The hidden costs of modern monetary policy

(Our new book with John Cochrane, “Crisis Cycle” is out! This post explores themes from it.)

Central banks have transformed significantly since the 2008 global financial crisis. The European Central Bank, Federal Reserve, and Bank of England no longer just set interest rates. They deploy trillions of euros, dollars, and pounds to buy sovereign and corporate bonds. The ECB also made large subsidised loans to banks.

These actions were seen by some as necessary to address financial crises (plausibly, during the 2008-2012 crises) and to push inflation up towards its 2% target (less plausibly, during the second half of the 2010s). Yet many measures continued even when inflation was above the target. Central bankers presented them as technical adjustments to keep the economy running smoothly. But they have also become major engines of redistribution, creating a web of winners and losers while distorting the incentives of banks, investors, and governments.

These policies result in major transfers of wealth and risk across various groups in society. As we detail in our new book, "Crisis Cycle", with our co-author John Cochrane:

Monetary and fiscal policy are also wisely separate for important reasons of political economy. Transfers of wealth from one person to another are highly politically sensitive, and usually the province of elected officials (...) large-scale asset purchases aimed either at making borrowing easier or at raising bond prices, loans to banks at favorable conditions, and sovereign bailouts more directly and visibly transfer wealth among winners, losers, and taxpayers.

This post explores three channels through which modern central banking has reshaped our economy, shifting wealth and risk in ways that are rarely debated by the public.

The great risk transfer

Quantitative Easing (QE) does more than just potentially lower long-term interest rates. It also directly transfers wealth among economic agents.

When a central bank announces it will buy massive quantities of government bonds, investors immediately bid up the price of those bonds. This directly benefits those who already own them—typically wealthy individuals and financial institutions who hold large bond portfolios.¹

As Isabel Schnabel (2024), ECB board member, put it

Therefore, central banks purchasing longer-dated assets disproportionately benefits wealthier households, whose assets tend to have longer durations than their liabilities.

Here is a back-of-the-envelope calculation of the wealth transfer towards bondholders (as a result of QE pushing up bond prices in part via lowering risk premia). Some studies find that the ECB's Asset Purchase Programme pushed average ten-year government yields down by roughly one percentage point. With an average bond duration of about seven years, this lifted the value of the entire €12 trillion euro-area government debt stock (2022) by about 7%, or €0.8 trillion.

At the same time, QE transfers a large risk to taxpayers, because it shortens the maturity of overall public debt. Think of the state and its central bank as one balance‑sheet: the public sector’s balance-sheet. The payments between different parts of the public sector cancel each other out.

Assume the government has just issued €100 billion of 10‑year bonds. Suppose the central bank then buys all €100 billion from investors and, to pay for them, credits banks with €100 billion of reserves. These are a form of deposits held by the commercial banks with the central bank–think of it like your own deposit account. They earn the “deposit rate”, which floats, as it is a policy rate set by the central bank.

Now the public sector as a whole owes the new overnight reserves. The long bonds have left the market, so the average maturity of the €100 billion public debt has collapsed from 10 years to a single day. The public sector has swapped long, fixed‑rate debt for overnight, floating‑rate debt.

Why this matters becomes clear when rates jump. Suppose the policy rate rises from 1 % to 3 % for the next 5 years. Before the QE swap, the government would still owe 1 % on the 10‑year bonds to the private investors: €1 billion a year. Nothing would have changed. After the purchase, the 10‑year bonds have been swapped for reserves, so the extra 2 percentage points hit the full €100 billion debt straight away. Annual interest on that slice of debt rises from €1 billion to €3  billion per year. This €2bn per year, over 5 years, means taxpayers must pay an additional €10bn to bondholders. The central bank must cover that payment by cutting its annual dividend payment to the Treasury.

With QE central banks take “duration risk” out of private markets and place it on the public balance-sheet. When inflation surged in 2021-2022 and rates rose dramatically, bondholders had already locked in gains by selling to central banks. The losses fell on taxpayers.

The scale is massive. The Eurosystem ended up holding more than €5 trillion in bonds. We estimate that when rates jumped in 2022-2023, the market value of the ECB's €5 trillion bond portfolio fell by about 13%, implying unrealized losses around €650 billion. The duration risk materialised and thus QE shifted significant wealth from taxpayers to bondholders.²

An exclusive club

When central banks create new money to purchase government and corporate bonds, that money ends up in commercial bank reserve accounts held at the central bank. The European Central Bank (ECB), for example, created nearly €5 trillion such deposits for banks by autumn 2022, compared to just €0.3 trillion in late 2014.

These reserves represent the safest and most liquid asset in the entire euro area. Banks can access this money instantly with zero default risk. The ECB pays interest on these reserves at its policy rate. Most importantly, this asset is available exclusively to banks. Ordinary citizens and companies are shut out. The ECB (and other central banks) effectively says: if you are called Joe Smith Bank, you may deposit your money here and earn X%. If you are, however, called Joe Smith, deposit your money elsewhere.

This disparity creates a significant inequality in the financial system. While the ECB’s deposit rate was slightly negative from June 2014 until July 2022, banks can now earn a positive risk-free return by holding reserves, often funding them with deposits from savers who receive a much lower interest rate. The difference becomes pure, risk-free income for the bank, courtesy of a system that reserves the safest assets for a select few, and impedes competition among banks to offer depositors higher rates. (The US Federal Reserve, in particular, has ruled out “Narrow Banks” which pass along the higher rates minus a very small fee, and by doing no other investing cannot fail.)

Banks can also lend to governments by buying sovereign bonds. This activity is strongly encouraged by regulations that give zero risk rating to government bonds, so banks do not have to use up any capital in order to hold those bonds. Banks can borrow from the ECB at a low rate, invest in high-yield government bonds, earn the spread between those rates.

The combination of reserves that pay interest above comparable (risk-adjusted) market rates, available only to banks, government debt held by banks treated (falsely) as risk-free by regulators, and the ability of banks to borrow at low rates while posting low-quality collateral, creates distortions to the functioning of markets and incentives for banks to avoid one of their core economic functions: channeling savings toward productive investment.

The scale is substantial. Between September 2023 and June 2024, the ECB's deposit rate stood at 4.0%. During the same period, the average interest rate paid by banks to households on overnight deposits was much lower; it hovered below 0.5%. If households had been able to hold even a portion—say, €2.5 trillion—of the reserves held at the time by banks, they would have earned around €65 billion in additional interest income in just 9 months. Instead, that income was captured by the banking sector. Even today there are still about €2.5 trillion in the deposit facility on which the ECB now pays 2% interest.

There are advanced preparations for creating a new central bank digital currency where every citizen can hold digital euros in a likely unremunerated account (or electronic wallet). Maybe this digital wallet is also a chance to end the exclusion of European citizens from the safest remunerated euro asset.

The stealth bank bailout

Beyond asset purchases, the ECB created another channel of support through programs called Targeted Long-Term Refinancing Operations (TLTROs). These programs offered banks access to multi-year funding at exceptionally low rates.

At times, the rates were so low (in part due to bonus payments) that banks could borrow money from the ECB at X% and then deposit it back at the ECB for X plus 0.5%—earning a risk-free profit on the spread. When challenged on subsidies during a 2019 press conference, former ECB President Mario Draghi was candid:

The issue is not whether there is a subsidy or not; there is a subsidy. The issue is whether the TLTRO fulfils monetary policy objectives and helps the transmission of monetary policy.

These subsidies reduce the profits of the Eurosystem’s 20 national central banks, meaning less money is returned to national governments. European taxpayers indirectly subsidize commercial banks.

This support extends to collateral rules. The ECB accepts a much wider range of collateral than private markets would, including lower-quality and non-marketable claims. Banks struggling to find private funding can still access central bank money by posting assets that private lenders might reject.

This arrangement suppresses market discipline. Weaker banks can secure funding without facing the higher costs that private markets would demand. This not only distorts the price of risk throughout the financial system but also undermines its long-term resilience, as we argue in the book:

Incentives for prudent liquidity management by banks are impaired. The result is that reliance on the ECB for liquidity, rather than developing robust internal management practices, could increase systemic risks.

Breaking the cycle

When Isabel Schnabel (2024) discussed “the benefits and costs of asset purchases”, she made an important point:

… asset purchases can be a powerful tool when financial markets are in turmoil. Outside these periods, however, central banks need to carefully assess whether the benefits of asset purchases outweigh the costs.

Central bank policies are no longer just steering inflation by changing the interest rate at which they will lend money. After large-scale balance-sheet expansions, they allocate risk and wealth across society.

The result is what economists Emmanuel Farhi and Jean Tirole (2012) called “collective moral hazard”—expectations of bailouts or subsidies lead all institutions to take on more risk. Investors expect support in a crisis, so they leverage up and take more risks. Governments expect central bank bond purchases to keep their borrowing costs low, so they delay fiscal reforms. Banks expect central bank intervention to prevent major losses on bonds, so they increase their sovereign exposure and keep capital buffers low. This allows governments to avoid difficult but necessary reforms like completing the Banking Union and breaking the bank-sovereign "doom loop". Why undertake politically painful structural changes when the central bank stands ready with another program, another acronym, another backstop?

Each crisis generates new interventions without credible exit strategies, making the next crisis more likely. Emergency measures become permanent, distorting incentives and concentrating risks. Outside major crises, central banks must return to small balance sheets, ensuring parliaments and governments, not independent central banks, make all important decisions about redistributing risks and wealth through public balance sheets.

References

Cochrane, John H., Luis Garicano, and Klaus Masuch “Crisis Cycle: Challenges, Evolution, and Future of the Euro” Princeton University Press, June 2025.

Farhi, Emmanuel, and Jean Tirole. "Collective moral hazard, maturity mismatch, and systemic bailouts." American Economic Review 102, no. 1 (2012): 60-93.

Schnabel, Isabel “The benefits and costs of asset purchases”, Speech at the 2024 BOJ-IMES Conference on “Price Dynamics and Monetary Policy Challenges: Lessons Learned and Going Forward”, Tokyo, 28 May 2024.

Our book in Blackwells bookstore in Oxford on June 18, 2025, picture by Becca Binnie.

1. We do not discuss here the indirect effects of QE on output and inflation, which are more uncertain and controversial.

2. We are not the only economists to have deep reservations about the gigantic experiment that was quantitative easing. Sir John Vickers, a former Bank of England chief economist and member of inaugural monetary policy committee, argues in a talk on February 2025 that while early QE by the Bank of England after the 2008 crisis was a "perfectly sensible policy response," later, larger rounds were a "fiscal gamble." He contends that large-scale QE "shortens the maturity of government debt in private hands," which "geared up" the "risk to the fiscal position." As interest rates rose, this gamble soured, leading to what he projects will be a "staggering fiscal cost" from the QE undertaken between 2016 and 2020. He is also sharply critical of the inclusion of corporate bonds in the purchases.