A better way to account for fiat money at the Central Bank

A better way to account for fiat money at the Central Bank

Thomas Colignatus, December 31 2005

Http://www.dataweb.nl/~cool

http://ideas.repec.org/p/wpa/wuwpgt/0512014.html

Summary

Proper monetary accounting rules are: (1) Central Banks should conform to the practice of the US Federal Reserve to distinguish its Balance Sheet from its Statement of Conditions. (2) Fiat money should not appear as a liability in a Balance Sheet. (3) The Central Bank should not record more government bonds than required for open market operations. Surplus bonds should be accounted as being void (on loan from the government who should destroy them). If these rules are not observed, a wrong measure of government debt arises, distorting the requirements for policy making.

Introduction

The most important property of money is that it is legal tender. If person A owes to person B, then A can pay off the debt by legal tender and B cannot refuse the payment, and if A would try to pay off the debt by offering his used car or some priceless painting then B can legally refuse such a redemption. The most important aspect thus is the existence of a legal framework that provides trust and stability within the community.

Once such a legal framework is in place then it appears advantageous to the community to use fiat money instead of gold-backed paper. There is no need to worry about the value of fiat money since the legal framework already exists. The advantage is not that paper is easier to carry and handle than gold, since if that were the only advantage, then we still would be using gold-back paper. The advantages to the community however are (1) that the price level can be influenced by the Central Bank rather than by discoveries of gold veins, (2) that seigniorage falls to the Central Bank. These two advantages are two aspects of the single advantage of increased monetary control by the community.

Seigniorage can best be defined as simply the change in the stock of money. If M is the stock of money, then seigniorage is ∆ M. Some authors such as Inklaar et al. (2005) and Drazen (1985) include the proceeds of productive investments from these additional resources. However, the government budget is a totality, it is arbitrary to single out line items, and thus it isn’t properly possible to assign such investments to a particular resource.

Using Fisher’s equation P Y = M V, for P the price level, Y real income, V money velocity, and assuming constant velocity, money can have the same growth as nominal income, so that seigniorage may thus amount to 5% of the stock of money (with 2% inflation and 3% real growth). This is a sizeable source of income.

If the Central Bank would not have the monopoly to issue fiat money then the seigniorage would disperse throughout the economy. Any individual with access to a printing press could try to issue IOU’s (“I owe you”). It may be noted that some supermarkets print their coupons, some stores print their gift-certificates, and the like, which can function as money. Banks could issue their own paper money (as Hayek once proposed) and add the proceeds to their profits. The law that “bad money drives out good money” would tend to work, such that people would hoard the paper from good banks, so that the money in circulation would be from bad banks that apply the printing press. The crucial observation is that the community would lose control over inflation, whence it follows that it is better to create the Central Bank monopoly.

The Central Bank controls inflation both by its system of inspection and quality control of commercial banks, and by its monetary measures. The latter are reserve requirements and open market operations. If there is too much liquidity in the system chasing too few goods, then the Central Bank sells government bonds, raising the rate of interest. If there is not enough liquidity in the system leaving too many goods on the shelves, then the Central Bank buys government bonds, lowering the rate of interest. Under a constant rate of interest, the stock of government bonds may also change due to the desire to allow some “liquidity” for the bonds themselves.

Over the years, the practice has arisen that the Cental Bank realizes its seigniorage by buying government bonds. The Central Bank prints its money, or credits the current account of the government, and receives government bonds in return. In cumulation over the years, the Central Bank balances the stock of fiat money with such government bonds. Thus, who opens the Annual Report of a Central Bank and looks up the Balance Sheet, finds the stock of fiat money issued by the Central Bank under the liabilities and the stock of government bonds held by the Central Bank under the assets. In practice, the seigniorage that the Central Bank hands over to the government is called “monetary financing”. As the government must pay interest on the bonds held by the Central Bank, these are counted as Central Bank income, and the Central Bank has an additional “transfer from profit” to the government (which is not proper seigniorage, but interest on seigniorage).

Accounting for assets and liabilities

For a commercial bank it is proper to account its stock of paper money under its assets. Namely, the paper money that a commercial bank holds can be traded for other commodities and thus it forms a claim on real resources.

For a Central Bank it makes some sense to catalogue its issues of fiat money under the liabilities. Any paper bill that it prints and sends into the economic system namely represents a claim on real resources, that the Central Bank appropriates and may feel accountable for.

For the whole economy, it makes some sense that all the fiat money assets of all commercial banks, companies and households are balanced by an equal liability at the Central Bank.

However, the point that this current article tries to make, is that fiat money is not a proper claim from an economic agent upon the Central Bank.

Legally, when a person goes to the window of the Central Bank say with a dollar note of legal tender, and wishes it to be exchanged into its real value, then the Central Bank will exchange it into another dollar note of legal tender. There is no such thing as a liability of the Central Bank to exchange its fiat money notes into something real.

The crux of this analytical point is that there is no reason for a Central Bank to hoard government bonds beyond those needed for open market operations. All those surplus bonds only take up storage room and accounting time, and contribute to confusion as to what the situation actually is.

An important aspect of the confusion is that the government debt at the Central Bank is often counted as part of national debt. In particular for developing countries, who have more use of seigniorage (inflation tax) since normal tax collection is difficult, the size of the government debt can be distorted, and a wrong way of accounting for fiat money can cause wrong decisions, such as overly ambitious austerity programs.

The US Fed vs the EU monetary system

The Annual Report 2004 of the US Federal Reserve may be the exception to the rule explained above. The Fed properly distinguishes its balance sheet of itself, seen as a company, from its holdings of monetary instruments. Thus on page 266 there is the “Statement of Condition of the Federal Reserve Banks, by Bank, December 31, 2004 and 2003”, which is not called the “balance sheet” but a “Statement of Condition”. Under the “liabilities” we find the “Federal Reserve notes outstanding”, with a subtle distinction of a part that finds “collateral” in government bonds and a part that doesn’t have such a “collateral”. The latter distinction has no real meaning, since it is not clear how much would be needed to perform the open market operations.

The Annual Report 2004 of the EU monetary system conforms to the rule explained above. The monetary reserves are catalogued under a “balance sheet”, while, with fiat money, there is no reason for such “balancing”.

We thus find that the Fed is already part of the way of accepting fiat money as fiat money, but not totally, while the EU system still tends to a way of accounting as if there were a gold standard. This is also reflected in the share of gold in all assets at those Central Banks, see also Henderson et al. (1997).

2004

All in millions_____US Fed. Res. ($)_ ECB (EUR)_ EUsys (EUR)

Total assets_______814,946_______90,212_____884,324

Gold ____________11,041 _______7,928 ______125,730

% Gold in assets_____ 1,4% _______8,8% _______14,2%

PM The Eurosystem consists of the ECB and 12 national Central Banks

Concluding remarks

In a next version of this paper it would be sensible to give an example of a rebalanced Balance Sheet. When fiat money drops out as a liability and when most government bonds drop out (as a donation to the government who then may tear up the paper), one wonders what the result would be. Properly, it would be a Statement of Conditions with less assets in the form of government bonds and more “goodwill”.

In the mean time, it seems useful that not only monetary economists and the monetary authorities themselves consider the argument, but that also economists who deal with developing countries, such as economists at the IMF and Worldbank, reconsider the issue of national debt.

Literature

Board of Governors of the Federal Reserve System (2005), “91st Annual Report 2004”, Washington, http://www.federalreserve.gov/boarddocs/rptcongress/annual04/ar04.pdf

European Central Bank (2005), “Annual Report 2004”, Frankfurt am Main

Drazen, A. (1985), “A general measure for inflation tax revenues”, Economics Letters, 17, 327-333 (cited by Inklaar cs.)

Henderson, Dale W., John S. Irons, Stephen W. Salant, and Sebastian Thomas (1997), “Can Government Gold Be Put to Better Use? Qualitative and Quantitative Effects of Alternative Policies”, http://www.federalreserve.gov/pubs/ifdp/1997/582/default.htm

Inklaar, R, R. Jong-A-Pin, J. de Haan (2005), “Geldscheppingswinst als bron van overheidsinkomsten”, Financiële en monetaire studies, issue 23, no 2