Both central banks and commercial banks issue liabilities that function as media of exchange. Why do we say that it is central banks, rather than commercial banks, that determine monetary policy; setting interest rates in the short run, and inflation in the long run? What makes a bank a central bank?
It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don't have to use paper money; we could use cheques or debit cards instead. If paper money disappeared, would central banks disappear, or lose their special power?
It is true that in some countries commercial banks are required to keep a certain ratio of central bank liabilities in reserve against their deposits, or choose to keep a certain ratio even if they are not legally required to do so. But what happens if they aren't legally required to do so, and don't choose to do so?
Here's the answer. Commercial banks promise to redeem their monetary liabilities for the monetary liabilities of the central bank at a fixed (or at least pre-determined) rate. Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks. This asymmetry of redeemability is what gives central banks their power over commercial banks. But a bank with that power is nevertheless not a true central bank unless it acts like one, and uses that power.
To see the power that flows from asymmetric redeemability, suppose bank A and bank B both issue paper money, but B promises to redeem its notes for A's notes at par, while A makes no such promise. Suppose interest rates are initially at 5%, and A decides it wants to lower interest rates to 4%, while B decides it wants to keep interest rates at 5%. What happens? The interest rate differential creates infinite arbitrage opportunities. Borrow A's notes from A at 4%, convert them into B's notes at par, and lend to B at 5%.
Bank B would end up accepting an infinite quantity of A's notes, which it could only lend out at 4%, while paying 5% on its deposits. It would make infinite losses. To avoid infinite losses, bank B would be forced to lower its rate to 4% too, or else suspend redeemability at par.
Now start at the beginning, with interest rates at 5%, and suppose A decides to raise the interest rate to 6%, while B tries to keep it at 5%. What happens? The arbitrage opportunity now works in the opposite direction. Borrow B's notes from B at 5%, convert them into A's notes, and then lend them to A at 6%.
Bank B would face an infinite demand to redeem it's notes, and it could only satisfy that demand by borrowing notes from A at 6%, while earning 5% on its loans. To avoid infinite losses, bank B would be forced to raise its rate to 6% too, or else suspend redeemability at par.
It's the asymmetric redeemability that gives bank A the power to set interest rates, and forces B to follow A. It's what gives A the power to act as a central bank, while the pursuit of profit (or the avoidance of infinite losses) makes B a commercial bank in A's orbit.
It makes no difference if the paper notes are ink marks on a ledger, or demand deposits recorded on a computer.
It also makes no difference if bank A is in one country, bank B is in another country, and they have different media of account, as long as B promises to redeem its notes for A's notes at some fixed rate, and A makes no such promise. In other words, a central bank that pegs its currency to another country's currency, with free convertibility, no longer has the power to set monetary policy, and isn't really a central bank (though it will look like a central bank to the commercial banks in B's country).
What about under the Gold Standard, where B promises to convert its notes into A's notes, and A promises to convert its notes into gold?
A central bank under the gold standard is like a central bank that unilaterally pegs its currency to the currency of another country; it isn't really a central bank at all (though it will look like one from the perspective of its commercial banks). And it's not a central bank in the modern sense, because it lacks the power to determine inflation rates in the long run. I am very tempted to say that the true central bankers under a gold standard are the gold miners. But gold miners might have the power to act as a central bank, but generally choose to maximise profits instead. They have the power, but lack the will to act like a central bank.
But a large gold mine, willing to lend or borrow gold at an interest rate of its choosing, could act as a central bank, if it had the will to do so.
Suppose that under the gold standard, two large firms controlled gold mining. All banks promise to redeem their paper money for gold at a fixed rate, but the gold miners make no such promise. But since gold from the two mines is identical, gold from one mine is redeemable into gold from the other mine at par. Here we have bilateral, or symmetric redeemability. This is exactly the same as France and Germany immediately before the introduction of the Euro, when both countries bilaterally agreed to the same fixed exchange rate between their currencies. What happens if one gold mine (France) sets a lower interest rate then the other gold mine (Germany)? Again we have infinite arbitrage opportunities. But now both mines (both France and Germany) will be required to redeem the other's gold (currency), and both will make losses. Whichever one has the strongest will, and the deepest pockets, and so cries "uncle" last, will become the central bank.
$1k? Nah!
Update: I'm not claiming any particular originality for these ideas. I got them from three sources (but don't want to claim that I have represented those sources accurately): a working paper from some economist in New Zealand (I think) whose name I have forgotten; conversations with Pierre Duguay, Deputy Governor Bank of Canada; and Willem Buiter's blog.
Worthwhile Canadian Initiative 
Nick:
If A lends at 1% under the market rate, its assets will soon be exhausted and its notes will be worthless. If A tries to borrow at 1% below the market rate, nobody will lend to it. If A lends at 1% above the market rate, nobody will borrow from it. If A offers to borrow at 1% above the market rate, its assets will again become exhausted and its notes will be worthless.
Mike: A doesn’t need any assets at all. It just prints notes. (Unless the paper and ink costs money, which I’m ignoring).
Of course A’s notes will become worthless, in the long run, if it sets an interest rate below the natural rate. That’s what “choosing the rate of inflation” means. That’s what I was trying to prove. But if B’s notes are redeemable at par into A’s notes, B’s notes will be worthless too.
What is the limit to A’s infinite ability? Can A be smaller than B?
“It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don’t have to use paper money; we could use cheques or debit cards instead.”
If by paper notes and paper money you mean currency, I believe there is a big difference. I believe that cheques or debit cards are actually a form of currency denominated debt that could be defaulted on, while currency does not suffer from defaults.
Sorry didn’t see Mike’s comment. You can delete mine.
Can B break off it’s agreement to convert at par though?
Nick said: “Of course A’s notes will become worthless, in the long run, if it sets an interest rate below the natural rate. That’s what “choosing the rate of inflation” means.”
What if there was enough currency for everyone so that no borrowed in currency denominated debt?
edeast: central banks are typically smaller than commercial banks. Because of asymmetric convertibility, the tail can wag the dog. The limit on A? Still got paper? Still got ink? No limit. As long as people are willing to use a medium of exchange denominated in A’s unit of account. Zimbabwe finally hit the limit. There’s a lot of ruin in the currency of a nation, even not so great a nation.
Too much Fed: “default” means failure to fulfill your promise to redeem. A cannot default, because it makes no promise. B can default, because it makes a promise to redeem.
And currency can default, if the currency promises convertibility into something else. Fed notes (and BoC notes) make no such promise, so cannot default. That’s because the Fed and BoC are central banks.
edeast: “Can B break off its agreement to convert at par though?” If B does this, and some people still accept B’s currency and use it as a medium of exchange, then B becomes a central bank in its own right, issuing it’s own currency that fluctuates relative to A’s.
My post said: “It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don’t have to use paper money; we could use cheques or debit cards instead.”
If by paper notes and paper money you mean currency, I believe there is a big difference. I believe that cheques or debit cards are actually a form of currency denominated debt that could be defaulted on, while currency does not suffer from defaults.”
Nick’s post said: “Too much Fed: “default” means failure to fulfill your promise to redeem. A cannot default, because it makes no promise. B can default, because it makes a promise to redeem.”
So, that means cheques and debit cards are a “B” (defaultable), right?
So B is everyone willing to use the currency, is there papers on what the Zimbabwe limit was? Because I’m thinking that the currency failure would start out with people further from the initial lender. There must be some value gap between the different actors, and the value would decrease the further from the money maker.
Nick said: “Fed notes (and BoC notes) make no such promise, so cannot default. That’s because the Fed and BoC are central banks.”
So, what is the price of a central bank’s currency that makes no promise to redeem?
What the hell time zone are you guys in??
It’s late here; I’m off to bed!
edeast, could the limit be when so much currency is printed and devalued that no one wants to lend?
This commenting is crazy, I should refresh before I post.
Sorry I can check for papers tomorrow, I just wondered if you new any offhand.
Too Much Fed. Ya but empirically what is the tipping point? Say you are B2 and you’ve just lent to B3, you can always get another loan from B1. There has got to be a spread in interest rates or other value between actors. So where in the chain does the system stop. Probably at the point where the transient value of the inflationary money is less then the utility of money over barter(If there is no substitute currency). But really I have no idea.
But then again, you could consider barter as the market for discrete currency. So discrete currency will beat out the inflationary semi-continuous money issued by A, around the edges of the system. And I don’t think it necessarily has to be hyper inflationary, just from experience growing up rural.
I find it curious that you omit any mention of required clearing balances—without which there would be no demand for reserve balances (in Canada, as there are no reserve requirements) and thus no linkage between the BoC policy-rate and rates in the loan-market.
Can I say that all actors are the same? Is a collection of personal I.O.U.s the same as a commercial bank’s liabilities? Cause if not this comment won’t make sense.
What are the properties of A’s system’s boundaries? Say two Bs ( B being members who accept the assymetric agreement) at the edge of A’s system are trying to transact. Either, amount problem, or value problem.
Amount problem.
Bq wants to buy something of value $a100 from Bw, but only has $a50. Must substitute, fortunately a coincidence of interests Bq and Bw are also members of C, ( c being stocks, dogs, sexual favors, or other currency) and the substitution is made. If they are not members of any other value system, transaction doesn’t take place.
The C can be just that interaction long.
Value problem.(Inflation)
Bq wants to buy something from Bw, normally Bw would oblige, however they cant seem to settle on a price. The value is $a is decreasing faster than Bw could extract value from.(?) They substitute. Bw is no longer a member of A.
I think you’re missing entirely it with this “asymmetric redeemability” thing. This is just a fancy and not terribly accurate way of portraying an agency relationship, whereby the commercial banks act as distribution agents for the central bank’s notes.
The central bank always forces the commercial banks to keep reserves with it. ALWAYS. The question is the level. The fact that the required level is zero in Canada is irrelevant. Banks are not allowed to keep negative balances for long. They must keep zero balances. That’s much different than saying they’re not required to keep balances. So the forced reserve balance is what makes a central bank central. This is common sense, since the central bank is the commercial banks’ banker. That’s what central bank means. And that’s what makes a central bank central.
The currency distribution function is just a sideshow. The central bank could just as easily set up its own branch system and require retail customers to get their notes there. Customers would pay for the notes with cheques written on the commercial banks, cheques which the CB would clear against the reserves of the commercial banks, since it is part of that clearing system.
Much more important than the distribution function is the fact that currency is a CB liability. And to understand why that is the case, you have to understand post Keynesian economics and Chartalism, and the forced relationship between taxation and CB fiat money issuance. I’m not going to get into that here.
Sorry, you’re way off here.
Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks.
This asymmetry perception is not real; it is only due to the existing note distribution agency relationship. A central bank with a branch system would redeem its own monetary liability (central bank notes) by issuing another (cheque on the central bank). When the customer takes that cheque to a commercial bank, it converts the central bank liability (cheque) to a monetary liability of the commercial bank, because the commercial bank gives its own deposit in exchange for cheque. Therefore, the central bank has effectively redeemed its own liability for a commercial bank liability. (The commercial bank then exchanges the cheque with the CB for a reserve credit.)
Don’t confuse stocks with flows in the agency relationship. The flow relationship is what characterizes the central bank role. Stocks of notes held by the banks are just inventories.
Nick:
“A doesn’t need any assets at all. It just prints notes.”
1) Name a bank, central or otherwise, that has ever issued notes (of positive value) without holding assets against them.
2) If the public, for some reason, desires 20% fewer notes, what will your zero-asset central bank use to buy back those notes?
3) Since A gets a free lunch in your zero-asset world, what prevents other banks from issuing rival notes, getting a piece of that free lunch, reducing the demand for A’s notes, and ultimately driving their value to zero?
4) If A’s notes have no backing, what happens when private banks issue derivative moneys, each of which is convertible into A’s notes (or something of equivalent value). Those banks can even operate offshore, where there is no reserve requirement. As the offshore bank issues 1 unit of derivative money, it puts itself in a short position in A’s notes, at the same time that it reduces the demand for (and value of) A’s notes. The offshore bank profits as A’s notes fall to zero value.
Central bank monopolies extend far beyond the issuance of paper notes. They can force banks to be members and abide by their rules. For instance, rules might include the requirement for a certain reserve balance, or the necessity of holding deposits for clearing/settlement purposes.
It is their ability to count on compulsion and threats of penalty that makes them “central”. Remove the government granted monopoly and you’d have a few private clearinghouses taking over the role once played by the central bank, and probably doing a much better job of things.
Good comment by JP Koning.
All good comments but beside the point. What makes the BoC paper special is that it is recognized by the government as government debt and as legal tender.
Commercial bank notes have a similar relationship to BoC notes as an ADR on BHP Billiton has to an actual BHP share. The ADR may pay the same dividend but that dividend doesn’t come from BHP (it comes from the ADR issuer) and BHP doesn’t recognize the ADR as an ownership share and doesn’t give the ADR holder any votes at the AGM. An intermediary is free to issue as many ADRs on BHP stock as they can sell but need to have enough money to pay the dividends (which explains why they usually fully hedge with the underlying stock). If the intermediary issues to many ADRs and can’t pay the dividend then the ADR value falls relative to the value of a BHP share. You don’t observe that very often because they are usually fully hedged but the principle remains.
By the same token you don’t often see the difference between commercial bank issued money and BoC money but sometimes you do (when a bank gets run).
Actually I take back the “beside the point” remark. JP Koning’s comment is also right on the money, so to speak.
Koning’s point that Central Banks have power beyond money (there’s that power thing again) is a good one, but anyone who is willing to claim that it’s likely that unregulated banks will do anything better than a government controlled bank has not been living on this planet for the past year.
Or perhaps the the question is: Better for who? Evidence suggests the answer is: Not me.
Lots of good comments.
Too much Fed: “So, that means cheques and debit cards are a “B” (defaultable), right?” In practice, yes. We can imagine central banks issuing chequeing accounts and debit cards, but I don’t think they do (at least not for ordinary people or firms).
“So, what is the price of a central bank’s currency that makes no promise to redeem?” Price in terms of goods? For the US and Canada, $1 buys you about 3/4 of a cheap cup of coffee, so that’s the price of $1.
Jon: “I find it curious that you omit any mention of required clearing balances—without which there would be no demand for reserve balances (in Canada, as there are no reserve requirements) and thus no linkage between the BoC policy-rate and rates in the loan-market.”
The “standard” approach to explaining how central banks control the money supply is via the formula M = [(1+c)/(r+c)]B (if I’ve remembered it right), where c is the currency ratio, r the reserve ratio, M the money supply, and B the supply of central bank money.
Yes, if c or r are non-zero, and pinned down by something, you can use this approach to explain why a bank is a central bank. It’s a sufficient condition, if you like. But I’m arguing it’s not a necessary condition for a bank to be a central bank, and that central banks could still control monetary policy even in the limit where c and r approached zero, or were of indeterminate value. I’m arguing that asymmetric redeemability is what ultimately gives central banks control over monetary policy, even if reserves and currency vanished.
edeast: “Can I say that all actors are the same? Is a collection of personal I.O.U.s the same as a commercial bank’s liabilities? Cause if not this comment won’t make sense.” If people had sufficient trust in your IOUs that they circulated as a medium of exchange, then they are money, and you are a (commercial) bank. But in practice this very rarely happens.
original anon: you and I have accounts at the commercial banks, and the commercial banks have accounts at the central bank. The central bank is the bankers’ bank. That is part of what being a central bank has meant, historically. But will it always be the case? And more importantly, is it necessary that the central bank be the bankers’ bank in order for central banks to be able to control monetary policy (interest rates and inflation)? If my argument is correct, it is not necessary. Asymmetric redeemability (plus will) is sufficient.
original anon @8.58. You lost me on this comment. “Therefore, the central bank has effectively redeemed its own liability for a commercial bank liability. (The commercial bank then exchanges the cheque with the CB for a reserve credit.)” I would disagree. It is the commercial bank that redeemed the CB liability for a commercial bank liability. The CB had no obligation to do so.
Mike: Good questions, and I would love to get into an argument about the backing theory of money, and the possibility of currency competition. But that would deserve a thread (or two) of its own. I want to stick to the narrower question here.
JP: Central banks may indeed have other legal controls over commercial banks. But are these legal controls necessary for central banks’ power to control monetary policy? I am arguing that they aren’t. Asymmetric redeemability (plus will) is sufficient.
Adam P: ” What makes the BoC paper special is that it is recognized by the government as government debt and as legal tender.” I disagree on this, but again it would take me too off-topic. The questions of why the central bank notes have value, are used as media of exchange, and why the commercial banks choose to peg to the CB notes, are all interesting questions, but I ignore them here. I just assume they do.
But I really like your ADR analogy, I think. I think it supports my argument. Even if the ADR market were much bigger than the true BHP market. But the BHP tail will still wag the ADR dog.
But Nick, we’ve already agreed that central bank notes are not the only medium of exchange. Commercial bank debt (checks, credit cards etc.) are also used as the medium of exchange.
The question is, why does all inside money have to backed by central bank notes or reserves? And the reason is that only central bank debt is legal tender.
The fact that inside money is generally fractionally backed is important but immaterial in trying get at what defines a central bank. (I’d imagine that dividends make it unprofitable to issue ADRs with fractional backing.)
All you’ve demonstrated is the existence of an agency function whereby commercial banks hold central bank liabilities in inventory for distribution. They act as distributors and redemption agents. There are better ways of demonstrating the centrality of a central bank than illustrating its principal role in a principal agent relationship. You haven’t demonstrated a unique asymmetry – it’s one that exists in any principal agent relationship. It really shows nothing about what’s central to central banking. It only shows what’s central to a principal agent relationship.
I don’t think it’s dividends on ADRs that make fractional backing unattractive, per se. It’s the risk of capital appreciation. To hedge that risk they would either need to buy massive quantities of call options (expensive), or fully back the ADR.
It shouldn’t be hard for a bank to beat the return of a dividend on a stock. Many large companies have dividends yielding lower than 2.5%.
Nick:
“I would love to get into an argument about the backing theory of money, and the possibility of currency competition. But that would deserve a thread (or two) of its own.”
Good idea Nick. Whenever you’re ready, I’ll be lying in wait.
Nick, I think the problem everyone is having is here:
“Here’s the answer. Commercial banks promise to redeem their monetary liabilities for the monetary liabilities of the central bank at a fixed (or at least pre-determined) rate. Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks.”
The statement is true but only begs the question of why do commercial banks promise to redeem their liabilities for central bank liabilities? This question you haven’t answered. JP’s comment and mine are trying to answer this question.
What you say subsequently, drawing out the implications of the asymetric redeemability I think everyone is agreeing with.
Adamp; In your description how does the intermediary make money? Sounds like a ponzi scheme. The ADR intermediate has to collect dividends from the BHP, because the ADR represents, a receipt for real stock.
I have questions about adding the government to the model, ala chartalism du anon originale, and the legal tender laws of adamP.
I think it deals with this assumption… “B promises to redeem its notes for A’s notes at par.”
Why would an agent agree to that?
But if you relax that assumption, then the definition changes;
“Can B break off its agreement to convert at par though?” If B does this, and some people still accept B’s currency and use it as a medium of exchange, then B becomes a central bank in its own right, issuing it’s own currency that fluctuates relative to A’s
I think that is a tautology.
The last factor, is people accepting the currency. Chartalism suggests that there is an agent G, who will only accept A’s currency. So I’m pretty sure that the people who interact with G and the people who use A’s currency are close to the same set.
So does B agree to the 1:1 arrangement for access to these people? What other reasons are there?
Adam P @4.41 : Thanks for that comment, because it clears things up for me. I was really wondering why so many commenters seemed to be having trouble with what I posted.
I just assumed that B promised to redeem its notes (monetary liabilities) at some fixed rate (e.g. par) with A’s notes. I didn’t try to explain why B would do that. That’s because my motivation was to explain to someone like Gary Marshall why the Bank of Canada (and not the Bank of Montreal, etc.) was in charge of monetary policy, and had power that BMO, TD etc. didn’t have, even though it was much smaller, and that you couldn’t see that power just by looking at their balance sheets.
So if you argued that the underlying reason for asymmetric redeemability was because A’s notes are legal tender, I would (mostly) disagree with you, but even if I did fully agree with you, I wouldn’t change what I wrote in the post. It’s a separate, albeit interesting, question.
To my mind, the main reason why commercial banks promise to redeem their money for central bank money is custom. Path-dependent, QWERTY equilibrium, in the choice of medium of account. It’s like languages; we speak the same language as people around us have been speaking. So if the people around us use the dollar as medium of account, we want to use money that is denominated in dollars, and is worth what it says it is worth in dollars. The Bank of Montreal could make up a new medium of account, and issue monetary liabilities in that new medium of account, but nobody would use them, because nobody else uses them.
Legal tender laws reinforce this QWERTY equilibrium by defining “the Canadian dollar” as “one of those bits of paper issued by the Bank of Canada. Like a legal dictionary.
On reading edeast’s comment, I think it’s similar, except when I say that people want to use money denominated in dollars, edeast would add that government is an important player, along with regular people, and what the government wants to use as money matters.
edeast: “I think that is a tautology.” Yes, I think it sort of is.
Here’s another way to think about the relation between central and commercial banks: if the Bank of Canada were to peg the Loonie to the US dollar, the relationship between the Fed and the BoC would be the same as the current relationship between the BoC and BMO.
Well, I would have said that custom and things like liquidity drive what the government declares as legal tender but are not the defining property of anything. After all, when a country like Ecuador(?) dollarizes, the choice of USD as currency is driven by it’s international liquidity but it actually becomes Ecuadorian money by legal decree.
A better example is the gold standard, the choice of gold as money was entirely driven by custom but by the time we got to the 1900’s gold was legal tender even though the medium of exchange was not gold but fractionally backed notes.
One piece of evidence that legal status trumps custom is that abandoning the gold standard did not leave us with a worthless currency. The reluctance to abandon the ‘golden fetters’ during the depression was largely a worry that the custom was paramount but it doesn’t seem that way ex-post.
“Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks.”
Before alleging this difference, understand that the customers of the central bank are not the same as the customers of the commercial banks.
The customers of the central bank are the commercial banks themselves. The reason for this is two-fold.
First, it is due to the fact that the commercial banks are required to maintain reserves (even if the level is zero) at the central bank. This requirement is actually what makes central banks central.
Second, it is because the commercial banks have an agency function with respect to central bank note distribution and redemption. This intervenes between what otherwise might be a direct relationship between the central bank and commercial bank customers in the case of central bank notes.
When one takes into account this customer base difference, your statement quoted above is seen to be wrong. One must ensure that it pertains to a situation in which it is the commercial bank that is requesting redemption proceeds in the form of its own liability. Your statement does not pertain to such situation. In general, anybody requesting credit in terms of his own liability is requesting cancellation of that liability. This actually happens when a CB extinguishes commercial bank borrowing from the CB in return for the commercial bank presenting it with a CB liability in the form of bank reserves. So your statement is false in the context of the actual institutional arrangements that pertain between a CB and the rest of the system. And so it obviously does not capture what makes a central bank central.
To repeat from earlier, it is the fact that a central bank imposes reserve requirements on commercial banks (even if the required level is zero) that makes a central bank central.
Ar, you two are tough critics! (But valued commenters despite/because of that!).
Adam: I can see legal tender laws as being very important for pre-existing debts. They define what legally counts as paying the debt. But for current exchanges, sellers can presumably choose medium in which they set prices and accept for payment “sorry, but I won’t accept cash for my house, but I will accept payment in bottles of whisky”.
Abandoning gold convertibility did not make paper money worthless, because people had already grown accustomed to using (convertible) paper money. And had already experience temporary suspensions of convertibility. That would be my explanation. Let’s try it the other way: suppose a government introduced a new paper money, without making it convertible into anything that had previously been used as money, but did declare it to be legal tender. So we have legal tender without custom. Could that work? When Cambodia introduced a new currency after the total economic collapse following the Kymer Rouge, they made it convertible into rice, I think. Presumably they didn’t think “legal tender” would be enough.
original anon: sorry, but you lost me in the middle of your penultimate paragraph: “In general, anybody requesting credit in terms of his own liability is requesting cancellation of that liability. This actually happens when a CB extinguishes commercial bank borrowing from the CB in return for the commercial bank presenting it with a CB liability in the form of bank reserves.” I have made several attempts to wrap my mind around those sentences (and how it shows symmetry of redeemability?) but failed each time. May be my fault.
Let me try to re-frame: I am looking for a “minimal” set of sufficient conditions for a bank to be able to control monetary policy. I am not saying that other sets of conditions (reserve requirements etc.) may not also be sufficient. I believe that condition is one-way obligation to redeem.
Are you saying that asymmetric redeemability is not a sufficient condition? Or are you saying that we do not in fact have asymmetric redeemability in Canada today (for example), so that the power of the Bank of Canada must instead rest on something else (that reserves may not fall below zero, for example)?
And I thought that in Canada commercial banks could have negative reserves at the Bank of Canada? Or am I muddled on the institutional rules again?
Adam: to put it another way, do legal tender laws really have coercive bite, or are they just a sunspot that helps people coordinate on a new monetary equilibrium, when a government introduces a new currency? Custom is the best sunspot, but announcements can work as well, I suppose.
I think that this discussion has become tangled because it is necessary to define what you mean by a central bank. Nick seems to be thinking in terms of controlling interest rates, whereas original anon (JKH?) emphasises the hub role in inter-bank payments settlement, and Mike Sproul is considering the nature of base money. A central bank can be some, all or none of these, and I dare say has been in history and still is in different countries.
Perhaps the most basic function of a central bank is to provide the medium of exchange (which has to be a durable store of value to some extent and is also likely to become the unit of account by convention). To do that, it can issue currency against anything of value (traditionally gold), and it need not be concerned with influencing interest rates at all.
Because currency is a substitute for short term debt, a currency issuer has some influence over short term interest rates, but this is enhanced if, instead of gold, the currency issuer trades short term debt for currency (although there were other, historical reasons, why central banks came to hold debt). Debt assets backing the currency are automatically created when the currency issuer lends currency or, equivalently, makes a commitment to supply currency on demand (ie credits a reserve account).
Because issuing zero-return currency tends to be profitable, there may potentially be more than one currency issuer, but the government may legislate in favour of one, traditionally to extract monopoly profit, but also for efficiency. Legal tender laws support this monopoly, especially when they apply to taxes, but they may even be essential if the government obliges the currency issuer to hold more government debt than might be otherwise acceptable to potential currency holders.
Though it is clearly a central role, there is no reason why the currency issuer needs to be the settler of inter-bank payments, but the banks involved typically need to hold a buffer stock of the medium of exchange to participate, which generates some demand for currency or reserves, and hence enhances the currency issuer’s influence over interest rates.
So, what function or mix of functions defines the central bank for the purposes of this discussion?
“In general, anybody requesting credit in terms of his own liability is requesting cancellation of that liability. This actually happens when a CB extinguishes commercial bank borrowing from the CB in return for the commercial bank presenting it with a CB liability in the form of bank reserves.”
Commercial bank borrows from the central bank because it is short reserves.
That increases a commercial bank liability (loan) and increases a central bank liability (reserves).
Commercial bank later recovers and recoups excess reserves sufficient to repay its loan from the central bank.
Commercial bank repays the loan with a central bank liability (reserves).
Central bank extinguishes the commercial bank liability (loan).
So as per my second sentence, the CB has extinguished a commercial bank liability by accepting a central bank liability in payment.
Returning to your original quote:
“Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks.”
The central bank in the case of loan repayment has redeemed its monetary liability because it extinguishes the reserve liability used as repayment for the loan. And it has issued a credit to the commercial bank in exchange. The form of credit it has issued is the cancellation of the monetary liability of the commercial bank (the loan). You can think of this directly as an accounting credit in the form of the commercial bank monetary liability, which when combined with the pre-existing monetary liability debit position, results in a net zero liability position. That is the actual accounting description. The accounting description also equates to a more conceptual interpretation whereby the central bank in the exchange is providing asset value to the commercial bank (in return for its payment of reserves) equivalent to the value of the monetary liability as an asset, which when combined with the pre-existing liability, nets the position to zero as an asset-liability offset.
This is the way you have to think of your sentence above when the central bank’s customer is the commercial bank rather than the commercial bank’s customer. It’s the way you have to think of the “monetary liability of the commercial bank” that is relevant to that interface. The monetary liability of the commercial bank to its own customer is completely irrelevant when talking about the relationship between the central bank and the commercial bank. The nature of that relationship again is determined by reserves and by a currency agency function.
Obviously I don’t think asymmetric redeemability is a sufficient condition because I’m alleging and demonstrating that asymmetric redeemability is a false characterization. I’m proving symmetry exists because of the nature of the direct relationship between the central bank and the commercial banks. If you’re going to do symmetry comparisons about redeeming liabilities, you need to know which liabilities are being redeemed in each of the two cases that frame the symmetry comparison.
Whether or not Canadian banks can have negative reserves is irrelevant to the issue of discussing redeemability. But since you ask – no they can’t have negative reserves, to the degree that a negative end of day position (or any required accounting period position) forces them to cover that shortfall by borrowing from the central bank. The borrowing brings reserves back to zero.
Whether or not Canadian banks can have negative reserves is very relevant to the issue of monetary control. That’s what it’s all about. When the central bank wants to increase rates, it is essentially that it has the power to force the commercial banks to borrow in the event of a negative reserve position. It’s the demand for that money and the power to enforce a penalty rate that makes the central bank central.
BTW, redeemability of any sort is not a sufficient condition for monetary control. As I’ve said ad nauseum, it’s simply an agency relationship in the case of central bank note distribution by commercial banks.
The necessary mechanism is banks reserves, with accompanying rules for maintaining required balance levels (even if zero).
One might include actual note issuance as a necessary condition as well, particularly if one is a Chartalist. But that’s quite a separate issue than the distribution function for the notes and the way in which notes are distributed and redeemed. As noted, the central bank has the option if it wants of issuing currency directly to commercial bank customers. It doesn’t do this for reasons of obvious institutional economies of scale. It’s more efficient to use the commercial banks as agents.
“I think that this discussion has become tangled because it is necessary to define what you mean by a central bank.”
But that’s the whole question of the discussion. What makes a central bank central?
Incidentally, edeast asked about papers covering the “Zimbabwe limit” to currency issuance. The classic academic paper (not necessarily the most accessible or informative) is Cagan’s “Monetary dynamics of hyperinflation”.
“it need not be concerned with influencing interest rates at all”
I’d be interested in an example of one that isn’t, present day or historic.
Wow. This is an interesting thread.
But I think I agree with most of the commenters. Asymmetric redeemability may be how the central bank executes its power, but in order to have asymmetric redeemability there has to be some other condition that prevents the other banks from unlinking their currency to the central bank.
In Nick’s original example, bank B could simply unlink its currency from bank A, and then they’d both presumably be quasi-central banks (like the two gold miners/France-Germany example). In other words, why the heck would bank B want to link its currency to bank A’s if it had a choice?
Thinking about it, I can see the remote possibility of a central bank without currency issuance (which wouldn’t preclude other forms of debt issuance by the government), but I can’t see the possibility of a central bank without reserve accounts held by the commercial banks. That’s what I’ve been arguing. If notes are issued, distribution and redemption arrangements are way down the list in importance.
I’d agree about everything you say about asymmetric redeemability (AdamP captures my views at 4:41am). But I’m more interested in the general asymmetric relationship between a central bank and private banks, a relationship which can take the form you talk about. But it can also be, say, an asymmetric reserve requirement, in which private banks must hold a certain % of government currency as reserves, but the government bank need not hold private currency as reserves.
But the point is: how does a central bank get to the point of having any sort of asymmetrical power to begin with? In my eyes that’s what determines the “central” in central banking.
I think your point about custom is incorrect. It is the government’s coercive power (at the point of the gun, so to say) exercised through legislation, not evolving custom, that allows it to arrive at its “sweet spot”. I just consulted my Breckenridge – The Canadian Banking System 1819-1891 for some examples.
In 1870, Canadian private banks were for the first time required by law to hold one third of their reserves as government issued Dominion notes (raised in 1880 to one half). Prior to that they’d held specie, other domestic notes, foreign notes, whatever they’d wanted. Then and there you see the beginning of the asymmetrical relationship between private banks and government issuers.
In 1880, Canadian banks were required to redeem their notes in Dominion notes at the option of the payer. Prior to that, redemption need only be in gold. Again we see the growth of asymmetric power, since Dominion notes had no requirement to be redeemed in private notes. Eventually the final steps in this process would be taken to the arrive at what we have today – asymmetric redeemability.
So the minimal condition to control monetary policy, in my view, is simply coercive power and the will to use it, as this creates some form of asymmetry between private banks and government banks.
“But that’s the whole question of the discussion. What makes a central bank central?”
Also, what makes central banking central?
Central banking precedes a formal central bank, at least it precedes the actual erection of one of those multi-columned central banks chartered by a highly complex central bank act. Canada had a form of central banking long before the introduction of the Bank of Canada in 1935. I would say central banking starts the moment that the first bank rule is centralized by a body with coercive power.
Thanks Rebel Economist.
I’ll look for it.
I found a paper, yesterday. On fiat currency failure.
It includes the government in the model. And tests 4 levels of government involvement.
1. Economy using backed money.
2. Economy required to use fiat money.
3. Economy using fiat money with a gov that can create money to make purchases.
4. Economy using fiat money that has exogenous growth of money supply at the same rate as with an active government.
Comparing (1-2) reveals effect of fiat money.
Comparing (2-3) reveals impact of government spending.
Comparing (3-4) determines if difference between fiat money and active government is due to the level of the money supply.
Then they also ran their test for a limited time, at the end of which the fiat currency was worthless, to simulate “extreme civil unrest” and test whether hyperinflations are caused by the expectations the the money has a short future.
Some results, fiat money can provide stable regime but level of inflation is dependent on the horizon.
The also show how government spending destabilizes the whole system, causing hyperinflation and decreased efficiency. What they don’t know is whether it is because they enter and compete in the market or the erratic way of injected money.
Also repeated experience with the horizon, causes increased inflation and decreased efficiency when approaching the horizon, but trade still takes place with the fiat currency.