Thursday, October 25, 2012
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.