Can a Central Bank Go Broke?

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Centralized
monetary authorities enjoy a privileged position in the current
monetary system. People tend to view the economists and politicians
at these institutions as demigods, individuals who if given enough
resources will ensure that the economy continues an ever-advancing
and smooth trajectory. However, unlike the Greek demigods of yore,
today’s central bankers are mere mortals who must work within the
confines and constraints of the institution that they head.

While they
present an aura of invincibility, the truth is that the effectiveness
of their policies faces severe limits.

Conventionally,
a central bank pursues its goal of price stability by adjusting
the money supply to alter the discount rate indirectly, thus making
lending more or less attractive. The recent crisis draws attention
to a secondary function of these banks – namely, as a lender
of last resort.

After the Lehman
Brothers collapse of September 2008, central banks of the world
intervened in a united effort to swap bad, illiquid assets from
the private banking sector for higher-quality government debt. While
this process proceeded unhindered in its early stages, central banks
soon found themselves with declining balances of higher-quality
debt to swap. The lone tool remaining to combat the liquidity crisis
was a quantitative expansion – increasing the money supply,
and thus making fresh liquidity available to the banking system
for retiring its liabilities.

Through this
qualitative expansion, central banks were able to bail out domestic
banking systems that were heavily indebted in domestic currencies,
such as the American system. However, other economies that relied
on foreign funding were not quite as fortunate. The insolvency of
the Central Bank of Iceland late last year brought this issue to
light; several additional central banks are still at risk.

Central banks
that are only able to inflate the money supply in their own domestic
currency face significant challenges when faced with banking systems
heavily indebted in foreign-denominated liabilities. As the recent
Icelandic example has
demonstrated, the possibility of central bank insolvency creates
the opportunity for real banking reform.

When Central
Banks Go Broke

Murray Rothbard,
in his book The
Case Against the Fed
, argues that a private, free-banking
industry is disciplined by the threat of a bank run, which keeps
it from overissuing its liabilities in excess of its assets. A central-bank-led
fractional-reserve system is, however, under no such constraint.
Fiat money grants the central monetary authority an advantage: its
own liabilities – primarily the monetary base – will never
be forced into redemption for anything other than the same nominal
units they are denominated in.

Guido Hülsmann
explains this peculiarity, using the British pound as an example:

Until 1914,
and then between 1925 and 1931, the Bank of England redeemed its
£20 notes into a quantity of gold that was called "the
sum of £20." Today it redeems these notes into other
notes of the same kind. The point is that in the old days the
expression "the sum of £20" had a different legal
meaning than it has today. At the time it designated some five
ounces of gold. Today it means something different. The suspension
of payments has turned the expression "the sum of £20"
into a self-referential tautology – it now designates £20
paper notes. The notes that promise payment of "the sum of
£20" do no more than promise payment in like notes.

The result
is that liabilities may be retired by inflating the money supply
and not through sacrificing any real savings, whether they be a
commodity (such as gold) or a foreign currency. This central bank’s
ability to effortlessly inflate away domestic liabilities has given
rise to its oft-cited function as a lender of last resort. Hence,
as banks find themselves facing illiquidity, entrepreneurs assume
that the central bank is capable of moving in swiftly to expand
the money supply and head off a crisis.

Read
the rest of the article

September
4, 2009

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