stock portfolio -- the $2 trillion in excess reserves could produce average annual yields of about $100 billion Economic and Political Problems
Central banks, through a series of accidents and failed policies, are now reinventing themselves as profit-maximizing asset allocators. But there are significant problems with this new mission, both economic and political. While modern portfolio theory considers government debt to be an “asset class”, government debt is not in the economic sense an investment. The economic meaning of investment is the employment of real resources toward to the construction of more productive capital yielding more consumption goods in the future. Treasury debt is fundamentally different from private savings in that it is simply a claim on the taxing power of the government that issued it with no productive capital behind it. The money that was borrowed upon the issue of the bond has already been spent to fund government consumption for its favored welfare and warfare programs, while the taxpayers were burdened with the obligation to repay. The two cases of domestic and foreign holdings of government debt are slightly different. When the central bank of country A holds the treasury debt country B, it has acquired a claim on the taxing power of B’s government (or a promise that the central bank of B will print enough of B’s money to pay off the debt). When the central bank of A holds A’s own government debt, this is a mere accounting arrangement for the apportioning of tax revenues among different branches of the same government. This is what occurs in the US when the operating portion of the federal budget3 borrows from the operating surplus of the Social Security System. The federal pays with non-negotiable bonds constituting promises to repay the SS out of future tax revenues.4 Concerning this arrangement Charles E. Rounds wrote,
Or perhaps better, the “federal fudget”. In the United States, the tax revenues used to pay the debt are paid to the central bank. Since the central bank accounts for its own account with itself, these revenues are journalled into this account. At the end of the year, the Federal rebates all profits back to the US Treasury, so in the end a big nothing has occurred.
Page 6 of 9
July 30, 2006
All the U.S. is actually doing is engaging in non-binding musings with itself about paying itself back for certain monies it has spent out of general revenues for purposes other than social security. The closest thing that a social security "bond" resembles to anything legitimate is the "bond" of a corporation that has been reacquired by the corporation, or more accurately the "bond" of a corporation that has yet to be issued, i.e. sold, to a third party by the corporation. In either case, the "bond" is neither the property of the corporation's stockholders nor of the investing public.
While the problems with central banks holding Treasury debt are bad enough, the problems with these institutions going into the market for private sector equity are even greater. Central banks are now verging on the same playing field as private sector investment banks and hedge funds. Owing to the massive size of their reserves, the presence of these actors in equity markets would instantly transform them into major players. The Bank of Japan’s portfolio valued at $800Bn is about equal in value to the market cap of the Swiss stock market, the eighth-largest share market in the world. Other emerging nations are of similar capitalization, for example Russia ($592Bn), South Korea ($557Bn) and India ($506Bn). Modern portfolio theory divides the financial world into asset classes having stable returns, where a return is associated with each class. The return of an asset class is thought to compensate investors for the asset’s volatility. Bonds, for example, are thought to earn around 3% and stocks around 8% in real terms, with stocks having greater volatility than bonds. The returns on a conservative stock portfolio, according to Summers, is about 5%. According to this theory, constructing a portfolio is equivalent to slicing up the pie into pieces consisting of single asset classes. Given the assumptions of the theory, an optimal portfolio can be constructed that maximizes risk-adjusted return. While Summers presents the issue as one of rational portfolio management, this view rests on a serious misunderstanding. The return on a private sector asset cannot be separated from the institutional context of private property rights in the means of production. Economic central planning is defined as a single owner-planner of all of the means of production. Ownership of financial assets is ownership of the means of production. To the extent that government agencies to own a portion of the stock market they are engaged in central planning. The purpose of capital markets is the channeling of savings into investment. Financial assets are ultimately ownership claims on real assets. Financial assets are created by the owners of real assets in order to subdivide, rank, and otherwise keep track of ownership claims. The existence of debt and equity shares simplifies economic calculation by enabling the pricing of assets used at different stages of production.
Page 7 of 9
July 30, 2006
As Mises showed in his famous critique of central planning, only private owners of capital allocate it in an economically rational way. The allocation of scarce productive assets, Mises showed, can only be done with market prices. Prices enable business firms to calculate profits and losses, indicating whether they have produced more of economic value than they have consumed, or the reverse. Prices are only economically meaningful when they are the outcome of individuals risking their own wealth to purchase factors of production in competition with other private owners of wealth. Without the private direction of investment, no economically meaningful calculation of profit or loss could be made. Accumulated capital would be consumed rather than augmented. Returns in this sense would be negative, though they could not be exactly calculated without market prices. While the trend in central bank thinking increasingly portrays the institutions as quasiprivate sector entities, similar to hedge funds, this is not the case. A central bank – because it does not put privately owned wealth at risk -- cannot possibly allocate capital rationally. The greater the share of total market capitalization owned by central banks, the less rational will be the allocation of real productive assets. A substantial ownership of equity shares by central banks would transform financial markets from a means of capital allocation to one of capital consumption and economic destruction. While Mises’ criticism of economic calculation without prices is decisive, there are serious political problems with this proposal as well. Ownership of capital ultimately requires control over its use in order to realize its economic value. Once government entities hold private sector equities, would anyone doubt that rent-seeking leeches would start to lobby for the politicization of corporate decision making? When central banks own stocks will Fed governors sit on the boards of corporations? Will Governor Kohn be involved in the hiring of new CEOs? Will self-professed Hayekian Governor Kroszner be for, or against, stock options as a means of executive compensation? Will Fed Chair Bernanke appear on Mad Money to tout his stock picks? More worrying still that a single institution with the power to create money and purchase financial assets is a threat to exercise both of those powers at once. A series of research studies by Bernanke and other researchers at the Fed explain how central bank purchases of financial assets could be carried out with with newly printed money. I have argued in my piece on Bernankeism this has set the US on a trajectory toward to a form of hyperinflation in which the Fed uses helicopter money to stave off a collapse in asset prices.
Conclusion: The Logic of Interventionism
Political institutions created to with the stated intention of solving one problem often outlast their original purpose and must continue to reinvent themselves in order to justify their continued existence. Once a single interference in the market is put in place, wrote Mises,
it may happen that the way in which they, the producers and consumers, react appears as still less desirable, in the eyes of the government and the advocates of its interference, than the
Page 8 of 9
July 30, 2006
previous state of the unhampered market that the government wanted to alter. Then if the government does not want to abstain from any intervention and to repeal its first measure, it is forced to add to its first intervention a new one. The same story then repeats itself at another level. Again the outcome of the government's intervention appears to the government as even more unsatisfactory than the preceding state that it was designed to remedy.
As long as the policy of interventionism is pursued, new “solutions” are required in order to solve the problems caused by the prior interventions. If not stopped, the end of this progression is a system of total central planning:
In this way, the government is forced to add to its first intervention more and more decrees of interference until it has actually eliminated any influence of the market factors— entrepreneurs, capitalists, and employees as well as consumers—upon the determination of the ways of production and consumption.
Central banks were originally created by fractional reserve banking cartels as "lenders of last resort" to bail out fractional reserve banks during banking crises. They found a new lease on life under Keynesianism as the focal point of central macro-economic management. Then under Bretton Woods, they took on the role of defenders of foreign exchange rates. The collapse of that system left them with large quantities of reserves that they had nothing better to do with than “invest”. For them to become active portfolio managers is nearly inevitable under the Misesean logic.5 The only exit from this process is a renunciation of monetary interventionism itself: the dissolution of central banks and a return to sound money.
Yet in Orwellian manner, the public soon forgets that the institution was created for an entirely different reason.
Page 9 of 9