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.

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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

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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.

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September 4, 2009