CENTRAL BANKS ARE GOING BUST / MACLEOD FINANCE

Central banks are going bust

Investors believe that central banks will always manage the financial system and act as lenders of last resort. This article explains why they will almost certainly fail.

ALASDAIR MACLEOD

It is some time since I wrote about the consequences of quantitative easing, and how it led to massive losses for central banks, enough to wipe out their own capital many times over. 

The Bank of Japan is in the worst position, having started QE in 2000 and now owning 60% of its government debt. 

The rise in bond yields has created massive losses. 

But so far, no one seems to care. 

The chart below shows how this problem is mounting for the Bank of Japan:

That people no longer care about central bank finances will almost certainly change. 

Signs of a private sector recession can no longer be ignored or covered up by excess government spending. 

Bank credit is being withheld from commercial enterprises, and tariff wars are just beginning. 

Government finances are deteriorating, inevitably leading to higher bond yields and pressure for further QE. 

Perhaps current complacency over central bank finances will shortly become an urgent topic for public debate.

Setting the scene

The current credit bubble is a doppelganger for 1929—1932: the Wall Street Crash followed by the depression. 

Before the crash, the Roaring Twenties had been fuelled by the Fed’s expansion of credit under Chairman Benjamin Strong. 

What followed in late-1929 was the bursting of that credit bubble. 

Also in 1929, the House of Representatives passed the Smoot-Hawley Tariff Act, which was finally signed into law by President Hoover in 1930.

Wall Street crashed, and 9,000 banks went bust.

Does this ring any alarm bells today? 

Evidenced by record levels of debt, we now have the biggest credit bubble in history. 

President Trump is implementing Smoot-Hawley Mark 2, which will inevitably lead to other nations retaliating with their tariffs —just as they did in 1930.

Besides the enormity of today’s bubble, there are some additional factors making things worse. 

A more important factor than in 1929, international trade now depends on complex supply chains and logistics: the economic consequences of their sudden cessation are unimaginable. 

Furthermore, adjusted for record levels of government budget deficits, private sector GDPs are already contracting, and some have already stalled (i.e. Germany) in recent years. 

That matters, because it’s the private sector which provides the government with its revenue.

Clearly, this massive credit bubble is fit to burst, because private sector credit being the other side of debt will not increase in the face of a private sector deterioration. 

Bankers and investors do not advance further credit in these conditions.

Some would argue that this is a problem exaggerated because increased government spending will stimulate growth. 

But governments are already tapped out and face debt traps of their own. 

Either borrowing costs must rise, or currencies will collapse — or most probably both.

There is a general assumption that in this event central banks will always come to the rescue, but they are hardly positioned to do so. 

The Fed, the Bank of Japan, and the ECB and its shareholding national central banks are deeply in negative equity as a result of QE. 

The Bank of England has a UK Treasury guarantee underwriting its losses, so it is in a slightly different position.

Two years ago, the Bank for International Settlement published a paper on this topic.[i] 

It tried to establish the point at which a central bank’s negative equity would lead to its failure. 

And if a central bank fails, its currency fails with it.

As its model, the BIS used the relationship between the Bank of Amsterdam, a private sector but proto-central bank, and the Dutch East India Company (DEIC) which was founded in 1602. 

Acting on its own behalf and those of merchant counterparties, the DEIC “sent nearly 5,000 ships between Europe and Asia in 17th and 18th centuries”.

The DEIC, its shareholders, and associated merchants increasingly dominated the Bank’s activities. 

War with Britain, particularly the fourth in 1780—84 led to losses for the DEIC leading to increasing demand for non-productive credit from the Bank by the DEIC and all the other parties involved. 

The Bank was already operating with negative equity which escalated sharply as bad debts mounted and the Bank decided to “start granting even larger overdrafts to the DEIC”. 

But with ships and their cargoes being sunk by the British navy the slump in the DEIC’s trade continued.

The BIS paper used the Bank of Amsterdam as an example of a proto-central bank, operating with increasing negative equity and which eventually failed. 

It tried to establish what the tipping point was. 

My approach with today’s central bank finances is similar, focusing on the relationship between central banks and their dominating interests which are the governments they represent as currency and debt issuers. 

In this sense, the Bank of Amsterdam’s dependency on one customer, the customer’s shareholders and dependent merchants is instructive.

Today, central banks are similarly dependent on a government customer, usually its sole shareholder, for their existence. 

In most cases, they remit all income generated to that one customer, retaining little or nothing for operational purposes. 

There has been no accumulation of shareholders’ funds to augment their own capital. 

They are, for all intents and purposes a government department, so-called independent but not in reality.

To most observers, the idea that a central bank can go bust is nonsensical. 

It can “print” its way out of insolvency. 

And ultimately, they have the fiscal backing of their government. 

But what happens if the government has difficulty backing its central bank? 

What if the government like the DEIC itself gets into difficulties?

That difficulty arises if the government’s own finances are in a debt trap. 

The classic definition of a government debt trap is when its debt liabilities increase at a faster pace than its national GDP, because it is the increase in GDP that yields its revenues.

We should amend that to take government budget deficits out of the GDP calculation, being wholly unproductive. 

Furthermore, if private sector GDP contracts, revenues contract and welfare expenses increase rapidly. 

That is a good description for the cliff-edge of the current US Government’s position and therefore ultimately for its backing for the Fed.

US debt to GDP is currently estimated at 125%. 

Despite the efforts of Elon Musk’s DOGE, annual deficits will increase sharply due to the private sector’s recession, likely to intensify further on the back of Smoot-Hawley Mark 2. 

The collapse of the largest credit bubble in history combined with President Trump’s determination to replace income and corporation taxes with tariff income is set to make 1929—1932 look like mild turbulence in comparison.

Other central banks are reading the runes

The combination of ultra-high debt, inflated assets, and government debt traps are a feature of the advanced but declining welfare-driven economies of America, Europe, and Japan. 

Elsewhere, the debt-credit problem is less acute, with some exceptions. 

Central banks and their governments, notably in Asia have been selling down their currency reserves in the major currencies in favour of gold.

We are too ready to dismiss central bankers for their policy failures. 

But privately, their understanding of the flaws in US, EU, UK, and Japan’s government finances should not be underestimated. 

Deep thinkers in Russia sussed this weakness out some time ago. 

And when SWIFT was closed down to Russia Putin was quick to make sure everyone else understood it as well. 

It is now an open secret at these high levels that western financial markets, their government finances, and their currencies are failing. 

Furthermore, they know that the answer is to get out of these currencies and into gold sooner rather than later.

The cat is out of the bag. 

An understanding that it is not so much gold rising, but the major fiat currencies failing is now spreading from foreign central banks and their government wealth fund managers to their wider financial interests. 

It is even beginning to trickle down to our own institutions and investors, evidenced by this chart of ETF net demand provided by the World Gold Council.

This is the gathering momentum behind any price rise. 

In gold’s case it also represents a deteriorating outlook for credit and the prospective failure of the entire dollar-based fiat currency system, as the major central banks meet the same fate as the Bank of Amsterdam.

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[i] BIS Working Paper No 1065: The Bank of Amsterdam and the limits of fiat money January 2023