13/06/2010: The sterile debate on sterilization

One important characteristic of the current financial crisis is that central banks have not been shy about taking stressed and underwater assets out of the system and giving fresh money to sellers of those assets in return. This has allowed financial intermediaries to clean up their balance sheets and regain a solid footing. The flipside is that those assets are now on the books of the central banks.

What the Federal Reserve did with mortgage-and asset-backed securities between 2008 and early 2009, the European Central Bank (ECB) is now doing with the sovereign debt of some countries at risk of defaulting such as Greece. But does doing so represent a risk for a central bank? That depends on what we understand “risk” to be for a policymaker.

In the sense that a central bank will always have the printing press as a financing alternative and is therefore unlikely to go broke, then it faces no credit risk. But once the central bank abuses its printing power and devalues its main asset – fiduciary money or its effective legal tender – then it creates inflation risk.

To counter the latter, central banks have the option of “sterilization”. In the past, this would have meant that a central bank buying foreign currencies to alter exchange rates, for example, could sell some of its assets to mop up the excess liquidity that comes with new-money creation. Today, arrangements such as financial intermediaries maintaining accounts with the central bank and central-bank bonds are further sterilization instruments.

In the case of the ECB, which is churning out fresh euros as it buys Greek government bonds, it can offer the bond sellers interest-bearing accounts in which to place their euros (such accounts are already in place at the Fed) or sell them its own interest-bearing bonds.

At first glance, this seems a nifty idea. The interest rate on the accounts or the bonds can stand as an added monetary policy instrument for the central bank. If it wishes to become more restrictive, it only has to lift the interest rate on those accounts or bonds. This will give financial intermediaries an incentive to pull some money out of circulation and place it at the central bank.

But there is one caveat to this thinking in the current situation. In the long run, sterilization is effective only if the central bank can resell the assets it buys from financial intermediaries for at least the same amount it paid to buy them. Looking at both the Fed’s toxic mortgages and real-estate-related debt and the ECB’s stressed sovereign debt, a good payback is far from certain.

Fast-forward to 2012. Imagine that after exhausting all help from its European neighbors, Greece decides to restructure its debt by asking bondholders including the ECB to take a 30–50% cut on the value of its outstanding debt. This means that the fresh money corresponding to the haircut the ECB will have to take will now be “forever” in the system. This would make the central bank’s job of containing inflation much harder in the future.

Crucial as sterilization might be, it leaves central banks with risks to manage.