What makes a central bank special?
The Bank of Canada can borrow and lend. So can the Bank of Montreal. So can I. Nothing special there.
The Bank of Canada can set any rate of interest it likes when it lends. So can the Bank of Montreal. So can I. Nothing special there. "If you want to borrow from me, you have to pay x% interest." We can all say that. (Whether anyone will want to borrow from us at x% interest is another question.)
The Bank of Canada can set any rate of interest it likes when it borrows. So can the Bank of Montreal. So can I. Nothing special there. "If you want to lend to me, you have to accept y% interest." We can all say that. (Whether anyone will want to lend to us at y% interest is another question.)
And yet there's this utterly bizarre belief among many economists that it is the Bank of Canada that has the power to set Canadian interest rates, just by borrowing and lending. And that the Bank of Montreal, and ordinary people like me, somehow lack this special power. Even though we can borrow and lend too.
Now it's true that the Bank of Canada is a lot richer than me. But what if I were a Canadian Bill Gates or Warren Buffet? And is the Bank of Canada richer than the Bank of Montreal? That can't be the difference.
Now it's true that the Bank of Canada can create money at the stroke of a pen, and I can't. But the Bank of Montreal can. What makes the Bank of Canada special, compared to the other banks? What power does the Bank of Canada have that the Bank of Montreal lacks?
I'm going to give the same answer I gave nearly three years ago. And then I'm going to expand on it.
The fundamental difference between the Bank of Canada and the Bank of Montreal is asymmetric redeemability. The Bank of Montreal promises to redeem its monetary liabilities in Bank of Canada monetary liabilities. The Bank of Canada does not promise to redeem its monetary liabilities in Bank of Montreal monetary liabilities.
Here's an analogy. Suppose the Bank of Canada pegged the exchange rate of the Loonie against the US Dollar by promising to redeem Loonies for US Dollars at par. Then Canadian monetary policy would be set by the US Fed. But suppose instead that the US Fed pegged the exchange rate of the US Dollar against the Loonie by promising to redeem US Dollars for Loonies at par. Then American monetary policy would be set by the Bank of Canada. Whichever bank makes the promise to redeem its liabilities loses its freedom to set monetary policy, and has to follow the other bank's lead.
Canadian monetary policy is set by the Bank of Canada, and not by the Bank of Montreal, because it is the Bank of Montreal that promises to redeem its money for Bank of Canada money, and not the other way round.
If I have $100 in a chequing account at the Bank of Montreal, I can demand $100 in Bank of Canada currency. It is the Bank of Montreal that must satisfy my demand for redemption.
If the Bank of Montreal has $100 in a chequing account at the Bank of Canada (it does), it can demand $100 in Bank of Canada currency. In that case, it is the Bank of Canada that must satisfy the Bank of Montreal's demand for redemption.
If I have $100 in Bank of Canada currency, I cannot demand redemption from anyone.
The Bank of Montreal can refuse my request to open an account to convert my $100 Bank of Canada liability into a $100 Bank of Montreal liability. It is not obliged to redeem my money.
And the Bank of Canada would just call security if I tried to redeem it there.
Bank of Canada currency is irredeemable. And yet people still accept that irredeemable currency in exchange for goods and services. It is that fact that makes the Bank of Canada special. It is that fact that makes the Bank of Canada a central bank. It is that fact that gives the Bank of Canada the power to set Canadian monetary policy, and to do things the Bank of Montreal cannot do and I cannot do.
I cannot issue irredeemable bits of paper (or electrons) and get people to use them as money. The Bank of Montreal cannot issue irredeemable bits of paper (or electrons) and get people to use them as money. The Bank of Canada can.
There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power. That's what makes central banks central.
Worthwhile Canadian Initiative 
BOC sets the rate by having the power to issue unlimited amount of “tax credits” – money accepted as payment of taxes. Since tax credits are always desirable, BOC can issue as many as it takes to set the rate. BMO has no such power – when it issues too many of its liabilities (which are only worth anything because they are ultimately redeemable for Canadian dollars = tax credits) BMO sets itself in for a scenario where it cannot service its debts. BOC can never face such a scenario.
Dan Kervick: “And if that were the case, wouldn’t that dominant bank have the effective ability to set interest rates by virtue of its preponderant market role?”
Probably. The cb has unlimited power to control rates in the market for interbank cash balances. In a competitive banking environment, this market determines the marginal cost of funds for all commercial banks, so the cb has total control over the risk free rate. But if one bank was totally dominant it might expect that deposits created via new lending would largely stay on it’s own balance sheet and its own deposit rates might be a more significant contributor to the marginal cost of funds than the interbank market. This is certainly not the case in Canada, the US, or Europe. In most of the world the cb is fully in charge of the risk free rate.
Nick: wrote the above before I saw your last comment.
“Monetary policy is not interest rate policy”
Maybe. At the ZIRB, the composition of the cb balance sheet matters a bit. But contingent on a particular non-zero rate of interest the quantity of money doesn’t matter. It is simply an endogenously determined variable that automatically compensates for changes in the velocity of money. Woodford rules 🙂 (Yes, that was fully intended as a provocative challenge just to help get you in the mood for your next post!).
Hi Nick,
I had a debate about banks “printing money” on another blog; I think what might be helpful is to follow the ledger of the BoC and compare it to BMO. I think the accounting is different, which is your point, but it might help to put it in tabular form. We can all balance chequebooks. A good question to ask is is there ever a point in which a central or chartered bank books an asset “out of thin air”.
The US government has a big holding on the Fed’s balance sheet. This is what enables the Fed to operate on the loan side. Of course the US Government should be paid for it, it made a deposit after all. But that deposit forms the core of a central bank’s balance sheet.
Same for the Bank of Canada. Further, monetary policy is not just setting the interest rate for clearing interbank settlements, it includes the setting of the rate of interest through the control of government securities auctions.
This is how the Bank of England became a central bank.
If it isn’t the government’s banker, it isn’t a central bank. It is the defining characteristic of a central bank.
Nick,
I thought the Fed issued reserves in exchange for bonds, not currency. When demand for marginal bank reserves is zero, banks accumulate ER’s. ER’s pay the IOR. So the stock of Fed assets (bonds) could theoretically earn less than its liabilities (ER’s and currency) pay: a negative NPV. If the private sector’s demand for currency rose, that would help, but it would also be inflationary.
In any case, it would be interesting to hear your thoughts on whether Fed buying of risk assets just transfers duration/credit risk back to the private sector via the Treasury. If so, the portfolio balances effect is limited to the reduction in the liquidity risk held by the private sector. That leaves the purpose of buying risk assets as “signalling” future intentions. However, if the portfolio balances effect is small today, what “signal” would promising future QE send?
K,
“It is simply an endogenously determined variable that automatically compensates for changes in the velocity of money.”
I rather wish that was the case, because then we could close the book on macroeconomics as the study of monetary disequilibria and start studying something a little bit more down to earth, like the consumer behaviour of gypsies in the modern developed European nations. However, since we repeatedly seem to end up with monetary disequilibria, we’ll have to press on and assume that Kaldor was wrong on this one (that’s not to say that he was right about anything else).
If one needs an empirical refutation of the theory that the quantity of money is demand-determined, then I recommend Tim Congdon’s “Keynes, the Keynesians and Monetarism” where he provides (a) an econometric reason to think that the money supply isn’t demand-determined and (b) a reason to think that the microfoundations of theorists like Kaldor are atrocious e.g. they depend on strange (presumably psychotic, in fact) behaviour by bankers.
For the BMO monopoly post, did the BOC ever make submissions to government a couple years ago when all the banks were lobbying to allow themselves to merge?
The fact that people don’t understand this is because they don’t know about the time before Fed where every bank had its own notes. What happened then was that due to various political issues the governments monopolized the creation of money and everyone has to use one set of bank notes, the one issued by BoC and its monopoly is strengthened by the fact that it is legal tender.
Historians of banking: during the period of significant private money issuance in the US, Canada and UK, was it still the case that taxes were paid in the “official” currency?
Ralph Musgrave:
I wouldn’t have to be the grocer’s landlord. I might be the landlord of a farmer who sells peaches to the grocer. For my bits of paper to circulate as money, it is only necessary that I am well known.
I, like the government, would also accept rent payments in the form of houses, cars, beaver pelts, etc. If I’m owed $5 of rent, I’d accept a $5 sandwich in lieu of rent. I don’t have to be paid in my own bits of paper, and neither does the government.
vjk: “Paying in FRNs (central bank money) is not even an option, much less an obligation.”
Or really?! And if you are a bank how do you pay taxes then?
Surely one can not pay taxes (directly) using FRNs because commercial banks are agents for the central bank which is the agent for the government. But to say that you can not come to a bank and ask to make a money transfer (tax payment) with FRNs is intellectually dishonest.
Determinant:
… and this is why the ECB cannot act as an Effective Lender of Last Resort: European governments do not hold deposits at the ECB so the ECB can only loan out emergency funds if it is permitted via the political process.
Which is fragile and that kills any notion of it being an effective LoLR.
So the ECB is not an effective central bank – especially not at zero lower bound interest rates.
IMO this also partly explains why Trichet was so keen on increasing rates (at exactly the worst moment): his only real leverage as a central banker was a non-zero interest rate with plenty of space down – and ZIRP has been with us for 3 years and he wanted his (only) tool back, badly.
Sergei:
“Or really?! And if you are a bank how do you pay taxes then?”
Really, that’s the operational reality, not pure MMT model.
As to intellectual or otherwise dishonesty, the bank is not part of the private sector and is not a representative taxpayer/agent. Think about it.
“What makes a central bank special?”
Well, one approach would be to look at the historical development of this institution, why it was created, and what role it plays. Look out your window.
A second approach would be to close the blinds and pontificate.
Central banks are called Reserve Banks. Their customers are other banks. Their primary role is to ensure that their customers can access the reserves they need. That is their essential nature, it is what makes them special. The need for this can be found in private attempts to set up clearinghouses that would match banks with excess reserves with banks with insufficient reserves, such as the Bank of Suffolk.
When banking crises became so large as to overwhelm the private Reserve banks, a government, or Federal Reserve Bank was created.
In the course of ensuring that banks have sufficient reserves, a side effect is to reduce banking failures, allowing the inside money supply to be more accepted, and allowing the money supply to be endogenous. Reserve Banking does not perfectly guarantee this — you still need other things, such as a deposit insurance and good regulation, a payment system, etc.
So what makes a central bank special is that it allows currency to be irrelevant as deposits become perfect substitutes for it.
That is the evidence based, historical, operational description.
Sheer pontification can lead you to basically any conclusion, depending your priors. Why you would fixate on convertibility versus non-convertibility is puzzling. If you want gold for your money, you can always buy gold with it. A nation that pegs its currency to gold only guarantees you a fixed exchange value, it does not prevent you, as the individual, from converting your money into gold. But of course the price of gold versus other goods fluctuates wildly, so what value is this guarantee? Moreover, nations that peg their currency to gold are free to and often change the value of the peg. No peg is ever fixed — it is up to the discretion of the government, based primarily on the forex policy. So in all cases, whether pegged or unpegged, you have a tension between freedom to offer a certain discount rate and the effect this has on current account. In a pegged regime, you are concerned about gold outflows, so if you de-value import prices rise and you may face inflation. In a non-pegged regime, if you lower the discount rate, you risk the same effect — capital outflows and inflation.
So how can pegged versus non-pegged currencies tell you anything special about Reserve Banks?
They can’t.
Reserve Banks existed during the gold-standard era, and they existed afterwards, playing essentially the same role in both cases, namely ensuring that their customers (other banks) were sufficiently liquid to make their liabilities equivalent to currency, allowing the quantity of money to be demand determined while the discount rate is a policy variable.
I should add that I agree that central banks in nations that peg are more constrained, and therefore less effective, then central banks that do not peg.
But the difference is one of quality not kind. In both types of nations, central banks have a special or essential role in supporting the domestic banking system, allowing deposits to be substitutable for currency.
The essential role of a central bank does not change when a nation abandons a peg, or moves from a peg that is changed only during crisis periods to a floating peg, or from a floating peg to a fully floating exchange rate.
Historians of banking: during the period of significant private money issuance in the US, Canada and UK, was it still the case that taxes were paid in the “official” currency?
As far as I can tell, taxes were payable by cheque or cash with Cash being an acceptable bank note. In Canada where the Government of Canada used the Bank of Montreal as its fiscal agent, BMO notes could be considered the “best” but any note drawn on a big Chartered Bank like the Imperial Bank or the Bank of Toronto were acceptable.
It would be better to say that notes drawn on banks in doubt could be refused, like a note drawn on the Home Bank which went bust in 1923.
Governments did not demand gold in direct payment and Dominion Note issues were for under $5.
The caveat is that income taxes came in as the chartered bank note era ended so the overlap is slim. WWI also complicated matters as it drove up taxes and made governments suspend the Gold Standard.
Determinant- thanks. I studied Canadian history as a minor course for a year at university, but we didn’t get into the details of your banking system.
vjk: “As to intellectual or otherwise dishonesty, the bank is not part of the private sector and is not a representative taxpayer/agent. Think about it.”
Any bank is an operational agent obliged to perform certain functions and comply with certain rules by its banking license. Think about it.
In the post I had BMO pegging its money to BoC money, which wasn’t pegged to anything.
The real world, of course, can be more complicated. E.g.:
1. Money A is pegged to Money B, which is pegged to Money C, which is pegged to gold.
(That, roughly, is the Bretton woods system, where B is a national currency, and C is US dollar currency) Could we say that B is central wrt A, C central wrt B, and gold miners are ultimately in charge of monetary policy?
2. Money A is pegged to money B, and money B is pegged to the CPI basket of goods. But bank B can choose, if it wishes, to change that peg, and bank A cannot.
That, roughly, is Canada’s inflation targeting regime. A is BMO, and B is BoC.
That asymmetry is pretty important. The fact that all dollars (US or C) are effectively backed by the central bank makes life a lot easier.
Before the US had a central bank, in the 19th century, any bank that wanted to could issue paper dollars. Of course, not all dollars were equal, and anyone who dealt with a lot of dollars looked them up in the Bank Note Reporter to find out what they were actually worth. (The dollars of less reliable banks were valued at a discount.) Interestingly, the Bank Note Reporter is still around, but more for people who collect paper currency the way others collect coins or stamps.
Can you imagine doing electronic commerce with this kind of system? It would be like having a whole slew of security certificate issuing authorities, some of greater probity than others. Oh, we do.