Do central banks need capital?

Here is the abstract of a 1997 Peter Stella paper:

Central banks may operate perfectly well without capital as conventionally defined. A large negative net worth, however, is likely to compromise central bank independence and interfere with its ability to attain policy objectives. If society values an independent central bank capable of effectively implementing monetary policy, recapitalization may become essential. Proper accounting practice in determining central bank profit or loss and rules governing the transfer of the central bank`s operating result to the treasury are also important. A variety of country-specific central bank practices are reviewed to support the argument.

More concretely, I am not persuaded by the view that a kind of sheer internal commitment to good outcomes, however sincere, can sustain a peg or nominal target.  The outside world always impinges on the logic of commitment, and thus capital is required.  This is also why I do not agree with Scott Sumner’s claim that a truly credible Swiss target, eliminating the need to expand the SNB balance sheet to make it stick, is possible circa January 2015 or for that matter anytime soon.

I do not, however, see time inconsistency as the central problem.  More likely the government either just doesn’t want to take the specified action (e.g., Germany with higher inflation), or part of the government would like to do something but it doesn’t have enough political capital (Draghi at the ECB).  Time consistency models have some neat analytic properties but often they distract our attention from these more fundamental constraints.

The pointer is from Alen Mattich, a financial journalist who by the way has just published another detective novel, Heart of Hell.


Do central banks need capital?

Do trees need leaves?

Its true that the SNB will face a credibility problem if they go back onto the peg. But they can easily deal with these skeptics if they follow the following process - print for free enough Francs to buy Euros's to hold the peg. With the Euro's they have bought (for free) buy some gold. Then their balance sheet is expanded, but the expansion is not in Euro's but in gold. In effect, every Franc they print is swapped with gold. Surely even their worst critics in Switzerland could not argue against this.

Gold prices in Euro's and Swiss Francs (and probably dollars) will probably explode if this happens. But so what. Gold is not used for anything much so the impact on the real world would be small.

@ChrisA - this is very provocative and interesting; not just because I'm a gold bug who is long gold either... I wonder indeed if holding lots of euros could be put to 'good use' by a central bank to do as you propose. China's central bank has been a buyer of gold recently, and so has Russia's... barbaric relic indeed!

But isn't this argument subject to Ricardian equivalence? The now discredited SNB must purchase MORE euros than if they hadn't removed the peg, which means more printed francs, which gets the market to wonder whether the economic leaders who dissolved the peg are even more scared (following their initial reasoning). You might see a scenario where the exchange rate approaches the new peg, then veers away with growing fears of a sharp SNB reversal.

Tyler may be right that even a truly, truly, truly credible peg of the SF to the Euro would not prevent the SNB from having to purchase euros and continuing to expand its balance sheet (but the reserves need not be denominated in euros but resold for some less risky currency), but so what? They just continue to expand the balance sheet and transfer the profits from the interest on the assets to the government.

The Central Bank of Chile has had negative equity for 30 years I believe.

In other words, a major constraint on central bank action is political opposition from those who don't understand economics, including the economic irrelevance of capital for an institution which can create money without limit.

Sure they can create money without limit, but would that money they create have any value?

What has characterized successful central bank action is both public and political support for the policy, and a financial system that profits from them. The power of the US Federal Reserve is that if you bet against them, you lose money, lots of money. No more, no less. If someone could bet against them and profit substantially, their influence would diminish because everyone would bet against them.

The more credible they are, the better politicians and sensors of prevailing thought and direction, the less they need in reserves.

Like fiat money, it is worth something because everyone agrees that it has worth. It has influence because everyone listens and acts based on what they say.

"Sure they can create money without limit, but would that money they create have any value?"

The purpose of the monetary expansion is to devalue it, or at least to prevent its value from increasing. A central bank may need capital, either explicit capital in the form of assets to sell or implicit capital in the form of government "backing", to *increase* the value of its currency, but decreasing currency value should never be difficult. Even the poorest individual can issue promissory notes and drive the notes' value down to zero.

| "... the economic irrelevance of capital for an institution which can create money without limit." |

Precisely. Central Banks get more assets simply by buying equities & bonds with the specific national-currency created from thin air. That magic power is limited only by how much inflation the national economy can tolerate and competing forms of money/foreign currencies.

Modern Central Banking was developed in 19th Century England with 2 main purposes -- help finance government debt & cartelize the nation's private commercial banks (to minimize normal market limits on their inflationary credit expansion and fractional-reserves counterfeiting).


Ray Dalio defends what he does as promoting an efficient allocation of a scarce resource (capital), and he has complained that a zero interest rate makes that task more difficult. There's as assumption by some academics that the bureaucrats (central bankers) are all-powerful, but is that true. Do the Ray Dalios make their jobs more or less difficult? Do they work in harmony with the bureaucrats or against the bureaucrats? Do they have more influence than usually acknowledged?

Gosh, Tyler, you think maybe Sumner is living in a fantasy world in which central banks can conjure up whatever level of NGDP growth they desire simply by declaring it their goal?

And here I was thinking he had discovered some kind of wishes-powered perpetual motion machine. What a shocking fall to earth this is.

A large balance sheet is not the same thing as a large negative net worth.

If the CB were a private entity, some 'risk capital' would be needed to stand behind a larger balance sheet, but the amount of capital would be a small fraction of the size of the balance sheet.

A CB prolly doesn't even need this, cuz printing press and guns.

I do not agree with Scott Sumner’s claim that a truly credible Swiss target, eliminating the need to expand the SNB balance sheet to make it stick, is possible circa January 2015 or for that matter anytime soon.

This might be missing the point a bit, though -- the purpose of the assets in the balance sheet is to make the policy credible. They are the people Chuck Norris has to beat up to clear the room.

That leads to a bit of a paradox: the CB must buy enough assets to make the policy credible, but the less credible the policy, the more assets they must buy to make it credible. So when doubt emerges about the CBs commitment, the need for QE increases dramatically.

On reflection, the size of the balance sheet seems like one those concerns that can’t logically be real. If the balance sheet was too large, that would mean too much money had been supplied, in which case inflation would be too high. So if inflation is not too high, the balance sheet is not too large. I think concerns about the mechanics of supplying money and managing the resulting assets are valid concerns, but are too much like what accountants call “letting the tax tail wag the investment dog.” The credibility of monetary policy is much too important to be ruled by such relatively petty concerns as what the effect of effective monetary policy is on the CB’s balance sheet.

At any rate, to the extent such large balances exist they must tend to be the product of the tension between actions, intentions, and expectations, that is to say credibility — by the Chuck Norris effect, permanent large balances shouldn’t have to exist, they are, in some sense, some portion of the markets saying they don’t believe the CB and are willing to bet against them. Since the CB is the only player that can print money, to bet against them is to be betting on some belief about their unwillingness to make the policy credible.

And as had been pointed out before, in a practical sense, these countries could be effectively retiring their national debt, or even establishing national savings, perhaps to offset their demographic problems, even assuming those balance sheets aren't unwound in the normal course of events.

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