Jens Van’t Klooster is a postdoctoral fellow at KU Leuven and is also a member of the research group, A New Normative Framework for Financial Debt at the University of Amsterdam. Jens has recently coauthored an article titled *The Myth of Market Neutrality: A Comparative Study of the European Central Bank’s and Swiss National Bank’s Corporate Security Purchases.* He joins Macro Musings to talk about this article and some of his other work on central bank purchases and what it may mean for the Fed’s purchase of corporate bonds.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Jens, welcome to the show.
Jens Van’t Klooster: Yeah. Thanks a lot for inviting me. I'm very enthusiastic to be here.
Beckworth: Well, I'm glad to have you on. I really enjoyed reading your article and some of your other work. It's very fascinating. As you know, over here, across the pond, our central bank, the Fed, is dipping its toe into corporate bond purchases. And where you are, that's old news, right? The ECB and the Swiss National Bank have been doing it for some time and you have a great article on that and we look forward to talking about that and maybe learning some lessons, shedding some light on what it means for us here in the United States. But before we get to that, Jens, tell us about yourself, what you do, and how did you get into this topic? Because there's very few writers who get into these deeper philosophical questions about what type of assets central banks should purchase.
Van’t Klooster: Yeah. Yeah. That's a good question. So, actually, that's very much related to a previous guest on your show, Ulrich Bindseil. So, a few years ago, I applied. I have a background in philosophy, a bit of economics, and then I wanted to do something really applied, and applied to the University of Cambridge with a project on financial markets, political philosophy, and then I got in and I was super, super excited about it. But I realized I don't actually know that much about financial markets, and then I saw on Facebook there was this ad for a one-week course given by Ulrich and his predecessor as head of market operations, Francesco Papadia, and they gave this really interesting one-week course in which they went through all the details of monetary policy operations at the ECB. And basically since then, I've been really fascinated by this topic, and it's sort of been one island in this incredibly complex world of financial markets that you really understand, right? And then from there, always sort of explored other topics.
Beckworth: Well, that's fascinating, so you were in Ulrich's class. That short class on central banking. I saw his textbook and his materials for that, so that would have been neat to sit through his class. And just for our listeners who may not know who he is, or they missed the episode, he was the individual who ran the actual implementation of monetary policy, right? The actual-
Van’t Klooster: Yeah. Yeah.
Beckworth: ... mechanics, the plumbing of monetary policy at the ECB. So, he would be the equivalent, but it's not quite the same, because ECB's set up differently, but he'd be the equivalent of the market desk at the New York Fed that implements Federal Reserve policy in the United States. And I know he's moved on since then. He's doing some other job now at the ECB. But he is one of the leading authorities on the plumbing of monetary policy, so what a great class, to be introduced to central banking through him, so that's fascinating.
Van’t Klooster: Thank you.
Beckworth: And for our listeners, I encourage you to go back and check out the episode with him if you want to learn more about him, but we're here today to talk with Jens, because Jens has got this really amazing paper on what's happened. This is prior to the crisis, but again, it sheds light on what's happening now. But what happened over at the ECB, and the Swiss National Bank, in terms of their corporate security purchases. And man, there was a whole lot more there than I ever knew or could imagine, and the Swiss National Bank in particular was very ambitious in some of its purchases. You do a great job getting into what they've done, but also the implications, and that's really what your paper is about.
Beckworth: And again, the title is... It's a coauthored paper and I'll let you speak about your coauthor and maybe the origins of this paper, but the title is *The Myth of Market Neutrality: A Comparative Study of the European Central Bank's and the Swiss National Bank's Corporate Security Purchases.* So, walk us through that, and start with what got you into this paper.
“The Myth of Market Neutrality”
Van’t Klooster: Yeah. So, my coauthor and I were both really interested in central banking, and sort of the big, normative questions about central banking. All the big changes that had taken place since 2008, and we thought really focusing on this one specific program brings out a lot of these issues and really allows us to go into a lot more detail. There had been a lot of discussions at the time about the distributive effects of QE more generally, that it drove up housing prices, for example. Maybe also encouraged share buy backs. But then there's also a further issue of once you start implementing QE operations in corporate securities, where in the case of the Swiss National Bank, buying these large portfolios, which companies are you going to buy? So, there again, the main distributive choices that central bankers were now suddenly making, and we thought it would be really interesting to puzzle out how that worked and to give our views on it.
Beckworth: And that was kind of the motivation, so yeah, a lot has changed since 2008. I mean, as you note, prior to 2008, there's kind of a consensus about what is the proper role for monetary policies, real simple, it was easy to be a technocrat back then. Just hit a few instruments, interest rates, you aim for price stability, you really minimized your footprint, or you tried to avoid as a central banker, fiscal policy altogether. But I think the point you're making as since 2008, since central banks across the world, and at least in advanced economies, have really moved into large-scale asset purchases, they've also backed up every market in times of crisis, and in the case of the ECB and Swiss National Bank, they're not just buying a lot more bonds, they're buying a lot more private bonds and private securities, which the Fed is just now getting into.
Beckworth: So, your point, I think one of the starting motivations for the paper you outline is central banks, they still want to pretend they're in the pre-2008 world, and they're being neutral, they're not really causing any ripples. But reality is that they're dipping their toes in fiscal policy with these purchases and there are distributive consequences. They are making credit decisions that have allocative outcomes, and that normally is a role reserved for the legislative body, right? Or the body politic, who can vote. Look, if we're going to make decisions about someone getting some kind of real resource and another person doesn't, at least it should be voted upon in a democracy.
Beckworth: And your point is central banks are slowly moving in that direction, right? That they're dipping more and more toes into the fiscal policy space, despite their claims they're being neutral about it. And so, you want us to walk through and think about these issues, right?
Van’t Klooster: Yes. Exactly. Exactly. So, at least the first two parts of the paper really sketch this story, right? So, you come from this situation where central banking is really simple, so you have one objective, and one instrument, and there are not supposed to be any distributive consequences, and we sort of also highlight that that story was never entirely true, right?
Van’t Klooster: But it had really worked and it was broadly accepted, and then suddenly in 2008, you see central bankers just moving in these completely new territories, where they're confronted with all these new choices, and then we argue what central bankers do in response to that is to stick as close as possible to that pre-2008 narrative in how they design their operations. So, if you think about it, they could design their operations in all sorts of ways, but they make the choices in such a way that it's as continuous as possible with the past. On the one hand, really emphasizing that, "Well, we're buying corporate securities, but it's really about price stability." And then we challenge that.
Van’t Klooster: And on the other hand, also saying, "Well, it doesn't have any distributive consequences, because we are market neutral." And then again, we also challenge that. We're skeptical that this story from before 2008 can really be applied to explain what central banks are currently doing.
We're skeptical that this story from before 2008 can really be applied to explain what central banks are currently doing.
Beckworth: Okay, and I think it's a reasonable argument. I mean, they are buying up non-governmental assets, private securities, private bonds, private stocks, so there's going to be some implications. There's got to be some ripple effects. And even their best attempts, and I'm glad I have you on, because this has come up before. What does it mean to be a neutral asset purchase? And I think what you showed me in this paper is it's really almost impossible for a central bank to be neutral when it makes these purchases, when it goes and starts buying private assets.
Beckworth: And I bring this up because Jens, in the past, I mentioned Ulrich before, Ulrich Bindseil was on the show, and I really enjoyed an idea he had. But again, your work is giving me pause. He presented two different views of what is a neutral asset purchase. On one hand, you have the US view and the UK view, he calls it the US-UK view, where you should only buy government securities, and if you do that from a consolidated balance sheet perspective, the government is minimizing its footprint. The central bank is minimizing its footprint on the economy, because it's really a wash.
Beckworth: The German view is no, no, no, no. If you do that, you're just buying government securities, and that's distortionary for other private assets, so what you should do according to the German view is you need to go out there and buy a basket of representative assets. Something that replicates that average investor. That's market neutral. Of course, that's what the ECB tends to do, and the Swiss National Bank tends to do. But the examples you gave, and we'll get through these, and the actual way this is done isn't actually neutral. It actually, even if you try… the ECB is very careful about being neutral, but even in their best attempts, it's not in practice as you outlined in the paper. Now, before we get into the specifics of it, and again, it's really fascinating details here, you used a great analogy, and that's the myth of Ulysses. So, walk us through that and why that's a useful analogy here, and how to properly apply it.
Applying the Myth of Ulysses
Van’t Klooster: Yeah. That story about Ulysses, that goes back a lot. Certainly before 2008, when central bankers are explaining why what they are doing is not undemocratic, right? So, why it's possible in a democracy to have these really consequential decisions made by central bankers, and the idea is just like Ulysses, right? Ulysses ties himself to the mast so that his rowers can row past the sirens. The rowers are deaf. And then, once they're past the sirens, then Ulysses can be untied again. But before that, he just follows the course set out previously, and then in the same way elected governments are supposed to tie themselves to the mast, because they are very tempted to use the money supply to do really expansionary or really unprudent fiscal policies.
Van’t Klooster: And then the central bankers, they are the rowers, and they row past these sirens, and then it's not really undemocratic for central bankers to take this role, because they're really following this very clear instruction set out in their mandate. That is one instrument, an interest rate, and they use that to achieve one objective, price stability, and that's sort of the narrative in which their discretion is very limited.
It's not really undemocratic for central bankers to take this role, because they're really following this very clear instruction set out in their mandate.
Beckworth: So, you still see this analogy used a lot. The central bankers like to invoke it and say, "This is who we are." Have you got any change from them on it?
Van’t Klooster: It's still very often invoked. For example, Vitor Constancio invoked it in detail in his speech when he left the ECB in 2017. He was also a board member of the ECB. And it's a very powerful metaphor in a field that can be a bit dry at times.
Beckworth: Okay. Well, let's move on to the actual experience of the Swiss National Bank and the European Central Bank, or the ECB, and let's start with the Swiss National Bank, because that's the order you do in your paper. And I was pretty surprised to read what all they have done, so maybe walk us through. What have they done? What are they buying? How big is it? What's going on over there?
Swiss National Bank Policies and Neutrality
Van’t Klooster: Yeah. Well, the Swiss National Bank has for a long time tried to stabilize the value of the Swiss franc against the euro, in part also as a consequence of the really super accommodative euro policies. It's been really difficult. So, what they've done to stabilize the franc, and this has not always been sufficient, or difficult to keep up, is to just buy a lot of foreign securities, right? This is in one sense a very traditional sort of operation. Central banks seek to stabilize their currency by trading in currency markets, but the size of this fund is quite exceptional, which is around $700 billion last time I checked.
Van’t Klooster: And what we focus on is that as part of that program, they are also buying corporate bonds and stock in foreign markets. And it's interesting, because from a strict price stability perspective, despite what they say, of course, you don't need to do this. You can just only buy government bonds, for example. More traditional reserve assets. And the reason they do this is that because the franc does still appreciate, they would at some point end up with negative equity if their portfolio wasn't sufficiently profitable, right? So, in terms of if you have no returns on a foreign exchange portfolio and your currency appreciate, then at some point you have negative equity as a central bank. Now, you can again ask whether that would be a disaster, but it's clearly something that central bankers would like to avoid.
Beckworth: Yeah. On that particular point I find it fascinating, because I remember one of the reasons they changed their policies, because they were worried about losses on their balance sheet. One of the reasons they pulled the plug or the peg between the... When they were pegging their currency to the euro, they were worried about losses on their balance sheet. And in my mind, well, that's exactly what you want. You want to do it in a controlled fashion, but if you're worried about a deflationary environment, you want to actually generate some inflation. You want people to worry maybe the money's losing value. You want to pick velocity spending up, then the way you do it is you do allow a little bit of a hole to emerge in your central bank balance sheet.
Beckworth: But they took the opposite, so I think I've always been puzzled by that. And I know one of the answers is that the Swiss National Bank has shareholders, and they've got to make them happy, too, which in my mind then presents a problem. Maybe that's not a good model. If you're trying to meet the mandate of price stability, avoid deflation, and that may require creating a hole in your balance sheet to create inflation, taking a loss, if that goal is overwhelmed by the shareholders' desire to maintain certain return on their investment, there may be something amok there. So, tell me a little bit about that. Does the central bank's mandate for price stability trump what the shareholders want? Or is there any tension there?
Van’t Klooster: Well, so we looked into that, of course. Whether we could in any way make that case. It must be said that the returns on those assets are capped.
Van’t Klooster: Also, it is not clear exactly whether a lot of people really hold these assets for their returns, or whether it functions more as a kind of safe asset, right? Because a lot of investment into the Swiss Bank is for safe asset purchases. But I do think it really points to what is sort of the elephant room politically, is that you could have all sorts of compositions of this for an exchange portfolio that would be more profitable, right? So, if you would turn into a slightly less liquid but more effectively invested portfolio, then it would just be more profitable. What you also just mentioned, you could also think like, "Well, losses don't matter.”
Van’t Klooster: “We really want to achieve our monetary policy objectives.” So, at this point you're suddenly confronted with all sorts of choices, right? And there's really no sensible arguments on both sides, and then we say, "Well, to now say we're just doing these purchases in the service of price stability," that really misses out on what you're really doing. You're making a choice in terms of how much return you want on your portfolio, and that's fine, but at that point, you do get the sort of democratic questions that you already mentioned.
Beckworth: Yeah, so just to be clear, they've capped the amount of returns that shareholders get. If they make more profits, then they got to pay out to their shareholders. The rest of it goes to the government? Is that right?
Van’t Klooster: Yeah.
Beckworth: Okay, so you can imagine a scenario, then, where they were taking a loss on their balance sheet, but it was consistent with price stability mandate, but they couldn't make a payment to their shareholders. I mean, I could see then you would have these choices, this tension that arises, and who trumps who? Who's more important? Price stability? Or is it the shareholders? So, I know that wasn't the focus of your article, but I couldn't help think about that, because again, one of the reasons they pulled the peg with the euro is because they were concerned about losses on the balance sheet.
Beckworth: But just to go back, and again, these numbers are staggering to me. So, you mentioned in the paper the foreign currency portion of the Swiss National Bank was about $790 billion in 2017. Now, maybe it's changed since then, but 11% of that was private bonds and 21% were stocks. It was a stock index. And you mentioned they try to be neutral. They try to have an index, so they're not influencing any one stock. But that's still pretty sizable. That's not nothing. That's actually a meaningful amount of funds invested in foreign stock, and that's just... It's fascinating. How long have they been doing this? Is this a long tradition there? Or is it more recent?
Van’t Klooster: So, they've been doing it I think from 2004 onwards.
Van’t Klooster: But then that it has this size, that's really a post-2008 phenomenon. And then indeed you do get questions like, "This is a really sizable investment that Switzerland is basically doing, right?" So, Switzerland just has all these exposures to other states, and they're fine with that apparently, but you do wonder.
Beckworth: Yeah. Well, it reminded me also of Japan. The Bank of Japan was investing in these ETFs, exchange traded funds, that were tied to corporate stocks, as well. And I remember the joke was if they kept buying at the pace they were buying a few years ago, that at some point they would own all of Japan. Corporate Japan. So, you can imagine Swiss National Bank, maybe they wouldn't own the world, but they could own a sizable portion of firms outside the country. Now, you mentioned the aim to be neutral here, right? They want to again follow a stock index. They don't want to influence any one. But despite that, there's still choices being made, so maybe walk us through. Why can't they be totally neutral with these decisions?
Van’t Klooster: Well, I think the most basic point is that there are all sorts of things which you could say are neutral, right? And you've already suggested on perspective is just by government bond. One perspective is buy sort of what a representative investor in this specific market would buy. They would buy the index. And you could think of all sorts of other versions of neutrality also that will have certain economic policy effects. Now, the issue with this very specific choice, particularly when it comes to bond markets, is that it also don't very neatly reflect the broader economy, so it's not as if you're providing equal amounts of funding to every sector of the economy. As a matter of fact, you're providing funding to specific sectors, and in that sense, this will have distributive effects, right? So, specifically in energy sectors, utilities, in manufacturing, there's a large dependence on bond markets, so there suddenly there's a lot of room for investment, and then that will have consequences for the future state of your economy, right?
It's not as if you're providing equal amounts of funding to every sector of the economy. As a matter of fact, you're providing funding to specific sectors, and in that sense, this will have distributive effects.
Beckworth: Yeah, Jens, so that's fascinating. I think the point you're making as I understand it is that not everyone's in the stock market. Not every firm's in the stock market. Not every firm is in the bond market. And even those firms that are in those markets, some of them have a bigger share of the market, so if you follow an index, it might be more heavily weighted in some big corporation. Therefore, just by construction you're going to be picking some winners and some losers. If you're a small business, a medium-size business, you may not be in either market. Maybe you haven't issued bonds or you're not a public corporation. So, you're definitely allocating credit, making decisions, passing favors, however you want to say it, and so it's hard to be neutral in a world where there's different firms of all different sizes, and doing different things, even if you follow an index, right?
Van’t Klooster: Yes. Exactly. Exactly. So, that's really important so you're not reflecting the economy, and then maybe you should also ask the question is that then the most obvious thing to do, right? So, that's again a certain political choice that you would want to reflect the underlying economy. But I think what a lot of people have picked up on with these corporate security purchases, specifically the bond purchases, is that they're very skewed towards manufacturing, utilities, energy sectors, and this has also come then with a really disproportionate carbon footprint for these investments.
Van’t Klooster: So, one number that a more politically-oriented NGO recently brought out is that if you take all the emissions associated with the Swiss National Bank's foreign exchange portfolio, the corporate security part, then these emissions are larger than the emissions of Switzerland, right? So, this is just a huge portion of the portfolio going to specific sectors which fit a specific future trajectory of the economy, where you stick to a largely carbon-based economy, and then of course also, governments are now pushing in our policies that try to put the economy on a different trajectory, so then to choose one over the other again isn't obviously apolitical, right? You're really making choices. This is the sort of sector we want to promote. Those sectors we don't want to promote. Just in virtue of trying to be neutral.
Governments are now pushing in our policies that try to put the economy on a different trajectory, so then to choose one over the other again isn't obviously apolitical, right? You're really making choices.
Beckworth: Yeah, so they mean well, they're trying their best, and you even note that they have a statement where the say no company that produces internationally-banned weapons, that seriously violates human rights or systematically causes severe environmental damage, that's part of their criteria. So, they're doing their best, but they can't avoid who relies on bond financing. You mentioned manufacturing, utilities, they tend to rely a lot on bond financing in Europe, so they're going to by default fall into those type of firms.
Beckworth: You also mentioned the Swiss National Bank does try to delegate its voting rights to some external service providers, so they do a lot, but they're still inevitably making decisions that affect different parties differently. And it's interesting to look at the Swiss experience, because I think we're beginning to see that in the US now. So, the Fed is trying to reach into corporate America and into Main Street, into small businesses, but it's having a lot more success with the bigger corporations, just because bigger corporations are collateralized, they have ratings, it's easier to deal with them, because they're already part of the financial market where a small business is much harder to get in. The Fed's also constrained by law to do lending. It can't give grants out.
Beckworth: So, it's just the way it is. It's harder to reach these other markets that are smaller and more unique than the big corporations. So, it's hard. Your point is it's hard to be truly neutral. You're going to be picking winners and losers no matter how you slice and dice it. So, how has the Swiss populous wrestled with this issue? Is this a big deal to them? Do they care that the Swiss National Bank is investing in stocks and bonds of private corporations?
Van’t Klooster: Well, it's always less political than fiscal policy, right? So, if you look at something like “we're purchasing this portfolio, and then that will provide investors with an opportunity to do new investment of a certain kind,” this gets very complex. It's not immediately attention grabbing. I sometimes get emails from people in Switzerland on this topic. I've written on this in different contexts. But it's simply not as politicizing as fiscal policy, right? It doesn't really bring in the crowds. People aren't very angry or happy about the design of monetary policy operations.
It's simply not as politicizing as fiscal policy... it doesn't really bring in the crowds. People aren't very angry or happy about the design of monetary policy operations.
Beckworth: So, they're not aware of what's going on as much as they would an overt fiscal policy action. So, that's the issue.
Van’t Klooster: Given the size of it, I think involvement is very limited. Also, for example, if you compare it with the Norwegian sovereign wealth fund, so now people are also very, very invested in what happens with the wealth fund. I don't see something similar in Switzerland. I must say I'm not Swiss, so I can't exactly, but my feeling is this is really not as big a topic as you would imagine it would be if you talk about such large investments.
Beckworth: Yeah. By the way, you mentioned in the article there's been talk of a sovereign wealth fund for Switzerland for some time, so what's the idea behind that?
A Swiss Sovereign Wealth Fund
Van’t Klooster: Well, this is again one of the choices they could be making, so if you as a matter of fact hold hundreds of billions in foreign assets, then there is a really good case, and people have made that case in Switzerland, to move it away from these very low yielding safe investments, and out of traditional reserve assets, and just make it more like a sovereign wealth fund that really tries to achieve a certain return. The Swiss Central Bank doesn't want that, because they say that will make the portfolio illiquid, and that will constrain their space for monetary policy. Of course, there are real tradeoffs, right? So, how likely is it really that Switzerland will need to really stabilize its currency upward in the near future? I think that is very unlikely and you wonder how expensive this insurance is for the Swiss.
Beckworth: Yeah. Again, going back to our earlier discussion, maybe the Swiss need to take a little bit of a loss to get inflation back to where they want it to be, to be consistent with their price stability mandate. But it's an interesting idea, sovereign wealth fund, and again there's been talk of a sovereign wealth fund in the US, where you issue treasuries. What's our scarce resource that the world wants? It's our safe assets, our treasuries, and Swiss, the same thing. They're a safe haven place to park your funds, so it's a very fascinating idea. And I guess the big difference is a sovereign wealth fund would be more transparent, more accountable, more oversight than a central bank. Is that the argument?
Van’t Klooster: Exactly, and at that point you could also have a bit more separation between monetary policy on the one hand and really making investment decisions on the other, where I think you'd have much more democratic control. This whole story of Ulysses doesn't seem to really apply here, right? There's not a short-term stimulus to go for a certain sector in your investment portfolio over another. This idea of a temptation that will get you to make a really bad decision in the short-term, where you should be aiming for the long-term. That doesn't seem to apply in how you design your investment portfolio.
Beckworth: Yeah. Okay, well let's move to the European Central Bank or the ECB, and they had a Corporate Sector Purchase Program, or CSPP. So, when did that start? Is that a fairly recent program or was that a part of the great financial crisis?
The ECB’s Purchasing Programs and the Price Stability Mandate
Van’t Klooster: No. QE in general started much later in Europe, in 2014. And then in 2015, the CSPP started. And that's really a part of this larger project, a program that really sort of mirrors also the general structure of monetary policy implementation in Europe, where you on the one hand, as you already mentioned, have an important role for government bonds, but also private assets are accepted as collateral at European Central Bank. And then also, the design of the asset purchase programs, or the ECB's QE program, reflects this. So, there's a covered bond purchase program, there's an asset-backed security purchase program, and then there is the corporate bond purchase program that we focus on, and now with the new Pandemic Emergency Purchase Programme, there are also again both private and public assets that the ECB buys.
Beckworth: Okay, so since about 2015, the ECB has been buying corporate securities, corporate bonds, and it's doing even more so now with the pandemic response, as well. And again, to kind of step back and summarize these two cases, you mentioned in the case of the Swiss National Bank, they argued that they needed to buy these corporate securities to meet their objective price stability, but when you show, it's really they're trying to maximize their return. It was more of a return, versus they could have gone other ways to maintain price stability.
Beckworth: And in the case of the ECB, the argument here is there's not enough sovereign debt to buy, so they have to. I mean, this is the argument one would make. There's not enough sovereign debt, so they got to buy private debt, and would you argue that's a reasonable answer or was there an alternative way to meet the price stability mandate?
Van’t Klooster: Well, so we were always a bit skeptical about this argument, because as we then noted, it's the sort of self-imposed limitation, right? There's nothing in their statutes that tells them to buy only a certain percentage from assets from the different member states, right? So, this gets a bit more complex, but the idea is they don't want to buy more from one member state than the other. It's all determined by the so called capital key of the European Central Bank. And then because they don't want to buy a disproportionate amount of German and Dutch debt, at some point you are constrained by there being a very limited volume of those assets available in the market, and then the idea would be that you wouldn't be able to buy more government debt.
Van’t Klooster: So, my coauthor, Clement Fontan, who I wrote this with, also wrote a lot on the different ways in which the ECB looks at public and private issuers, and the ECB has always had a very hands-off approach towards government issuers. It's been very hesitant to be seen to provide too much support. What's interesting is that that has changed the past weeks in a very dramatic way. So, with the start of the Pandemic Emergency Purchase Programme, the ECB has said, "Well, these are all self-imposed limitations," and acknowledged that this is not in their mandate, and also given up on these issuer limits. So, what in 2015 they presented as really a fixed constraint that forced them to move into corporate bond purchases, now turns out also on their own account to be actually quite flexible and something that you can also move if you think you don't want to buy too much corporate bonds.
Van’t Klooster: What has, I think, been more important there is that they had an entire secondary motivation [for] why they wanted to buy corporate bonds, [which] is that they also wanted to support the development of a more market-based finance in Europe. So, looking at the US, this has been a perception on the side of your policymakers for longer, you have this nice market-based channel of credit provisions, and in the context of so-called capital markets, union project, European commission, and also to some extent the ECB, it really tried to develop markets like that in Europe, as well. And that's probably a key motivation for including these bonds into the QE program.
What has, I think, been more important there is that they had an entire secondary motivation [for] why they wanted to buy corporate bonds, [which] is that they also wanted to support the development of a more market-based finance in Europe.
Beckworth: So, the ECB's new Pandemic Emergency Purchase Programme, you have several articles here. We'll provide links to them. It's in a publication called Digressions & Impressions, but you say this is a big deal. I think you just outlined why, because it took off the shackles, right? It freed the ECB up from its own self-imposed constraints, where it had to buy only so many sovereigns and was forced to buy so many private, but now it's kind of like set itself free, and it can buy up a whole lot more in this crisis. And this is I guess somewhat tied into that controversial court ruling from Germany, right? The Constitutional Court, and these pieces are all moving together. But the big takeaway is the ECB has given itself more freedom in this crisis to buy public bonds and not have to buy as many private bonds. Is that right?
Van’t Klooster: Yes, exactly.
Van’t Klooster: Well, and also given itself particularly more freedom to buy a much larger volume of public debts than they originally suggested they would be allowed to do within their mandate. Also, the current program, there is still this CSPP component, right? So, there also is part of this new program, they're buying corporate bonds, and that again raises some questions about why it was previously included, if it turns out that actually if you don't have the constraints in buying government bonds, you're still buying corporate bonds, then that's maybe not been the only motivation. Times have changed, of course, now.
Beckworth: So, part of the motivation, at least some part of the motivation was to develop the corporate bond market in Europe, and this was one way to support that happening. So Jens, I'm also wondering some of maybe the legacy, the history of the euro coming together, and the Bundesbank. I've heard that it's preferred more private debt purchases, is that right? And that kind of had an influence on the ECB's approach to its portfolio.
Van’t Klooster: Yeah. Exactly. So, after working on this project with Clement, I spent a lot of time really going into the history of the ECB and how they developed their rules for risk management from the early 1990s onwards. Today, there's maybe a story about how the ECB ends up with the German conception of market neutrality that you already mentioned, which is also not directly in the paper, but which really shapes the way in which monetary policy is done at the ECB. So, what's really the key in this history, [is] to realize that the ECB, on the one hand, it's one central bank, and it's modeled after the Federal Reserve. It was called also the Euro Fed for a very brief period in the design.
Van’t Klooster: But then in reality, it's made of all these individual central banks, which have a very long history and have very different historical practice of implementing monetary policy. So, in the 1990s, suddenly the challenge was to develop one way of doing monetary policy that all these national central banks could implement, which was also politically acceptable to these individual central banks. And there, for example, the Germans but also the French were really invested in implementing monetary policy in part with corporate debt. They also still to this day have this very large internal rating facilities, whereas other central banks, really implemented monetary policy basically only buying a public debt, a bit like the Federal Reserve. And then the third group, for example the Netherlands and the UK, who were more market based, already accepted a lot of securitization, sometimes even imposed haircuts.
What's really the key in this history, [is] to realize that the ECB, on the one hand, it's one central bank, and it's modeled after the Federal Reserve... But then in reality, it's made of all these individual central banks, which have a very long history and have very different historical practice of implementing monetary policy.
Van’t Klooster: And these different traditions sort of come together in the design of the ECB. That's also a bit the background why on the one hand there is this strong private debt component in the way in which the ECB implements monetary policy. On the other hand, of course it would be completely unacceptable for a lot of member states to not have government debt supported by the central bank, and the eurozone crisis, which brings out how important that support is, and some of these older discussions can also resurface when countries like Greece and Ireland suddenly face much higher bond yields. The question comes up, how much should the ECB be supporting these public issuers? And this is a discussion that in the European context, you have much longer than in the US. So, now in the US this is coming up a bit. Should the Federal Reserve really be buying all these private issuers? But in Europe, this has been very long, very heated discussion, to what extent the ECB should be providing support, either to private issuers or public issuers, and how to balance that.
Beckworth: And coming back to your article, the point of all this discussion is that even the ECB and its great attempt to be neutral in implementing these private purchases still leaves a footprint and still makes decisions that affect some firms over others. So, you note that the ECB will only buy these bonds in proportion to market share. They want to be, again, very much like an investor out there, an average investor. However, not every firm issues the bonds, so you leave out the small and medium-sized businesses. It also influences share buybacks for certain corporations.
Beckworth: So, it's impossible again, going back to our discussion with the Swiss National Bank, it's impossible to truly do this in a neutral way that some party is not adversely affected and some party is positively affected by these decisions. So, your critique then is that central banks have more and more veered into this fiscal policy lane, even though they still claim it's monetary policy, even though they claim they're being neutral. They're aiming for price stability. And you're showing it's a whole lot more complicated than what they say, and they're not admitting or acknowledging that what they do has distributive consequences, and so they need to wrestle with it, right? One of your points of the paper is they need to wrestle with this reality. And the governments and the countries that they're in need to wrestle with the reality that central banks are more and more doing this.
But in Europe, this has been very long, very heated discussion, to what extent the ECB should be providing support, either to private issuers or public issuers, and how to balance that.
Beckworth: And I think it's a fair point, and I suspect we'll see more of it. I mean, I've had George Selgin on the show many times, and he's a big critic of the floor operating system, where central banks, they separate the size of the central bank balance sheet from the stance of the monetary policy. And what that does is you can adjust your interest rate independent of how many securities you purchase, so if you start to buy corporate bonds, well, why not buy some other enterprise out there? You open Pandora's Box for more and more.
Beckworth: And reading through the histories of what the ECB has done and the Swiss National Bank has done, you begin to see this is a real concern. This could happen. It seems easy. It seems innocent right now. But you've opened up this Pandora's Box where monetary policy is increasingly moving into fiscal policy's lane. And if that's the case, I think again your argument is there needs to be more oversight, a better way to evaluate, better checks and balances for this, and so tell us where you would like to see all of this go. What's your solution to this mess that you've kind of outlined in the paper?
Fixing the Central Bank’s Fiscal Policy Actions
Van’t Klooster: Yeah. Well, in the paper itself, we made basically this observation, right? So, there's just a lot of political choices here that are made to do what traditionally I think should be made in a more democratic way. On the one hand for procedural reasons, right? Just where we live in a democracy, you make choices, they need to be authorized in a clear way from a democratic side, and that's currently just completely lacking for a lot of these programs.
Van’t Klooster: Now, of course if you would think, "Well, it's not really democratic, but they're really good decisions." Then you might think there's a real dilemma, but we also think from all the effects that we show, they're not really ideally designed programs, and that is because they are designed to not look too political, to look a lot like monetary policy was designed before 2008, and not so much really thinking about what makes sense from an economic policy perspective. So, the example of the environmental impact is just one example of many consequences that the design of these programs had that are not really taken into account in how programs are currently designed.
Van’t Klooster: So, our observation in the paper is really, look, the way this is currently done, this is not something that central banks are really suited to do. This is something that you would preferably leave to a more political, better equipped organization. Now, of course, and I think that's in the background both in the US and in the EU context, those political organizations also have their challenges, right? And I think in both cases, a lot of that's about really difficult veto players who would make it difficult to implement programs like this very quickly and effectively. So, that, the sort of simple is like look, just send it to parliament. And you might also wonder is the fact that central banks are now doing this also serving as a sort of pressure valve, right?
The way this is currently done, this is not something that central banks are really suited to do. This is something that you would preferably leave to a more political, better equipped organization.
Van’t Klooster: Because we know we can just leave it to the central banks. We don't really need to solve the issues of our current democratic institutions. But ideally, of course, we would take a step back and think how are we going to fix these institutions, and not rely on central bankers to keep the system going, not collapsing, but also really doing this in a way that retains a lot of older structures that are currently not working very well. So not, for example, doing this environmental transition, but also more generally, as we've seen in the past 10 years, doing this in a way that has very strong and egalitarian consequences that really drive up wealth inequalities.
Van’t Klooster: The question there is just once you have the observation, look, central banks are not really fit to do this, how ambitious are you in terms of what your alternatives are? And I think we wisely sidestepped that issue in the paper to not… in one specific version of this, and I had a brief exchange with George Selgin about this and it was clear that he was probably in agreement until this point, and there we sort of diverged. But yeah, I have ideas about that, but in the paper, that's certainly not where we focus our efforts.
Beckworth: So, the tension is, as you just mentioned, is that Congress in the US, parliament over there, they're not doing their job, right? I mean, that's the issue, and so like you said, the central bank becomes a pressure valve. It's the outlet to which things do get done. Maybe it's the choice that we're left with, not the ideal choice, because we don't have Congress responding rapidly to the crisis in the way it should. Treasury, Congress over here should maybe be doing more that help out the small medium-size businesses, to help out Main Street, and it'd be much more transparent, it'd be something that maybe people could debate, as opposed to the Federal Reserve going in, being somewhat unaccountable. I mean, the Fed is accountable, it goes before Congress, but it can do things quickly and be a technocrat and make a decision without having to get approval until they go back before Congress.
Beckworth: So, what is your solution? What would you do? Because to me, I look at this and it's not a very hopeful scenario. But the world's not ending. It's not like we've reached some awful place. It's still a fairly... I think we're still in a relatively good place, but I think the issue is we want to avoid getting to a bad place, right? We make the decisions today, we see things are far from perfect, and we want to move us into the right direction. So, why don't you give me your solution and I have a solution too, and I think probably both of our solutions will be controversial, so I'll let you go first.
Van’t Klooster: Okay. Okay. Well, then I'll give the European side of the story, right?
Van’t Klooster: So, from here the issue is really the member states of the Euro just really disagree on where they want to take the Euro, right? So, there is one group who really thinks like, "Look, this is just a currency and we can sort of keep it like this, but only once you have really converged economically that would work." And then that position sort of merged now into the idea, "Look, every member state looks after its own individual budget, borrows by itself in markets, and there's absolutely no responsibility for that on the EU level." Then there's another side that says, "Well, look. You have this common currency. There should be more responsibility, more for individual member states to look after their ability to fund themselves." And then also there's a vision there of moving more towards a more federal EU institution.
The issue is really the member states of the Euro just really disagree on where they want to take the Euro.
Van’t Klooster: Now, my own version is somewhere in between, so I think it's really important to retain these individual member states. I think they have really strong democratic cultures on the national level, and I live in Brussels, but that's not the site of democratic decision making for Europe, right? It's just something that is very far removed from people. There's also a huge language gap, so most Europeans don't have sufficient amount of English to take part in political debates in that context. There's a really difficult challenge that I think nobody has really been able to resolve entirely of on the one hand doing things together on the EU level, and also having this common currency which I think is probably basically a good idea, but on the other hand also retaining autonomy for the member states.
Van’t Klooster: Now, if you can borrow on your own account, and of course there should also be constraints on that. It can't be that other member states then have to pay for the debt. And I think finding a solution for that bigger problem is really a precondition for finding a different way of doing monetary policy in Europe. Somewhat promising at the moment, what you see now is that, this is again getting very much into all this EU complex institutions, that there is a new recovery fund that's going to be financed by the European Commission borrowing in capital markets. So, what that means is that you will have a form of debt on the EU level that will be a bit like a safe asset also for the EU, that sort of mirrors the role of treasuries in the US, and I think developing that more and maybe also turning that more into a centerpiece of ECB monetary policy implementation would resolve a lot of these earlier debates.
Beckworth: Okay. Well, my-
Van’t Klooster: What's your version?
Beckworth: Well, my solution really isn't a complete solution, I'll tell you up front. It's a partial solution. I think the Fed, two things. I think one, the Fed still needs to intervene and help out liquidity when there's a liquidity rush, so I think many of the facilities, such as primary dealer facility, the money market facility, commercial paper, all of these are geared towards preserving liquidity, and I know the Fed would argue that its corporate bonds facilities are the same thing, but I would draw the line between I guess what I consider a liquidity facility and a credit facility. And I would encourage us to move away from credit facilities and rely more heavily on liquidity facilities.
I think it's really important to retain these individual member states. I think they have really strong democratic cultures on the national level.
Beckworth: And really, the liquidity facilities are used to respond to runs in the shadow banking system, and that's something if you can resolve that another way, it's great. Lev Menand was on the show and he has a proposal, as do others, of having a Basel IV, some kind of Basel agreement, where you can somehow globally reign in shadow banking systems. I'm not as optimistic as he is that that can work, but if that could work, then that would make life a lot easier for the Fed, period. But in the absence of that, I would say continue doing what you're doing with liquidity facilities, and instead of going down the credit facilities path, I would just say do monetary policy more aggressively.
Beckworth: And specifically, instead of getting all these private assets on your balance sheet, I would do something that's still going to be controversial, but I think less controversial, and that is authorize a facility for the Fed so that it can do helicopter drops. To me, helicopter drops would be far less political. There's going to be some politics involved. I mean, who gets a check? Some logistical issues. We've seen that so far. But helicopter drops to me is definitely far more neutral than buying up corporate securities, no matter how hard you try.
Beckworth: And I think if you did those aggressively enough, and in my mind, aggressive means tying them to have some kind of level target, and then doing your liquidity facilities. I think that should be enough. Now, I may be wrong, but I think you could do that without going down the path of buying corporate securities. That would be my first take at a solution.
Van’t Klooster: Yeah. No, I strongly agree certainly with the first part of what you proposed, that central banks should focus maybe a bit more on financial stability and much less on this macroeconomic policy, and leave that maybe more just to fiscal policy. Right? If I understand you correctly. And that might just already be in practice what they're doing, right? In all these programs, there's a good case to be made that in part what's motivating it is just stabilizing the financial system. I think that's become also more overt the past weeks.
Van’t Klooster: And then helicopter drops, of course, yes. I'm for them, right? I see the advantages. I also think you're right it's in a way more neutral. If you could think of a really technical way of defining when that's used, you could also say, "Well, they could develop a democratic mandate for it." But I also think in a way it would again sort of weaken a democratic system, right? So, part what makes people pay attention is that there's something at stake. It's about real money. You can influence where that money goes to. So, I wonder whether from a more democratic perspective, it's probably ideal to let the helicopter drops just to... Left to profligate governments and the central bankers just to…
Beckworth: Well, I guess the ideal solution is to let governments do their job, or have governments do their job, right?
Van’t Klooster: Yeah.
Beckworth: Maybe my solution is one in the second-best world where we don't have parliaments and Congress doing their work. We're stuck with the Fed being the only player in town, the only game in town, and so I don't see this changing. Maybe I'm wrong, but I don't see Congress here, at least in the United States, setting something up like a facility, an emergency facility that's authorized by Treasury to use in a crisis. That doesn't seem to be something that's in the works, and if that's the case, the Fed will be relied upon again in the future, and so that's the world I'm thinking of. But I would agree. In an ideal world, fiscal policy would be 100% left to Congress and the US Treasury Department, and the Fed would do monetary policy. I just wonder how realistic that is going forward.
Van’t Klooster: Yeah. No, I agree. Well, so I think something needs to happen, right? So, some revision needs to take place of central bank mandates in the coming years. At some point, you'll just reach a point where you can't call this price stability with one interest rate anymore, and people will suddenly pay attention, and it becomes a topic. And then I think something along those lines is much more likely to come out and a complete rethinking of democratic systems and the way you ideally want them to function.
Some revision needs to take place of central bank mandates in the coming years. At some point, you'll just reach a point where you can't call this price stability with one interest rate anymore, and people will suddenly pay attention, and it becomes a topic.
Beckworth: So, you're saying we got to wait till the time where many people become interested in this issue before it really gets addressed. It's got to become something super popular among the masses before it gets meaningfully fixed.
Van’t Klooster: Well, I don't know, but I think these things suddenly go very fast, right?
Beckworth: That's fair. Yeah.
Van’t Klooster: Years nobody's paying attention, and suddenly everybody's like, "Oh my God. There is a Federal Reserve? Wait, they're not controlled by Congress? They can just decide all these things?" And then I think we might see movement to revise some of these aspects of the mandates.
Beckworth: Well, with that our time is up. Our guest today has been Jens Van't Klooster. Jens, thanks so much for coming on the show.
Van’t Klooster: Thank you. Thank you. This was a really interesting discussion.
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