Yet not only is further balance sheet expansion imminent. The Fed's latest statement also suggests that balance sheet policy has arrived as a tool proper: "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate".
This raises the following questions: Is balance sheet policy, which we define as a change in the size and composition of the central bank balance sheet for a purpose other than to steer the level of the overnight interest rate, now a permanent tool of monetary policy? Should it be? And if it is, what are the implications?
Before answering these questions, it is worth taking stock of what balance sheet policy has done so far, and what risks arise from these actions.
I. What Has Been Done? Actions
How have central bank balance sheets been deployed in the crisis? In what follows, we de-emphasise institutional detail in favour of the big picture. Naturally, the particulars of how a central bank uses its balance sheet (which assets are bought, in which market, and from whom) depend on the nature of the financial system it operates in. The ECB and the BoJ, which face more bank-based financial intermediation, pursue their goals through alleviating the situation in the banking sector, including bank funding. The Fed and the BoE, on the other hand, operate in economies where financial intermediation is more market-based - hence most of their interventions are directly in financial markets. We distinguish, schematically, three stages of central bank balance sheet policy:
1. Change in balance sheet composition through collateralised lending, no increase in monetary base: Initially, central bank balance sheets were used to address dysfunctionality in certain segments of financial markets and/or to relieve funding stress in the banking sector. Typically, this involved collateralised lending, whereby market participants posted illiquid securities and obtained liquidity, frequently on a longer-term basis, i.e., at longer maturities, than would normally have been the case. This lending was not allowed to expand the monetary base: central banks either sold other assets (leaving the overall size of their balance sheet unchanged) or sterilised the expansion in bank reserves that would have resulted via the issuance of other liabilities. This may be described as financial stability policy rather than monetary policy proper. In this case, the central bank acted as a market maker of last resort, sometimes substituting for a dysfunctional (money) market.
2. Change in balance sheet composition through collateralised lending, increase in monetary base - passive QE: As the crisis escalated in the wake of the Lehman Brothers collapse in September 2008, central banks had to allow an expansion of the monetary base. Rather than selling other assets or sterilising, they proceeded to issue bank reserves in exchange for the assets lent to them by their counterparties within the collateralised lending framework. We call this passive QE as the size of the central banks' balance sheet is determined by the private banking sector's demand for liquidity (see Manoj Pradhan, The Global Monetary Analyst: QE2, March 4, 2009). Among other reasons, this was done to accommodate the shift in liquidity preference on behalf of financial institutions, but also the public - corporates and households - who, unlike financial market participants, do not have access to central bank liquidity. For the public, an increase in liquidity preference could only be accommodated via an increase in the stock of money, which an increase in the monetary base facilitates.
3. Change in balance sheet composition through outright purchases, increase in monetary base - active QE: The next stage was outright, i.e., uncollateralised, purchases of assets, financed again through the issuance of central bank liabilities (bank reserves). We call this active QE, as the amount purchased and hence the size of the balance sheet are determined by the central bank. This is monetary policy proper. The objectives here were much broader, and macroeconomic, in nature: lower yields for households and businesses should support consumption and investment and lead to an overall reduction in the likelihood of deflation.
Active QE, and balance sheet policy in general, was aimed at substituting for interest rate policy, in a context where the ability of central banks to affect aggregate demand through the manipulation of the interest rate had reached or approached its limits (because of the zero bound to nominal interest rates).
II. Taking Stock: Consequences
During 2007/08, the private sector's liquidity and risk preferences underwent a tectonic shift - the relative valuations of almost the entire universe of assets changed dramatically. As a consequence, the private sector's desire to aggressively deleverage - shrink its balance sheet - has meant trying to dispose of a lot of assets. As the above schematic description demonstrates, central banks have used their balance sheets to effect:
• Liquidity transformation, by exchanging illiquid assets for liquid ones (T-bills and bank reserves, i.e., their own liabilities); often hand-in-hand with
• Maturity transformation, by exchanging long-term assets for liquid assets (again, their own liabilities); and
• Risk transformation, by exchanging risky assets for safe ones (again, their own liabilities).
In short, central banks have, through expanding their own balance sheets, in effect liquefied the private sector's balance sheet and taken the unwanted assets off it. That is, central banks have used their balance sheets to act as a buffer, thus performing a crucial intertemporal stabilisation function. Note that central banks' balance sheet cannot, and should not, prevent deleveraging. Rather, they facilitate a smoother adjustment over time so as to alleviate the adverse macroeconomic effects of (too rapid) private sector deleveraging (see also The Global Monetary Analyst: The Past, the People, The Policies, October 26, 2011). Put differently, through using their balance sheets to provide these transformation services, central banks have eased funding conditions for banks, non-bank corporates, households and sovereigns. It is clear that central bank actions have both alleviated market stresses and had macroeconomic effects.
But this hasn't come without a price. We highlight two worries:
Fiscal dominance: When the medium-term path of the economy is determined by fiscal deficits and deleveraging, attempts to control inflation by increasing policy rates may prove counterproductive: higher policy rates increase sovereign funding costs; this weighs excessively on the economy and could force the central bank to back-pedal. In short, in economies under potential fiscal duress, monetary policy is constrained in its actions: we call this fiscal dominance (see Manoj Pradhan, The Global Monetary Analyst: Is Modern Central Banking Ancient History? October 19, 2011). Now, active QE for sovereign bonds - that is, the outright purchase of government debt in the secondary market - also provides financing for governments, albeit indirectly (purchases in the primary market, i.e., at auction, would be direct monetary financing; however, this would be illegal as it is prohibited in central bank statutes - see The Global Monetary Analyst: G3 Central Banks: Constitutional Issues, January 19, 2012). We think that QE locks central banks into a tighter embrace with fiscal policy and thus reinforces fiscal dominance over monetary policy: as public debt climbs, so must central bank government bond purchases to keep yields low, all else equal. In addition, given that exit from QE is not as easy as entry - exit will almost certainly have to be much more gradual - the more government debt accumulates on central banks' balance sheets, the more difficult and protracted the exit will be.
Equity provision by central banks? In this very context, current discussions regarding the ECB potentially taking losses on its Greek bond holdings provide a cautionary tale. By purchasing assets from an entity which subsequently proved insolvent, the ECB has in this case de facto provided equity, rather than simply liquidity. This is problematic not least because central banks are not democratically mandated to provide equity, which belongs to the realm of fiscal policy. For the central bank itself, the dangers are obvious: losses would ultimately have to be borne by the government - this creates the risk of curtailing the de facto independence of a central bank. More broadly, central bank balance sheets have taken on a great deal of risk. This risk has not disappeared, certainly not all of it. Since the central bank is but a branch of government, any risks materialising would end up with the sovereign - which in turn implies that the private sector would have to foot the bill in the end.
III. Looking Ahead
With more QE by major central banks ante portas, we ask: are there limits to balance sheet expansion? And should balance sheet policy become standard in central banks' toolkit? Yet, before answering whether continued balance sheet expansion is desirable, we must ask whether it is possible.
Are there limits to balance sheet expansion? There is no technical limit to balance sheet expansion because there is no limit to the amount of reserves a central bank can issue. Yet the ability of central banks to perform the intertemporal buffer function discussed above rests on them being the monopoly issuer of a liability that the private sector accepts as an asset and thus is willing to hold on its own balance sheet. This is only true if, and for as long as, central bank liabilities remain safe and liquid assets in the perception of the private sector. From this, the true limits of central bank balance sheet expansion follow immediately. The trick can work only for as long as the private sector is willing to hold these assets. That is, it is entirely a matter of confidence in the central bank and in particular in its commitment to maintain the real value of its liabilities - both reserves and cash. The ability to act as a buffer disappears if confidence were to disappear. We are not suggesting that we are necessarily close to such a point. Yet, as balance sheets keep climbing, we will probably be getting closer to this point rather than further away.
Does this mean balance sheet policies are here to stay - possibly forever? First, balance sheet policy, by its very nature, distorts market prices and hence influences resource allocation (to be precise, so does interest rate policy - but to a much lesser extent). While interfering with market pricing is exactly the point in times of financial market distress and severe economic weakness, presumably it is not something that can be deemed desirable in the long run. Take interest rate policy, the regular central bank policy instrument, as a benchmark. Under ‘normal' circumstances, the central bank only manipulates the overnight rate - by trying to steer the market overnight rate as closely as possible to some desired level. The pricing of the entire universe of financial assets - whatever the riskiness, duration, liquidity, etc. - is left to the market. Second, the effects of balance sheet policies as a macroeconomic tool are as yet insufficiently understood, certainly less so than ‘conventional' macro policy through the interest rate tool. In view also of the risks discussed above, we do not think that active balance sheet policy should become a permanent tool of macroeconomic management.
As an emergency tool, however, it is entirely legitimate - that is, as a continuation of conventional monetary policy at the zero lower bound for interest rates and/or when the transmission mechanism is blocked. That is, while we don't think that central bank balance sheets should remain bloated forever - and indeed, we think that they should return to ‘normal' as soon as the economy and markets allow it - monetary authorities should, and will, retain the option to expand their balance sheet when deemed necessary.
Normative considerations aside, what will actually happen? Central bank balance sheets are likely to remain bloated for a long period of time - indeed, the balance sheet expansions might even end up being quasi-permanent.
First, even if all goes smoothly and the recovery proceeds slowly but surely, it will probably take central banks many years to exit, even if you discount the fiscal dominance argument. Asset sales would have to proceed with the utmost caution - indeed, risk-aversion implies that central banks would rather err on the side of caution and sell too little, too late - just one of the reasons why we are worried about inflation in the long term. Second, if (i) the recovery remains bumpy, with more growth scares; and/or (ii) we revert to recession at some point over the next few years, it seems almost certain that balance sheets will be deployed again. So, in the near-to-medium term, the only way for balance sheets seems to be up. Finally, because of the possibility of economic shocks, the unwind of balance sheets might even take the shape of ‘two steps forward, one step back'. That is, unless we are wrong in the above and balance sheets can indeed be reduced rapidly, a balance sheet reduction that's on the way could be interrupted by a large deflationary shock, which necessitates renewed expansion, and so on.
What are the implications of quasi-permanent central bank balance sheet expansion? The long-term adverse consequences on capital allocation aside, the main question here is whether it would be inflationary. The short answer is, not necessarily. Roughly speaking, to avoid inflationary effects, the permanent part of the expansion in the monetary base should not exceed the increase in the economy's long-term liquidity preference. Clearly, the latter is not an animal that is easy to pin down, not least because it depends on risk-aversion and the evolution of the economy. And of course, central bank balance sheets themselves distort the very prices that would indicate such shifts.
Conclusion: We believe that although there are no technical limits to balance sheet expansion, central banks should not jeopardise confidence in their own liabilities by issuing too many of them - confidence is the ultimate constraint. While QE/balance sheet policy is by now firmly established as a central bank policy tool, the deployment of outright asset purchases for macroeconomic reasons should remain confined to extraordinary macroeconomic circumstances - occasions where the conventional interest rate tool has exhausted its potency at the zero lower bound. That said, reverting balance sheets back to normal is likely to take a long time - so long, that balance sheet expansion could end up being quasi-permanent. This could be inflationary unless the size of the monetary base keeps in lockstep with the evolution of the public's liquidity preference over the long term.
‘Social VAT' is not a reform per se from candidates in the upcoming elections. Rather, the measure has been proposed by the current government and should be implemented after the elections. The parliament is expected to vote on the reform before the elections though. Still, given the pre-election campaign context, the proposal has generated a lively debate across the political spectrum. In addition, the presidential candidate, Francois Hollande, has already said that he will reverse the reform if elected, as the VAT would weigh on household purchasing power.
The Case for ‘Social VAT'
Last Sunday, President Sarkozy announced the introduction of ‘social VAT' in France. The proposal aims at cutting employer social security contributions by €13 billion and replacing them with a value added tax (VAT), raising the standard rate by 1.6pp to 21.2% to finance social security. The measure would be completed by an extra increase of 2pp in social welfare tax (contribution sociale généralisée) on investment income.
The main arguments in favour of introducing a ‘social VAT' are essentially threefold:
i) Social security contributions in France are elevated and fall more heavily on the labour inputs, which discourage businesses from hiring new employees, but instead to use more capital-intensive technologies. In addition, assuming unchanged policies, population ageing is likely to put upward pressures on social expenditures in the years ahead, which is likely to raise social security contributions even further. Hence, other sources of financing, which would not weigh on the labour inputs, have to be mobilised to finance social security. In particular, a ‘social VAT' would have the advantage of being applied to all income (labour and investment income). In addition, the measure would improve the competitiveness of domestic products compared to imports, which are subject to VAT. As the cut in social security contribution would reduce labour costs, it could also lower the costs of exports.
ii) The international evidence suggests a positive impact. The most often mentioned examples of countries that have replaced part of social security contributions with a VAT to finance social security are Denmark and Germany. For example, Denmark reduced social security contributions paid by employers (financing unemployment benefit and disability). In turn, the VAT has been increased by 3pp to 25% between 1987 and 1989. The VAT increase had little impact on inflation over that period. Still, it is difficult to establish whether the strong performance of the Danish economy was due only to the reduction in social security contribution. Indeed, the reform was part of broad macroeconomic measures implemented to stabilise the economy and restore competitiveness. Germany increased the VAT rate by 3pp to 19%, on January 2007. However, in case of Germany as well, the aim of the measure was not to boost competitiveness of businesses. Only one-third of the receipts generated by the VAT hike have been used to finance the cuts in employer social security contributions (financing unemployment benefits), the remainder being used to reduce the fiscal deficit. In fact, the measure was part of reforms aimed at restoring the sustainability of public finances. As German businesses were already highly competitive compared to their European peers, it is difficult to establish whether the measure has further improved their competitiveness. In addition, inflation picked up after the introduction of the measure, though less than proportionally to the VAT hike, presumably because high profit margins of German companies allowed them to absorb part of the VAT increase, in a context of strong economic growth acceleration.
iii) Government reports, based on large macroeconometric models, have shown that the introduction of a ‘social VAT' in France may improve the competitiveness of the French economy and support job creations. More specifically, the reports concluded that the impact on competitiveness would be larger if the cut in social security contributions was targeted at highly skilled workers. By contrast, the measure would generate more job creation if were targeted at low-paid workers. For example, reports published by the French ministry of finance showed that an increase in the standard rate of VAT of 1.5pp (2pp cut in employer social security) would lead to up to 300,000 new jobs (around 1.8% of total employments in competitive sectors) if targeted at the minimum wage workers (SMIC) in the medium term, compared to around 30,000 if it is generalised to all workers.
High Social Security Contributions, a Hurdle to Job Creation
In France, the financing of social security relies mainly on social security contributions from labour input. The amount of social contribution affected to the financing of social security was about €390 billion in 2009 (64% of total resources). Among those, employer social contribution amounted to €217 billion, while the employee contribution amounted to €101 billion. The high taxation on labour income in France is a problem, especially if compared to other developed countries. France has indeed one of the highest shares of social security contributions from wages. In particular, social contributions paid by employers are one of the highest among OECD countries at almost 30% of total labour costs in 2010, compared to 14% for the average OECD or 16.2% in Germany, France's main trading partner.
The Value Added Tax (VAT); a Potential Source of Financing
In France (mainland), three VAT rates are applicable. Most goods and services sold are subject to the standard VAT rate of 19.6%. The reduced VAT of 7% applies to necessity items (food consumption and cultural products such as books). Finally, a super-reduced rate of 2.1% is applied to newspapers and some pharmaceutical products reimbursed by social security. Overall, the VAT is an indirect tax for which the receipts are affected in large part to the state budget. The net VAT receipts represented around €125.4 billion in 2010, almost half of the state budget receipts. Hence, VAT receipts might be a potential source for financing social security, especially because the standard rate of VAT in France is slightly lower than the European average, suggesting that there is still some scope to raise it without creating distortion compared to EMU trading partners.
The ‘Social VAT': Weighing Costs and Benefits
The objective of the proposal is to cut social security contributions. In turn, a fraction of the VAT receipts would be transferred to finance social security. This measure increases the tax base to finance social security, as the VAT is levied on all consumed products (domestic and foreign), while social security contributions are only levied on gross salaries. In addition, increases in the social welfare tax (contribution sociale généralisée) on financial income follow the same logic of shifting away from taxation on labour income. Ultimately, a cut in social security contribution is expected to reduce production costs, which should allow a reduction in prices net of VAT.
An Almost (Theoretically) Inflationary/Fiscal-Neutral Reform
The net impact of the ‘social VAT' is deemed to be almost neutral for both inflation, at least for domestic products, and public finances. Assuming, for instance, a generalised cut in social security contributions financed by an increase in the VAT rate, we can show a simplistic illustration of the expected benefit from that measure.
We assume that a 1.6pp increase in the standard VAT rate to 21.2% is used to finance the cut in social security contributions. In turn, firms would lower their prices net of VAT by the same amount in order to preserve their competitiveness. In this example, the level of prices inclusive of VAT remains unchanged. So there are no negative effects on consumers of domestic products and wages. However, as imports are subject to VAT and do not benefit from the cut in labour costs, the aggregate price level should go up.
For public finances, the reform is deemed to be neutral as well, as the taxation on consumption is used to compensate the cut in social security contributions in order to finance social security.
Still, this illustration is quite simplistic, as we assume that companies have no pricing power and will be cutting their gross operating surplus. In practice, the impact on prices of domestic products would depend on how businesses adjust their prices net of VAT.
The Pros
The expected positive effects of shifting taxation from labour income to consumption are as follows:
- Stimulates employment in all the sectors (tradable and non-tradable) and increases the attractiveness of France for foreign companies, as the costs of labour and production are reduced;
- Improves competitiveness of French products, as the cuts in social security contributions lower export prices, while the VAT hike raises import prices (exports are not subject to the VAT). The decline in export price improves price competiveness, while the increase in the VAT benefits domestic products relative to import products, provided they are highly substitutable.
The Cons
The social VAT is likely to lead to an increase in the level of prices though, if companies do not reduce prices net of VAT. In turn, this would likely lead to:
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