What happens to the Afghanistan central bank's assets?

The Afghanistan story is a tragic one and I don't have much to add to it apart from my ability to read central bank financial statements and balance sheets. Here's a quick analysis of the balance sheet of Afghanistan's central bank, da Afghanistan Bank. And following that, I'll provide some thoughts on what this means for Afghanistan. As always, feel free to add your opinions and data in the comments section.

Da Afghanistan Bank issues the Afghan afghani, the currency symbol of which is the Af. 

At year-end 2020 the central bank had 781 billion Afs worth of assets, which comes out to around US$9.5 billion at the current exchange rate of US$1-to-86 Afs. That's a lot of resources. No doubt the incoming Taliban regime is keen to access this $9.5 billion. But it will be tough for the Taliban to do so.

Here is what the assets section of the central bank's audited balance sheet looks like, in Afs:

Source: DAB

(Note: For the rest of this article, I will assume that da Afghanistan Bank's 2020 year-end numbers are similar to those prevailing as it is taken over by the Taliban.)

In what follows I'm going to analyze the four biggest components of da Afghanistan Bank's balance sheet: gold reserves, foreign currency cash reserves, due from banks, and investments.

1. To repeat, da Afghanistan Bank lays claim to 781 billion Afs worth of assets. Of this amount it reports holding 703,000 troy ounces of gold, worth 101.77 billion Afs, or 13% of da Afghanistan Bank's assets. At the current gold price, this comes out to a whopping USD$1.25 billion.

But a quick peek at the notes to the financial statements reveals that da Afghanistan Bank's gold is held on the other side of the world, at the Federal Reserve Bank of New York. With the Taliban taking over the central bank, my guess is that this gold will be frozen by the U.S. government. That is, the incoming Taliban regime won't be able to access a single ounce of the yellow metal.

Afghanistan's central bank, da Afghanistan Bank, holds 703,005 ounces of gold, all deposited at the Federal Reserve Bank of New York. That's worth US$1.25 billion. It's a safe guess that with the Taliban taking over this gold will be frozen.

Source: https://t.co/wtF6QOlRtq pic.twitter.com/xxqImhtCeJ

— John Paul Koning (@jp_koning) August 17, 2021

2. The next big line item on da Afghanistan Bank's balance sheet is foreign currency cash reserves. A glance at the notes to the central bank's financial statements reveals that this refers to actual physical banknotes. This stock of currency seem to be held at the Presidential palace and the central bank's head office as well as its branch offices. Most of it U.S. dollars:

Source: DAB

The central bank presumably holds a big stock of U.S. banknotes because it also offers U.S. dollar accounts to locals, and account holders surely want to withdraw money in physical form to make payments. Afghanistan is mostly a cash economy.

At year-end 2020, da Afghanistan Bank held 34 billion Afs of foreign physical cash, or US$400 million. That's not as big as the gold line item, but it still accounts for another 4% of da Afghanistan Bank assets.

My guess is that this US$400 million in cash was quickly whisked away by the outgoing regime on one of the many planes departing Afghanistan, probably for eventual deposit at the Federal Reserve Bank of New York. So that's another big chunk of central bank assets wrested away from Taliban control.

3. Having dealt with gold and physical cash, the next line item is Due from banks and financial institutions. This amounts to 254.7 billion Afs (US$3.2 billion), or 33% of da Afghanistan Bank's assets. Looking through the notes to financial statements, much of this is comprised of various types of deposit accounts held at foreign banks:

Source: DAB

It is likely that these bank deposits are protected from the incoming Taliban regime, depending on the jurisdiction of the bank. If deposits are held in U.S. banks, I suspect they will have already been frozen. But if they are socked away in a place like Switzerland, perhaps the Taliban will be able to use them? I don't know enough about international politics to be sure. If the U.S. quickly institutes some sort of sanctions regime against da Afghanistan Bank, then even neutral foreign jurisdictions will have to lock down the assets of a Taliban-led central bank.

4. The fourth and last line item is investments, best described as a portfolio of U.S. government securities. These investments comprise the biggest chunk of da Afghanistan Bank's assets, summing up to 369 billion Afs (US$4.2 billion), or 47% of the total.

One more glance at the notes to the financial statements tells us that da Afghanistan Bank's investment portfolio is mostly managed by the Federal Reserve Bank of New York and the World Bank's International Bank for Reconstruction and Development (IBRD). A small chunk is run by the Bank for International Settlements. 

Source: DAB

If the chunk held at the Federal Reserve isn't already frozen, I suspect that it will quickly be rendered unusable. I don't know enough about the politics of the World Bank or the BIS to pass comment, but I'd bet that these institutions will also prevent the Taliban from getting access to the funds.

So let's do the math. Gold + foreign cash + due from banks + investments sums up to 760 billion Afs, or 97% of da Afghanistan Bank's assets. That's US$8.8 billion worth of funds. So effectively all of the central bank's assets is either already frozen or capable of being frozen.  

One thing I worry about is that a Taliban-led Afghanistan will quickly experience hyperinflation.

Here's the logic. Da Afghanistan Bank has issued around 293 billion Afs worth of Afghani-denominated coins and banknotes into circulation, for use by regular Afghans for payments. (That's around US$3.5 billion worth of cash). Banks and other customers hold another 106 billion Afs worth of electronic Afghani accounts at the central bank.

Up till now the Afghani notes and electronic deposits that the central bank has issued have been stabilized by its underlying investments, including the gold and dollars held at the New York Fed. Treasury securities yield income. So do bank deposits. Along with gold, these assets can also be used to repurchase issued Afghani currency, thus supporting the Afghani's value. 

But U.S. officials are justifiably worried about what other things the Taliban might do with those assets. What if the Taliban wants to sell $50 million of the central bank's stock of Treasury bills or gold ounces to buy more weapons? A blanket ban on accessing all of da Afghanistan Bank's funds will prevent the Taliban from using those assets to finance itself.

But with these assets being frozen, they can no longer be effectively put to work as stabilizers. And so the Afghani can only fall. In theory I suppose that the Taliban could find replacement backing, but in practice I doubt it has the resources to do so.

As far as developing nation currencies go, the Afghani has been fairly stable against the dollar for the last decade. Inflation has remained low. Freezing da Afghanistan Bank's assets hurts the Taliban, but it also means ensuring that a painful hyperinflation falls on regular Afghani people. This will be an abrupt departure from what Afghans have become used to, and a lot to bear on top of what they are already enduring.

Banknotes in bottles in coal mines

[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]


“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

-J.M. Keynes, The General Theory.


Keynes’ ruminations about bank notes and coal mines are a good place to draw a dividing line between classical economists and Keynesians.  In contrast to Keynesian optimism about the coal mine scheme, classical economists tell us that the newly dug-up bank notes will only succeed in causing inflation, while wasting the labor of those who dig up the notes.

Surprisingly, there is some middle ground about burying bank notes. Economists of both stripes generally agree that money shortages cause recessions. If there is not enough money for people to conduct business conveniently, then people are forced to revert to barter or other less efficient means of trade. Trade slows, and productivity suffers.  Some economists will call it a “money shortage”. Others will say “liquidity crisis”, “credit crunch”, “tight money”, “failure of aggregate demand”, and so on. Whatever the terminology, economists have been saying for centuries that money shortages cause recessions.

In the year 1722-3, the Governor and Assembly…thought themselves obliged to take into their serious consideration the distressed circumstances and sufferings of the people, through the extreme want of some kind of currency…These bills being emitted, their effect very sensibly appeared, in giving new life to business, and raising the country in some measure, from its languishing state. (Pennsylvania Assembly to the Board of Trade, 1726. Cited in Brock, 1941, p. 76)

Now we begin to see the middle ground. Both Keynesians and Classicals agree that the coal mine scheme could potentially provide badly needed liquidity and thus end a recession. Once this is agreed, the rest is just dickering over the size of various forces. A Keynesian might think that the misallocation of labor spent digging up bank notes might drag down national production by 5%, but that the notes dug up might lubricate trade enough to boost production by 20%.  A Classical might put the figures at 10% drag and 15% boost.

The backing theory of money gives us a way to clear up some confusion between these two views, and provides a liquidity-based theory of recessions that both Keynesians and Classicals can live with.

The backing theory is summed up in figure 1:

In line (1), the bank (which may be a central bank or a private bank) receives 100 ounces of silver on deposit, and issues $100 of bank notes in exchange. Each dollar note is worth 1 ounce of silver.

In line (2) the bank issues another $200 in exchange for 200 ounces worth (or dollars’ worth) of bonds. The backing theory view is that even though the bank tripled the money supply, the bank also tripled the assets backing that money, so it remains true that $1=1 ounce.

Now suppose that the $300 in circulation is 10% less than the “ideal” quantity of money, and that the economy is therefore in recession. A well-functioning bank would respond to the money shortage by issuing another $30 of bank notes, while getting 30 ounces (or $30) of bonds or other assets in exchange. This open-market purchase of bonds would relieve the money shortage, end the recession, and leave the value of the dollar at $1=1 ounce. The open-market purchase method gives excellent results. Keynesians would not be surprised at this, but Classicals might be surprised that the money injection caused no inflation.

Next, let’s try the bottles-in-coal-mines method. The bank prints $30 of bank notes, places them in bottles, and buries them in coal mines. Workers will waste (at most) $30 worth of labor digging up the notes. The bank gets no new assets as it issues the $30 of bank notes, so the value of the dollar falls by about 10% relative to silver. While there are 10% more dollars in circulation, each dollar is worth 10% less silver. The real value of the aggregate circulating cash is thus unchanged. There is no relief of the money shortage, and so the recession continues. The bottles-in-coal-mines method gives terrible results, just as Classicals would expect. Keynesians might be surprised to see that even in a recession, the money injection still causes inflation and fails to stimulate production.

We can improve on the bottles-in-coal-mines method by following Keynes’ suggestion and issuing bank notes in exchange for houses and such. The bank prints $30 of bank notes and spends them acquiring 30 ounces (or $30) worth of houses. The bank’s assets (including houses) rise in step with its money-issue, so the value of the dollar remains at $1=1 ounce. This method relieves the money shortage, ends the recession, and causes no inflation. Excellent results, and not especially surprising to either Keynesians or Classicals. The problem is that it is not always easy for the bank’s assets to keep up with its money-issue. If the bank had spent its $30 of new notes on houses that were only worth 29 ounces, then money-issue would outrun the bank’s assets, and inflation would result. Overall, it’s safer for the bank to spend its $30 buying bonds than buying houses.

There are many more methods of issuing banknotes, but I’ll mention just one: Print $30 of bank notes and give them away to passers-by outside the bank. Then have the government give $30 of bonds to the bank. The bank’s assets will rise in step with its note issue, so there is no inflation. At the same time, the real money supply rises by 10%, so the money shortage is relieved and the recession ends. Excellent results once again. The only problem is that the government will eventually run out of wealth, and will be unable to help the money-issuing bank’s assets keep up with its money issue.

Conclusions:
1) Money shortages cause recessions, and the solution is to issue more money.
2) Issuing new money won’t cause inflation, as long as the new money is adequately backed.
3) It is best to issue new money via conventional open-market purchases of bonds. Failing that, it’s ok to issue new money for houses, or even to give it away, provided the government can cover the give-away. But whatever you do, don’t bury the money in coal mines.

The final chapter in the Zimbabwe dollar saga?

Here's an interesting fact. Remember all those worthless Zimbabwe paper banknotes? The Reserve Bank of Zimbabwe (RBZ), Zimbabwe's central bank, is officially buying them back for cancellation. According to its recent monetary policy statement, the RBZ will be demonetizing old banknotes at the "United Nations rate," that is, at a rate of Z$35 quadrillion to US$1. Stranded Zimbabwe dollar-denominated bank deposits will also be repurchased.

As a reminder, Zimbabwe endured a hyperinflation that met its demise in late 2008 when Zimbabweans spontaneously stopped using the Zimbabwe dollar as either a unit of account or medium of exchange, U.S. dollars and South African rand being substituted in their place. Along the way, the RBZ was used by corrupt authorities to subsidize all sorts of crazy schemes, including farm mechanization programs and tourism development facilities.

Upon hearing about the RBZ's buyback, entrepreneurial readers may be thinking about an arbitrage. Buy up Zimbabwe bank notes and fly them back to Zimbabwe for redemption at the RBZ's new official rate, making a quick buck in the process. But don't get too excited. The highest denomination note ever printed by the RBZ is the $100 trillion note. At the RBZ's demonetization rate, one $100 trillion will get you... US$0.003. With these notes selling for US$10 to $20 as collectors items on eBay, forget it—there's no money to be made on this trade. If you've already got a few $100 trillion Zimbabwean notes sitting in your cupboard, you're way better off hoarding them than submitting them to the RBZ's buyback campaign.

But this does give us some interesting data points about the nature of money. Last year I wrote two posts on the topic of whether money constituted an IOU or not. With the gold standard days long gone, central banks no longer offer immediate redemption into some underlying asset. But do they offer ultimate redemption into an asset? A number of central banks—including the Bank of Canada and the Federal Reserve—make an explicit promise that notes constitute a first claim or paramount lien on the assets of the central bank. This language implies that banknotes are like any other security, say a bond or equity, since each provides their owner with eventual access to firm assets upon liquidation or windup of the firm.

George Selgin is skeptical of the banknotes-as-security theory, replying that a note's guarantee of a first claim on assets is a mere relic of the gold standard. However, the Bank of Canada was formed after Canada had ceased gold convertibility. Furthermore, modern legislation governing central banks like the 2004 Central Bank of Iraq (CBI) Law declares that banknotes "shall be a first charge on the assets of the CBI." [See pdf]. So these promises certainly aren't relics of a bygone age. The Zimbabwean example provides even more evidence that a banknote constitutes a terminal IOU of sorts. After all, Zimbabwean authorities could have left legacy Zimbabwe dollar banknotes to flap in the wind. But for some reason, they've decided to provide an offer to buy them back, even if it is just a stink bid.

Given that banknotes are a type of security or IOU, how far can we take this idea? For instance, analysts often value a non-dividend paying stock by calculating how much a firm's assets will be worth upon break up. Likewise, we might say that the value of Zimbabwean banknotes, or any other banknote, is valued relative to the central bank's liquidation value, or the quantity of central bank assets upon which those notes are claim when they are finally canceled. If so, then the precise quantity of assets that back a currency are very important, since any impairment of assets will cause inflation. This is a pure form of the backing theory of money.

I'm not quite willing to take this idea that far. While banknotes do appear to constitute a first claim on a central bank's assets, the central bank documents that I'm familiar with give no indication of the nominal quantity of central bank assets to which a banknote is entitled come liquidation. So while it is realistic to say that the Reserve Bank of Zimbabwe always had a terminal offer to buy back Zimbabwe dollars, even during the awful hyper-inflationary period of 2007 and 2008, the lack of a set nominal offer price meant that the value of that promise would have been very difficult to calculate. More explicitly, on September 30, 2007, no Zimbabwean could have possibly know that, when all was said and done, their $100 trillion Zimbabwe note would be redeemable for only US$0.003. The difficulty of calculating this terminal value is an idea I outlined here, via an earlier Mike Friemuth blog post.

While the final chapter of the Zimbabwe dollar saga is over, the first chapter of Zimbabwe's U.S. dollar standard has just begun. Gone are the days of 79,600,000,000% hyperinflation. Instead, Zimbabweans are experiencing something entirely new, deflation. Consumer prices have fallen by 1.3% year-over-year, one of the deepest deflation rates in the world and the most in Africa. With prices being set in terms of the U.S. dollar unit of account, Zimbabwean monetary policy is effectively held hostage to the U.S. Federal Reserve's 12 member Federal Open Market Committee. Most analysts expect the Fed to start hiking rates this year, so I have troubles seeing how Zimbabwean prices will pull out of their deflationary trend. Few people have experienced as many monetary outliers as the citizens of Zimbabwe over such a short period of time. I wish them the best.

Short Squeezes, Bank Runs, and Liquidity Premiums

This is a guest post by Mike Sproul. Many of you may know Mike from his comments on this blog and other economics blogs. I first encountered Mike at the Mises.com website back in 2007 where he would eagerly debate ten or twenty angry Austrians at the same time. Mike was the first to make me wonder why central banks had assets at all. Here is Mike's website. 

On October 26, 2008, Porsche announced that it had raised its ownership stake in Volkswagen to 43%, at the same time that it had acquired options that could increase its stake by a further 31%, to a total ownership stake of 74%. The state of Lower Saxony already owned another 20% stake in VW, so Porsche's announcement meant that only 6% of VW's shares were in “free float”, that is, held by investors who might be interested in selling.

Porsche's buying had inflated the price of VW stock, and investors had been selling VW short, expecting that once Porsche's buying spree ended, VW shares would fall back to realistic levels. Short sellers had borrowed and sold 12.8% of VW’s outstanding stock, but with free float now down to 6%, short sellers owed more shares than were publicly available. If the lenders of those shares all at once demanded repayment of their shares, then there would be 12.8 buy orders for every 6 shares available. In what was called “the mother of all short squeezes” share price rose until the short sellers went broke.

A short squeeze is bad news for financial markets, largely because the fear of short squeezes deters short selling, and thus inhibits the normal arbitrage processes that keep securities correctly priced. If I may make a suggestion to the owners of the world's stock exchanges, there is a simple way to prevent short squeezes from happening on your exchange: Allow cash settlement of all short positions, just like in futures trading. If the most recent selling price of VW was 250 euros, and if short sellers suddenly find no shares available, then allow those short sellers to pay 250 euros in cash (plus some small penalty) to the lenders of the shares, rather than having to return an actual share of VW. This would prevent the stampede to buy VW, and would assure that VW’s price would not skyrocket to crazy levels. (As a measure of short-squeeze mis-pricing, it is worth noting that VW briefly became the world's most valuable company at the height of the short squeeze.)

Short squeezes on stock exchanges are mercifully rare. Unfortunately they are not quite as rare in the banking world, where they go by the name of bank runs. Just as a short squeeze pushes short sellers to hand over more shares of VW than can be obtained on the market, a bank run pushes banks to hand over more currency than can be obtained on the market. And just as short squeezes can be mitigated by allowing cash settlement, so can bank runs be mitigated by allowing banks to settle their obligations in forms other than currency. Clearinghouses and other banking associations can issue loan certificates or scrip for use in clearing checks, or even for public use as currency. Some creativity might be required in the issuance of money substitutes, but in return banks are spared from having to sell their assets at distress prices, while the community is spared from the effects of a bank panic.

What I find most interesting about short squeezes and bank runs is that they are a clear case of market failure, where financial instruments are obviously trading above the value of the assets backing them. During a short squeeze, value is no longer determined by backing, but by the forces of supply and demand. I don't think that economists pay enough attention to this point. The price of financial securities is normally determined by the underlying assets, while the price of commodities is determined by supply and demand. When economics textbooks explain supply and demand, they speak of the supply and demand for apples and oranges or other commodities. They rarely if ever speak of the supply and demand for stocks and bonds, because stocks and bonds are not objects of consumption, and they are not produced using scarce resources. There is no production function and no consumption function, hence there are no supply or demand curves. When we examine a bond that promises to pay $105 in 1 year, we find the price of that bond by dividing 105/(1+R). If R=5% and we tried to sketch supply and demand curves for that bond, we would draw a pair of meaningless curves that were both horizontal at $100. This is what makes short squeezes so strange. The price of VW stock is supposed to be determined by backing, and not by the supply and demand for VW shares. But during a squeeze, supply and demand take over, and stocks trade at a premium relative to their backing. The same might be true of money during a bank run.

This is a problem that JP and I have batted around a bit. I usually argue that arbitrage prevents money from trading at a premium relative to its backing, while JP usually argues that money can trade at a small premium. I can never pin him down on the size of the premium, but he doesn't argue much when I throw around a figure of 5%. Well, here we have VW stock trading at a premium of 500%. Might such a premium be possible for money?

Apparently not. We never see comparably large premiums on currency during bank runs. Gerald Dwyer and Alton Gilbert (Bank Runs and Private Remedies, May/June, 1989) examined American banking panics that occurred between 1857 and 1933, and found that the largest paper currency premium (relative to certified checks) ever observed during bank panics was 5%. The average paper currency premium during bank panics was much lower, only about 1%. Other measures of a currency premium, such as a rise in the value of money relative to goods in general (i.e., deflation), are also in the modest range of 1-5%. Why the enormous gap, from a 1% premium on currency to a 500% premium on VW stock? My best explanation is that banks can get creative in devising alternate forms of payment, while the traders in VW stock simply did not have the time or the legal means to devise alternate forms of payment. Thus the market in VW stock failed catastrophically, while banks facing a run are able to muddle through.

The result of the banks' muddling with money substitutes is that even during stressful events like bank runs, the value of money is, at most, only 5% higher than its fundamental backing value. This makes sense, because any premium over backing value gives an arbitrage opportunity to investors. If the fundamental backing value of each dollar is 1 oz. of silver, and if the dollar somehow trades at 1.05 oz., then the issuer of that dollar earned a free lunch of .05 oz. This free lunch would attract issuers of rival moneys, and rival moneys would keep being created until each dollar traded at its fundamental value of 1 oz.

The idea that money is worth no more than the assets backing it is consistent with finance theory, and with the backing theory of money, but it contradicts the quantity theory of money. The quantity theory asserts that modern fiat money has no backing, that it is not the liability of its issuer, and that its entire value is therefore a monetary premium. Which of the two theories gives a better fit to real-life moneys? When we look around for moneys that fit the quantity theory, that have no backing and are not anyone's liability, we find very little. Just bitcoin and a few orphaned currencies like the Iraqi Swiss Dinar. When we look around for moneys that fit the backing theory, that are the recognized liability of their issuer, and are backed by their issuer's assets, we find every other kind of paper and credit money that has ever existed. I conclude that the backing theory beats the quantity theory.

Dismantling a central bank

In a previous post, I made the point that banknotes aren't Samuelsonian bubble assets, say like a chain letter or a ponzi scheme or bitcoin. Upon the dismantling of a central bank, each note has a senior claim on a central bank's remaining assets. Rather than being mere "oblongs of paper", as Samuelson described them, banknotes occupy the very top of the capital structure hierarchy, above stock and bonds. This quality of being "well backed" might be sufficient for notes to trade at a positive value in the first place, and also help explain subsequent fluctuations in the purchasing power of those notes. In this post I revisit these ideas.

The process of dismantling a central bank would go like this. Imagine that the Reserve Bank of Fiji announces that it will wind up operations next week and recall all notes. Its assets consist entirely of Fijian dollar-denominated bonds. With the eminent end of Fijian dollars, the entire Fijian economy will have to quickly re-denominate existing debts and contracts into a new unit of account, say U.S. dollars. After this redenomination, the Reserve Bank of Fiji now finds itself holding a large quantity of U.S. dollar-denominated debt. It proceeds to sell these bonds, as well as its printing presses and premises, for dollars, and then uses dollars to cancel all Fijian notes. The Reserve Bank of Fiji is no more, and neither are Fijian dollars.

Because the central bank's hypothetical dissolution would result in noteholders ending up with some ultimate quantity of U.S. dollars in their pockets, Fijians can use this terminal value as a basis for computing the present value of Fijian banknotes. They would go about doing this computation in the same that they would with a stock and bond, both of which also have hypothetical terminal values, or liquidation values.

The inestimable Mike Freimuth, who blogs here, pointed out that there is a problem with this. How can Fijian noteholders actually quantify the amount of dollars to which they are entitled upon dissolution? This is easy if the Reserve Bank of Fiji is already on a dollar standard (say it redeems notes for US$1). Once all of the central bank's assets have been sold for U.S. dollars, each noteholder would get US$1 until all Fijian noteholders had been satisfied, upon which less senior stakeholders like bondholders and shareholders would get their portion of the central bank's remaining stash of U.S. dollars.

However, if Fiji is on a floating standard, the task of valuing noteholders' claims gets quite thorny. While fiat notes may have a senior claim on assets upon dissolution, it isn't evident how many actual dollars this entitles noteholders too. And if their quota of remaining assets, or terminal value, is not known at the outset, how can Fijians arrive at a value for notes in the first place?

One answer to Mike's criticism is that Fijian note owners come up with their best estimate of how much dollars the central bank (or a judge) would decide to award them upon a hypothetical dissolution. If the market's collective guess is that no assets would be forthcoming, then Fijian dollars would be worth nothing upon windup. If Fijians on average assume that the sale of bank assets would net $100m, and they think a judge would award them half of that, then each Fijian banknote will earn a prorated share of $50m. If they think that the all assets will be awarded to them, then they'll get a prorated share of $100m.

While these expectations about the terminal value of notes would probably be sufficient to jumpstart the positive value of Fijian dollars in the first place, this isn't a very satisfying explanation for subsequent variations in the price level. After all, the Fijian price level on any given day would be a function of Fijians' many and divergent expectations concerning their as-yet-unstated share of some future pie. As noteholders take potshots at guessing what this unknown size of this slice would be, the Fijian dollar would fluctuate wildly, sort of like a penny stock. Penny stocks owners have wildly fluctuating estimates concerning their ultimate, and unfixed, share of the corporate pie, which is only determined after debtors have had their pickings.

However, the behavior of currencies is not like penny stocks—the former tend to vary only a little in price from day-to-day. To explain price level fluctuations, it would seem that something other than the terminal value of the Reserve Bank of Fiji's assets must be at work.

Here I would like to reiterate my point from an earlier post that once a banknote has been jumpstarted into having a positive value, the dissolution-value of a central bank assets will only have a distant influence on those note's subsequent value. By far the more immediate effect that central bank assets have on the value of notes emerges via their ability to be mobilized in the maintenance of price stability. By selling assets for notes and retiring them (or threatening to do so), a central bank can prevent the value of their notes from flagging. Alternatively, the income earned by those assets provides the central bank with the resources to pay more interest (on reserves at least), a feature that will also ensure price stability.

So it seems to me that any impairment to a central bank's assets will affect the value of notes not so much because it lowers their value come future dissolution, but because it limits the central bank's ability to repurchase notes and pay interest in the present so as to maintain their price target. If a central bank didn't provide a target supported by a repurchase facility, then the value of notes would be dictated by something like their terminal value—and prices would be much more volatile then they are now.

The three lives of Japanese military pesos

1942 Japanese Invasion Philippines Peso with a JAPWANCAP Stamp

In his reply to Mike Sproul, Kurt Schuler brings up the question of the determination of the value of a very peculiar kind of money: military currency. Curious, I investigated one example of such money, Japanese-issued "invasion money" in Philippines both during and after World War II. As best I can tell, the mechanism by which the value of these military notes has been mediated has gone through three different phases, each of them teaching us something interesting about money.

In January 3, 1942, a few weeks after successfully invading Philippines, the Japanese Commander-in-Chief announced that occupying forces would henceforth use military-issued currency as legal tender. Notes were to circulate at par with existing Philippines "Commonwealth" Pesos. Since this military scrip was not directly convertible into existing pesos, the trick to get it to circulate at par can probably be found in the tersely titled proclamation Acts punishable by death which, among seventeen acts that could result in loss of life, listed the thirteenth as:

(13) Any person who counterfeits military notes; refuses to accept them or in any way hinders the free circulation of military notes by slanderous or seditious utterances.

This is a great example of a Warren Mosler fiat money. According to Mosler, the state's requirement that citizens discharge their tax obligation with a certain intrinsically worthless medium on pain of being shot in the head is sufficient to give that medium a positive value. Likewise, requiring citizens to use the same medium in the course of regular payments and accept it to discharge debts, all on pain of death, would probably have promoted a positive value for intrinsically worthless paper.

Over time, those bits of "forced" paper will enjoy constant purchasing power as long as the issuer withdraws excess currency or adds it when desired. This is the quantity theory of money.

By 1943, however, it seems that the Japanese occupying forces, now being pushed back by the Allied forces, were desperately issuing excess notes to pay for operations. The Filipino monetary system proceeded to run smack dab into Gresham's law. The unit of account, the peso, was defined in terms of two different media—original pesos and military pesos. This meant that debtors could choose to discharge their debts with either. However, if one was perceived to be more valuable than the other, this superior medium would be hoarded and the inferior one used to pay off the debt. Legacy pesos had completely disappeared from circulation by 1943—only war pesos were being used to discharge debts and pay for goods, a decent indicator that the value of Japanese invasion pesos had fallen below that of original pesos. Bad money had chased out the good. (See [1] and [2] for evidence of Gresham's law)

Through 1944 and 1945, the war peso would endure extreme inflation. 10P had been the largest denomination in 1942. The military introduced 100P, 500P, and 1000P notes in subsequent years. In Neil Stephenson's Cryptonomicon, a wide-ranging historical/science fiction novel filled with monetary themes, there's an interesting passage in which Japanese soldier Goto Dengo describes the use of military scrip, probably sometime in 1943 or 1944:

The owner comes over and hands Goto Dengo a pack of Lucky Strikes and a book of matches. "How much?" says Goto Dengo, and takes out an envelope of money that he found in his pocket this morning. He takes the bills out and looks at them: each is printed in English with the words THE JAPANESE GOVERNMENT and then some number of pesos. There is a picture of a fat obelisk in the middle, a monument to Jose P. Rizal that stands near the Manila Hotel.
The proprietor grimaces. "You have silver?"
"Silver? Silver metal?"
"Yes," the driver says.
"Is that what people use?" The driver nods.
"This is no good?" Goto Dengo holds up the crisp, perfect bills.
The owner takes the envelope from Goto Dengo’s hand and counts out a few of the largest denomination of bills, pockets them, and leaves.
Goto Dengo breaks the seal on the pack of Lucky Strikes, raps the pack on the tabletop a few times, and opens the lid.

Japanese invasion currency, already being well on its way to being repudiated, would become completely worthless upon Japan's unconditional surrender in 1945.

Well, not entirely valueless. The second chapter in the life of military scrip begins with The Japanese War Notes Claimants Association of the Philippines, or JAPWANCAP. Formed in 1953 on behalf of Filipinos left holding stranded quantities of worthless Japanese invasion money, JAPWANCAP's mission was to hold both the US and Japanese government's liable for the redemption of war currency (the US had also issued counterfeit Japanese military currency). So while pesos had been valued prior to the war's end upon pain of death, and their value regulated by limiting the quantity outstanding, those same pesos were now valued on the margin as a liability of their issuer. Given the possibility of redemption, an old invasion note was worth more than zero.

Was JAPWANCAP successful? While the case was heard in a United States Court of Claims in 1967, it was thrown out on a technicality, the statute of limitations having had passed. Put simply, the court would not hear a claim that had not been filed within six years of that claim first being accrued, and in JAPWANCAP's case many more years than that had already passed.

This makes one wonder, if Filipinos in 1953 were already convinced that Japanese invasion pesos were the liability of the issuer, and therefore redeemable in some quantity of yen or dollars, did that same motivation also lead them to originally accept new military pesos in 1942? To what degree was the initial acceptance of pesos driven by the threat of force (& subsequent changes in value regulated by their quantity), and to what degree was their value dictated by their status as a liability of a well-backed issuer? That's a question we can never be entirely sure of. But while the force/quantity theory story fits the facts, the liability story does too. The military peso's inflation, for instance, can be attributed to the rising quantity of money, but also to the increasing likelihood of Japan losing the war, a loser's liability's being worth far less than a winner's.

Which brings us to the third chapter in the evolution of Japanese military pesos. Nowadays you can buy the notes on eBay for a few bucks. Their value is no longer dictated by gunpoint, nor by their liability nature, but their existence as a unique commodity, much like gold, bitcoin, or some rare antique.

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To learn more, here is a paper called "Financing Japan’s World War II occupation of Southeast Asia"

Note: I will be posting sparsely over the next two months, probably once every two weeks.

Friends, not enemies: How the backing and quantity theories co-determine the price level

Kurt Schuler was kind enough to host a Mike Sproul blog post, which I suggest everyone read.

I think Mike's backing theory makes a lot of sense. Financial analysis is about kicking the tires of a issuer's assets in order to arrive at a suitable price for the issuer. If we can price stocks and bonds by analyzing the underlying cash flows thrown off by the issuer's assets, then surely we can do the same with bank notes and bills. After all, notes and bills, like stocks and bonds, are basically claims on a share of firm profits. They are all liabilities. Understand the assets and you've understood the liability (subject to the fine print, of course), how much that liability should be worth in the market, and how its price should change.

Mike presents his backing theory in opposition to the quantity theory of money. But I don't think the two are mutually exclusive. Rather, they work together to explain how prices are determined. By quantity theory, I mean that all things staying the same, an increase in the quantity of a money-like asset leads to a fall in its price.

We can think of a security's market price as being made up of two components. The first is the bit that Mike emphasizes: the value that the marginal investor places on the security's backing. "Backing" here refers to the future cash flows on which the security is a claim. The second component is what I sometimes refer to as moneyness—the additional value that the marginal investor may place on the security's liquidity, where liquidity can be conceived as a good or service that provides ongoing benefits to its holder. This additional value amounts to a liquidity premium.

Changes in backing—the expected flow of future cash flows—result in a rise or fall in a security's overall price. Mike's point is that if changes in backing drive changes in stock and bond prices, then surely they also drive changes in the price of other claims like bank notes and central bank reserves. Which makes a lot of sense.

But I don't think that's the entire story. We still need to deal with the second component, the security's moneyness. Investors may from time to time adjust the marginal value that they attribute to the expected flow of monetary services provided by a security. So even though a money-like security's backing may stay constant, its price can still wobble around thanks to changes in the liquidity premium. Something other than the backing theory is operating behind the scenes to help create prices.

The quantity theory could be our culprit. If a firm issues a few more securities for cash, its backing will stay constant. However, the increased quantity now in circulation will satisfy the marginal buyer's demand for liquidity services. By issuing a few more securities, the firm meets the next marginal buyer's demand, and so on and so on. Each issuance removes marginal buyers of liquidity from the market, reducing the market-clearing liquidity premium that the next investor must pay to enjoy that particular security's liquidity. In a highly competitive world, firms will adjust the quantity of securities they've issued until the marginal value placed on that security's liquidity has been reduced/increased to the cost of maintaining its liquidity, resulting in a rise or fall in the price of the security.

This explains how the quantity theory works in conjunction with the backing theory to spit out a final price. In essence, the quantity theory of money operates by increasing or decreasing the liquidity premium, Mike's backing theory takes care of the rest.

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P.S. Kurt Schuler's response to Mike.

The rise and fall (and rise) of the hot potato effect

Don Randi Trio +1 at the Baked Potato, Poppy Records, 1971. [link]

In this post I'll argue that:

1. When it comes to financial assets, the hot potato effect is irrelevant.
2. The hot potato effect is born the moment we begin to talk about non-financial instruments — things you can touch and consume, like gold or cows or houses or whatnot.
3. Because central bank reserves are simultaneously financial assets and a tangible consumables, they are capable of generating a hot potato effect.
4. The moment that central bank money ceases to be valued as a consumer good, its hot potato effect dies.

Here's a short illustration of the hot potato effect that should serve as my definition of the term. Imagine that a gold miner finds several huge gold nuggets and quietly brings them to town to sell. The gold miner approaches the town's merchant with an offer to exchange gold for supplies, but at current prices the merchant is already happy with the size of his gold holdings. He will only take the the miner's gold if the miner is willing to buy supplies at a premium to the prevailing market price. The miner grumbles but sells the gold anyways. Now the merchant approaches the town's largest landowner with an offer to exchange gold for land, but the landowner is already content with the size of his gold holdings. He will, however, accept the offer if the merchant is willing to improve his price. The merchant accepts and the transaction is consummated.

Each subsequent townsperson will require a higher price to convince them to part with their goods and hold the newly mined gold. In this fashion the gold miner's nuggets work through the town's economy like hot potatoes, pushing up all gold-denominated prices.

With non-tangibles like financial assets, the hot potato effect is irrelevant. Say that our merchant decides to issue new stock or bonds into the town's economy by purchasing other stocks/bonds, gold, or by funding viable projects. The landowner takes the merchant up on his offer and tenders some gold, land, and shares in return for the merchant's newly-issued financial instruments. The merchant's financial instruments are fairly liquid and function as useful exchange media.

A few days later the landowner decides to sell these financial instruments and approaches the miner. The miner, who earlier experienced the hot potato effect, says that he'll only buy the financial instruments if the landowner will sell them for less gold. The landowner is about to consummate the transaction when the merchant barges in. The merchant offers to buy back the financial instruments at a smaller discount. After all, the merchant still owns the same land, shares, and gold that the landowner originally submitted for shares, and he can make a quick profit by repurchasing and retiring the landowner's stock with a smaller quantity of land/gold than was initially tendered. The miner reacts to the merchants competing offer by reducing the discount he required of the landlord, but each time he does so the merchant will match him with a better price. After much haggling between merchant and miner, the landowner will be able to sell his shares to one of them at a price very close to their original gold-denominated value.

Financial asset prices are driven not by the hot potato effect but by a "modern finance effect". The market value of a claim on an issuer is determined by the issuer's earning power and the risk of its underlying assets. If an individual tries to sell claims away like they were hot potatoes, profit maximizing arbitrageurs will step in and bring their price back up to their fundamental value, thereby annulling any hot potato effect.

Now back to central banks. Much like a merchant will buy back the instruments he has issued, a central banker commits to mobilize whatever bonds, gold, and other assets he holds in his vaults to repurchase every reserve he has ever issued. Like any other financial asset, the price of reserves is determined by underlying earnings power. Should a central bank issue new reserves by swapping them for bonds or gold, this issuance will not ignite a hot potato cycle of declining prices because arbitrageurs will compete to buy up any underpriced reserves.

The story doesn't end here. In addition to functioning as financial assets, central bank reserves also function as consumables. A bank that holds reserves enjoys a convenience yield: they can be sure that come some unforeseen event, they'll have adequate resources on hand to cope. Reserves are consumed in the same way that fire extinguishers are used up. While it is unlikely that either will ever be mobilized to deal with emergencies, their mere presence is consumed by their owner as a flow of uncertainty-shielding services over time.

Unlike fire extinguishers, reserves can be created instantaneously and at no cost. If fire extinguishers were like reserves, we'd conjure up any amount of them that we desired, their price would fall to zero, and everyone would enjoy their convenience for free. The marginal value that the market places on the consumability of reserves, however, never plunges to zero because a central bank keeps their supply artificially tight.

A central banker's ability to set off a hot potato chain of rising prices stems from the role of reserves-as-consumable, not their role as financial assets. Say that the banker offers to loosen the supply of scarce reserves. Existing consumers of reserves are already well-stocked with reserves at current prices. They will only accept the new issue by reducing the quantity of goods or other assets that they're willing to swap for reserves. Put differently, the price level must rise. This is the same mechanism by which the miner's gold nuggets were passed on hot-potato-like.

On the other hand, when a central banker further constricts the supply of already-scarce reserves, the marginal consumer of reserves will face a deficit in their reserve inventories, a hole that the consumer can only fill by offering larger quantities of goods/assets in return for reserves. Put differently, the price level must fall.

As a central bank issues ever larger amounts of reserves, the marginal value the market places on their consumability, or their marginal convenience yield, falls towards zero. As this happens, the hot potato effect becomes almost negligible—each subsequent issue of reserves increases the supply of what has already become a free good. The consumptive quality of central bank reserves is now akin to oxygen. Just like an increase in the amount of air has no effect on air's price—we already value it on the margin at zero— increases in the quantity of reserves are irrelevant. With the hot potato effect officially dead, we've arrived at Scott Sumner's case 5b, or Stephen Williamson's not-your-grandmother's-liquidity-trap.

With the death of the hot potato, the market's valuation of reserves is now solely governed by what I referred to earlier as the modern finance effect. Subsequent increases in the quantity of reserves via open market operations have no effect whatsoever on the price level. Anyone who sells reserves as if they were hot-potatoes will be corrected by arbitrageurs who return the price level to its fundamental value. This is a world in which Mike Sproul's backing theory precisely applies, or what Miles Kimball calls Wallace irrelevance/neutrality holds absolutely.

Reintroduce a shortage of central bank reserves and the marginal consumptive value, or convenience yield, of reserves will once again move above zero. The ability to harness the hot potato effect arises once again.

Real or unreal: Sorting out the various real bills doctrines

In the comments section of my post on Adam Smith and the Ayr Bank, frequent commenter John S. brought up the real bills doctrine. The phrase real bills doctrine gets thrown around a lot on the internet. To muddy the waters, there are several versions of the doctrine. In this post I hope to dehomogenize the various versions in order to add some clarity.

1. Lloyd Mints's version

We may as well start with Lloyd Mints's version, since he coined the phrase real bills doctrine back in 1945 on his way to denouncing the doctrine. Mints taught at the University of Chicago and mentored Milton Friedman. [1] Here is Mints:

The real-bills doctrine runs to the effect that restriction of bank earning assets to real bills of exchange will automatically limit, in the most desirable manner, the quantity of bank liabilities; it will cause them to vary in quantity in accordance with the "needs of business"; and it will mean that the bank's assets will be of such a nature that they can be turned into cash on a short notice and thus place the bank in the position to meet unlooked-for calls for cash. - A History of Banking Theory

Mints's RBD states that so long as only real-bills (short term liquid debt instruments created by merchants to finance inventory) are discounted by the banking system, an excess amount of notes can never be issued. When businesses require cash, they'll simply discount bills at a bank, and when that cash is no longer required, they'll pay back their borrowing. Even in a world *without* note convertibility into specie (a "fiat standard")  the real bills stipulation alone is sufficient to keep the price level anchored.

Mints rightly declared that this version of the RBD was "completely wrong". After all, a central bank not constrained by convertibility might discount only real bills, yet by discounting at an unreal price, it would alter the purchasing power of the notes it issues and create either runaway inflation or deflation). The price level was indeterminate in Mints's RBD-world.

Mints singled out Adam Smith for being "the first thoroughgoing exponent of the real-bills doctrine". For the next forty years, Smith's reputation as a monetary theorist would be tarnished. [2]

2. Adam Smith's version

Though tarred and vilified, poor Adam Smith never actually conformed to the real bills doctrine as described by Mints. This has been pointed out by David Laidler in his 1981 paper Adam Smith as a Monetary Economist, one of the first efforts to rehabilitate Smith's reputation as a monetary theorist.

Smith lived in an era in which paper money was fully convertible into a fixed amount of gold. Mints's description of the RBD, on the other hand, applies to a fiat world. For Smith, the gold convertibility clause was sufficient to ensure that the economy needn't endure an excess amount of notes. After all, should banks as a whole issue more than was desired, the public would return the notes en masse for specie. This is the so-called reflux process.

That being said, Smith did mention real bills several times in the Wealth of Nations. He famously advises banks that they should only discount "real bills of exchange drawn by a real creditor upon a real debtor." (I go into some detail in my last post on the personal and historical reasons that may have motivated Smith to advocate this position).

Why limit discounts to real bills? When the banking system issues excess paper currency, gold convertibility ensures that this excess will soon reflux back to issuer. A bank that holds long term loans and bonds issued by speculators will be insufficiently prepared to meet the demands of reflux since liquidating such debts might take time. A bank that holds short term bills issued by credit-worthy merchants will be better equipped to meet redemption demands, and less likely to meet the same demise as that experienced by the Ayr Bank, a bank run that Smith personally witnessed.

Thus Smith's admonishment to only discount real bills wasn't a mechanism for anchoring the economy's price level—gold convertibility served this purpose. Smith's real bills stipulation was just good advice for individual banks: stay liquid and don't take on too much credit and term risk. This distinction has been aptly described by David Glasner in his paper the Real Bills Doctrine in the Light of the Law of Reflux, and for his part Laidler notes that "as advice to an individual bank, it's probably pretty sound, as a principle of
monetary policy under commodity convertibility it is relatively harmless..." [link]

3. The Bank Directors' version

Why did Mint's cast Adam Smith as his first thorough-going exponent of the RBD?

In 1797, some seven years after Smith had died, Britain went off the gold standard. (See this post for details). The pound soon began to trade at a discount to its pre-1797 gold value. In other words, the pound was capable of purchasing less gold. The Directors of the Bank of England found themselves accused of creating inflation, notably by the members of the 1810 Bullion Committee. One of the apologizers for the Directors, Charles Bosanquet, a pamphleteer, wrote a famous rebuttal in 1810 that insisted that by limiting discounts to "solid paper for real transactions," the Bank could not have contributed to a deprecation of the pound. According to Bosanquet, several factors outside of the Bank's control had caused the deprecation.

To help buttress his point, Bosanquet invoked the name of Adam Smith. Wrote Bosanquet: "The axiom, or rule of conduct, on which the Committee has been pleased to heap contempt and ridicule, respecting which they have declared that the doctrine is fallacious, and leads to dangerous results, was promulgated by, and is founded on, the authority of Dr. Adam Smith."

Bosanquet's appropriation of Smith's name was inappropriate since Smith implicitly assumed gold convertibility. But the damage had been done. From then on, economic historians like Mints would automatically associate Smith's name with the arguments of the Directors.

The Directors' RBD is very much a manifestation of Lloyd Mints's RBD, which we already know was a poor guide for monetary policy. Years later, Walter Bagehot would write that when the Directors were examined by the Bullion Committee in 1810, "they gave answers that have become almost classical by their nonsense". If anyone deserved to be castigated as the first thoroughgoing exponents of Mints's real bills doctrine, it was the Directors and not Smith.

4. Antal Fekete's version

If you've spent some time wading through the online monetary economics community, you'll have run into Antal Fekete's real bills doctrine. This is an attempt to apply a warmed over version of Adam Smith's RBD mixed in with some Austrian free market economics.

The use of bills of exchange began to diminish in the late 1800s and today they are a relatively unimportant financial instrument, having been replaced in bank portfolios by commercial paper, bonds, mortgages, and other types of debt. Fekete tries to draw a number of broad based conclusions from this trend. The crowding out of real bills by non-real bills (longer term finance bills and government issued treasury bills), for instance, is seen by Fekete as the reason for the Great Depression and the creation of the modern Welfare state:

When real bills were replaced by non-self-liquidating finance bills, payment of wages has become haphazard. Employment was made touch-and go, hiring, ‘hand-to-mouth’. This threatened with unemployment on a massive scale, unless governments were willing to assume responsibility for paying wages. [Link]

Conversely, rehabilitating the real-bills system would end chronic unemployment and reduce the size of government. I only have a passing knowledge of Fekete's thinking — it really doesn't do much for me —so hopefully someone in the comments section can pick up the slack.

5. Mike Sproul's version

Of the modern reincarnations of the RBD, I'm far more familiar with Mike Sproul's version.

Mike's version is an application of modern finance to monetary economics. The price of a financial asset is determined by the discounted value of the expected flows of cash thrown off by underlying capital. Alcoa's stock price, for instance, will equal the sum of discounted earnings that Alcoa's machinery and employees are expected to generate. Transferring this idea to the monetary landscape, Mike says that value of modern central bank liabilities should be determined by the earnings power of the assets held by that central bank.

Like the other versions of the RBD, Mike's version shares a preoccupation with the asset side of a bank's balance sheet. But that ends their similarity. For instance, Mike doesn't have a fetish for actual real bills. I doubt he'd agree with the Directors that so long as they only discounted short-term mercantile bills of exchange, they'd never cause a decline in the value of the pound.

That's why I prefer to call Mike's RBD the backing theory. It's a very different beast from the RBDs of Mints, Smith, Fekete, and the Bank Directors, and to share the same name only adds to the confusion.

So there you have it. If you're going to have an argument over the RBD, make sure you know which one you're arguing about!

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1. Fischer Black received this letter from Milton Friedman on August 6, 1971: "With respect to your so-called passive monetary policy, here you are simply falling into a fallacy that has persisted for hundreds of years. I recommend to you Lloyd Mints' book on The History of Banking Theories for an analysis of the real bills doctrine which is the ancient form of the fallacy you express. Do let me urge you to reconsider your analysis and not let yourself get misled by a slick argument, even if it is your own. " Ouch. Play nicely, Milt. I get this via Perry Mehrling's book on Fischer Black.
2. Here's a video of Lloyd Mints in 1988 upon his 100th birthday.

What would destroying a central bank's assets do?

Gavyn Davies's post Will central banks cancel government debt? dovetails nicely with the recent fundamental value of fiat money debate. [For commentary on this debate, see Nick Rowe, Paul Krugman, David Glasner, Stephen Williamson here, here, and here, David Andolfatto, Brad DeLong, and Noah Smith]

Let recap the debate first before turning to Gavyn's post. Noah Smith pointed out that since fiat money is fundamentally worth nothing (its future value = 0), then all financial assets are worth zero. Financial assets, after all, are mere promises to receive fiat money. Now back up a second. As I pointed out here, modern central bank money is not fundamentally worthless. Were it to fall to a small discount to its fundamental value, Warren Buffet would buy every bit of money up. Central bank money has a fundamental value because even if it can no longer be passed off to shopkeepers, there are assets in the central bank's kitty. Modern central bank money provides a conditional claim on those assets. David Andolfatto and Stephen Williamson also note the importance of central bank assets.

I got this idea from Mike Sproul. Back in the day, Mike used to start huge comment wars on the Mises blog when he brought up the topic of central bank assets "backing" its liabilities. In fact, here's the post where I first ran into Mike talking about this interesting feature of central bank money. Geez, I sound pretty ornery.

Nick Rowe also brings up central bank assets in his contribution. It's a rendition of his old classic, From gold standard to CPI standard (which I commented on here). In his new post, Nick explains how a modern central bank holds hypothetical CPI baskets in its basement, promising to redeem the liabilities it issues with those CPI baskets at a declining rate 2% every year.

Bill Woolsey gives a similiar story to Nick's in this comment on David Glasner's blog. Bill's point is that if a central bank provides a credible commitment to repurchase and cancel its liabilities should the demand for them evaporate, then central bank money will have value. As he points out, this commitment is only credible as long as the central bank holds (or can get a hold of) the necessary assets to commit to those buy backs.

The point of all this is that central bank assets are important. They are the key for understanding why modern central bank money is different from pure fiat money, why central bank money's future value > 0, and why financial assets (like corporate bonds) that pay out central bank money are not fundamentally worthless. Which brings us back to Gavyn's post.

Gavyn describes a radical idea to reduce UK sovereign debt whereby the Bank of England, the nation's central bank, would cancel part of the government bonds that they've acquired via quantitative easing. By canceling debt held at the BoE, the government's debt-to-GDP ratio comes down. No one in the private sector loses out, since they don't hold any of the canceled debt. The central bank loses out but its loss is counterbalanced by the government's gain such that if you aggregate both under the title "public sector", nothing has happened.

Let's look at this with our previous discussion in mind. With less assets on the BoE's balance sheet, the fundamental value of BoE money would have deteriorated. Why? Should the monetary demand for pounds disappear so that all that remains is fundamental value, the BoE will have fewer assets remaining to commit to repurchases so as to prop up the value of the pound.

Now, it could be that the debt cancellation really means that a formal debt on the asset side of the central bank's books has been replaced by an implicit promise that the government will come to the aid of the central bank during a run on a central bank's liabilities. In that case, holders of BoE money will quickly realize that there is an unwritten and unrecognized asset on the central bank's balance sheet. As a result, the fundamental value ascribed to the central bank liabilities would be damaged somewhat less than a scenario in which the debt was canceled outright. But damaged they would be since implicit guarantees are not as good as real assets.

One reason to make a central bank independent is to cordon off a fixed set of assets that can be used to provide a permanent basis for the fundamental value of central bank money. In this respect, a central bank is like a special purpose vehicle. SPVs are subsidiaries to which a parent company has transferred specific assets. The vehicle has been structured to prevent the parent from tampering with the assets after the fact. The SPV issues its own liabilities to other investors using these ring-fenced assets as backing. A central bank, much like an SPV, has been hived off from its parent, the government, and as a result the holders of its liabilities, the public, can be sure that they have claim to a secure set of assets. If an SPV suddenly had its assets removed by its parent with no guarantee of replacement, the liabilities issued by that SPV would suffer. Same with the liabilities of a central bank.

Gavyn worries that the destruction of central bank assets would unleash inflation. He also points out that there are people who are worried about deflation, and they would welcome a destruction of central bank assets. Whichever way you stand, the point here is that central bank money has a fundamental value. The proof of this would be what Gavyn describes: a scenario in which the value of central bank money declines as central bank assets are destroyed.

Update: Britmouse and Nick Rowe have blog posts on these issues too.