How modern methods
of making payments economize the use of money.
The role of checks
and bank-notes
The enormous edifice
of credit
The Book of Popular
Science (1924; revised 1929) New York: The Grolier Society.
Group IX Ch.
31:4231–40
For a long time, it
was the habit of writers on the subject of money to picture an
imaginary stage of barter which continued for a long period before it
became possible to agree to use one particular commodity as the
medium of exchange or measure of value, and thus to adopt money.
This view of things,
that men invented money in order to rid themselves of the
difficulties and inconveniences of barter, belongs, along with much
other conjectural history, on the scrap-heap of discredited ideas.
Men did not invent money by reasoning about the inconveniences of
barter any more than they invented government by reasoning about the
inconveniences of some mythical primitive state of anarchy. The use
of money, like other human institutions, grew or evolved. Its origins
are obscure. It is, nevertheless, fairly certain that at no period in
his history has man ever conducted any considerable volume of trade
by means of barter. There was a very small gap, perhaps no gap at
all, between the beginnings of trade and the origin of money.
Of course, traders
dealing with regions where civilization has scarcely appeared may
even now find it possible to exchange beads, cheap bright-colored
calicoes, knives, mirrors, etc., for goods which are in modern
markets vastly more valuable. But the trader, unless he be a trained
observer, is likely to disregard the fact that the savages with whom
he barters have some crude, primitive monetary system of their own.
In fact, it is not at all uncommon for the beads, or other (to them)
rarities, which the savage tribe obtains by way of barter from
civilized peoples, to become, by reason of their scarcity and
desirability, the money, for the time being at least, of the tribe.
A host of different
commodities have been used at different times, and by different
peoples, as money. If we scrutinize a list of such commodities ever
so carefully, we shall find it difficult to see that they have any
common characteristics beyond the fact that, for various reasons, the
commodities have all had, at a given time and place, an assured
market or outlet.
Consider the fact,
noted by the great German historian of Rome, Mommsen, as well as by
other observers, that the peoples of the early civilizations of the
world, like the moderns, almost uniformly selected for use as money
commodities that were ornamental rather than useful. This fact calls
for explanation, and the explanation may throw some light upon at
least one of the mysteries of money. If there is any one clear-cut
and fundamental difference between necessary commodities and
luxuries, it is that human wants for necessaries are satiable, while
the desire for ornaments, as for other goods that minister to the
love of distinction and display, is insatiable. Of course, it is not
true that normal men place luxuries above necessaries. It is simply
true that when one is provided with the necessaries of life, the
normal man, in adding to his goods, will increase his stores of
luxuries rather than his supplies of necessaries. To use a technical
phrase explained in earlier chapters, the demand for ornaments, and
consequently the demand for the metals from which ornaments are made,
is elastic, while the demand for the necessaries of life is, by
comparison, inelastic. There is a surer market and a surer outlet for
ornaments and for their materials. Their value is less variable than
that of necessaries. Especially is this true in communities with
little foreign trade. Wheat might be a drug on the market; but such
could never be the case with respect to precious stones or ornaments
of gold.
The definition of
money and its essential characteristic
Money may be defined
as a commodity or group of commodities customarily paid and received
in exchange for other commodities and services without reference to
the personal credit of the one who offers it. That is, a personal
note is not money, but a bank-note is. It is necessary to observe
further, however, that not only the credit of the one who offers it,
but also the desires and intentions of the persons who receive it,
have an important bearing upon the question of what is and what is
not money. The person who receives money in exchange for commodities
or services takes it with no other thought than that of passing it on
again in exchange for other goods and services. No one, except the
miser, values or wants money on its own account, even though the
materials of which some forms of money are made may have utility and
value of their own.
The one really
essential characteristic of money is that the holder should be able
to get rid of it without undue loss. Other commodities have their
ultimate consumers; money never finds an ultimate destination or
resting-place: it is tossed about from person to person until
finally, worn out, lost, or melted down, it passes out of use.
Illustrations
showing money is not primarily valued for itself
If, with these
fundamental principles in mind, we survey such facts as are available
respecting the monies of the primitive peoples and the diverse types
of money used even by modern peoples, we shall find that they have
just that one essential characteristic. The precious metals, almost
from earliest times, have been used as the materials of ornaments,
and so also from almost the earliest times, they have been used as
money. The precious metals could always be passed on to the man whose
wealth and standing in the community were estimated, as today in some
parts of India, by the number and the weight of the silver and gold
ornament worn by his wife. An elastic demand in itself creates a safe
outlet. Why was tobacco used as money in early colonial Virginia; or
furs in some of the northern colonies and in Canada? Or rice in the
Carolinas? Why did the New England colonists sometimes use the
Indians’ ornamental strings of beads—wampum—as a medium of
exchange in certain of their own transactions?
Utilizing again our
unifying principle, the answer to each of these questions is obvious.
Tobacco was the most important Virginia product for export. It was
the medium by which English goods, of which the colonists were in
sore need, could be obtained. It was the one product for which there
was, for the time being, a certain and undisputed market. What more
natural than that accounts as between the colonists themselves should
be transferred by means of this particular commodity, their best
embodiment of purchasing power? And so with furs, obtained by
trappers or bought from the Indians, and sold in the export market:
they also came to have a local currency as a means of getting other
things. They could be passed on from hand to hand with the certainty
that the holder for the time being could pass them on again when he
so desired. The case of wampum is a little different. There was, of
course, no European outlet for it; but it had purchasing power in
dealings with the Indians, and it is very likely that, for that
reason, some of the colonists were not unwilling to accumulate a
stock of it. All of these illustrations serve to make it tolerably
clear that money is not primarily a thing that is valued for itself.
The value of money is its purchasing power. Just so far as any
commodity serves as money, it is because it is wanted, not for
personal or permanent use, but for passing on. The material of which
money is made may have its own use. This merely makes it all the more
certain that money itself may be passed on, that someone may always
be found who is willing to take it in exchange for goods or services.
With respect to
another problem—the economic functions of money—there has also
been unnecessary confusion of thought. Money is an important part of
our commercial mechanism. The “functions” of any piece of
mechanism are properly determined, not by what we think that
particular bit of mechanism ought to do, but by what it actually
does. In economics, as in the natural sciences, we shall see farther
and see more clearly if we consistently try to avoid the use of
loose, vague and general terms, and fix our attention upon concrete
facts, upon what actually takes place in this complicated world.
The money price of
commodities is final criterion of relative values
Money is often said
to be a medium of exchange and a measure of value. Taken loosely,
these descriptive phrases are not objectionable, but when we use them
we should try to see back of them into the actual facts they loosely
summarize or describe. Otherwise we are likely to forget that after
all the “values” of things are their money prices. We do not, in
actual fact, determine the relative values of different kinds of
commodities and services, and then bring in money as a means of
“measuring” the different values or of reducing them, as General
Francis A. Walker preferred to say, to a common denominator. The
general exchange values of the commodities that are bought and sold
in modern markets are, in fact, merely relations that we derive or
infer from their money prices. The money price of a commodity is the
fundamental original fact with which the economic scientist must
deal. Interpreted generously and understood, however, there is no
real difference between the two functions of serving as a medium of
exchange and as a measure of value.
It is only in the
actual exchange of goods for money, or in deciding whether or not to
make such exchanges, that we really use money as a “measure of
value.”
In the same way, of
course, it is proper to say that a yard-stick is both a measure of
length and an instrument used in measuring. Anyone would say at once
that these two alleged functions of the yard-stick are really but one
function. Precisely so with money: measuring values and serving as a
medium of exchange are only one function, not two.
It is better to
avoid these word-wasting controversies over the meanings of terms by
recognizing money for just what it is, namely, a means of payment.
The prices of goods and services are stated in terms of money and we
pay for them with money. Debts are promises to pay money, and we pay
our debts with money.
Money is sometimes
said to serve also as a standard of deferred payments.
Properly understood,
again, there is nothing objectionable in this statement. It merely
emphasizes the fact that debts which run for many years, like
short-time debts, are usually made payable in money. The farmer who
borrows money on mortgage security and agrees to pay off the loan at
the end often years, will gain or lose according as prices in
general, especially the prices of agricultural products, move upward
or downward during the ten-year period. If prices move downward, he
has to pay his creditor in money which costs more, which will buy
more, and which therefore is worth more than the money he borrowed.
If the debt had been contracted in terms of bushels of wheat, the
relative positions of the creditor and debtor at the end of the
transaction would have been very different. If prices move upward,
rather than downward, it is, of course, creditors who lose and
debtors who gain. In saying that money serves as a standard of
deferred payments we are really doing little more than calling
attention to the importance of this particular problem. As a matter
of fact, this function of money, like the others, is really covered
by the simple statement that money is the ordinary means of payment.
It would be
possible, of course, to divorce the standard of deferred payments
from the ordinary means of payments. Thus, the law might prescribe
that debts stated in terms of money should be increased or decreased
according as the general purchasing power of money declined or
advanced. In such case, although money would remain the means of
payment, the standard of deferred payments would really consist of
the list of goods whose prices were taken and compounded to measure
the general purchasing power of money. Or, as some have proposed, the
cost of money, or the amount of labor required at different periods
to earn a specified amount of money, might be made the basis of a
standard of deferred payments. The problem of the standard of
deferred payments has had in the past a very large political as well
as economic importance, as we shall see when, in a later chapter, we
examine some of the outstanding facts in the monetary history of the
United States.
What gives different
kinds of money its value
We now pass to the
consideration of certain problems associated with the coinage of
money. There is a widespread illusion that the essential
characteristic of a coin is the government stamp, that it is the
power and authority of the government which give the coin its value.
This notion has done a vast amount of harm, and more than once it has
been used by governments as an excuse for unsound monetary policies.
On some peculiar kinds of coins, as we shall see, as well as on most
kinds of paper money, it is the government’s stamp which, in a
sense, gives money its value. But in precisely the same way, it is
the solvent debtor’s name on his promissory note that gives the
note its value. We must distinguish carefully between two wholly
different kinds of coins: standard coins and subordinate coins.
Put a ten-dollar
gold piece upon an anvil and deface it with a heavy sledgehammer. The
shapeless lump of gold you will have left will not be a coin, but it
will be worth precisely ten dollars. By defacing the coin, you will
have removed merely a useful and convenient label. But treat a silver
dollar in the same fashion, and you will have left sixty cents’
worth of silver or more, the exact value depending upon the price of
silver at the time. In defacing the government stamp you will
undoubtedly have destroyed some of the value the coin had.
The fact is that the
coinage of standard coins, such as the gold eagle, is nothing but a
dependable official certification of their weight and fineness. They
are in reality nothing but pieces of precious metal.
Anyone can take gold
to the United States mint, and if it is of the required standard of
fineness, the government will pay him for it at the rate of one
dollar for 23.22 grains of fine gold. Silver coins, however, are made
from metal purchased by the government. There is less than a dollar’s
worth of silver in the silver dollar and in a dollar lot of smaller
silver coins, just as there is less then five cents’ worth of metal
in the nickel and less than one cent’s worth of bronze in the cent.
The details of the process by which these coins are kept at a parity
with gold will be discussed in a later chapter. We may note here,
however, that just so far as the government in its own transactions
does not discriminate among these different types of coins and, in
particular, just so far as it remains able and willing to exchange
any one type of coin for any other sort, just so far will the
business world accept these coins as of identical value per dollar.
But it is important to observe that in foreign trade the subordinate
coins are at a disadvantage. Save in exceptional cases, such as in
border trade with neighboring countries, the general rule is that
they will be taken only at the value of their bullion content. Gold
also passes in foreign trade at its bullion value, but in its case,
as we have seen, bullion value and coined value are identical. For
this reason, gold, whether in coins or in bullion form, is the
international monetary standard and the means of paying the final
trade balances between different countries.
We have assumed thus
far that the government makes no charge for the coinage of gold.
Such, in fact, is the case in most modern countries. The United
States, like most other countries, makes a necessary charge for
assaying and refining the gold if it does not conform to the required
standard. France and a few other countries make a very small
additional charge called “brassage” to cover all or a part of the
actual expense of coinage. The operations of the English mint, in
principle, are gratuitous like those of the United States mint. There
is the essential difference, however, that in England one who takes
gold to the mint would supposedly be asked to wait until his bullion
had been converted into coin. In practice, the Bank of England acts
as intermediary between the mint and the public. An ounce of gold
suffices to make £3 17s. 10 1/2d. in English gold coins. The Bank of
England will at all times buy gold at the price of £3 17s. 9d. and
it may give somewhat more than this price when it desires to
strengthen its own gold reserves.
Seigniorage and its
results
Modern nations, it
is clear, view the maintenance of the coinage as a public function to
be performed in large measure at public expense. Very different has
been the attitude of governments in earlier times. The monopolistic
power of coining money was often held as a prerogative of the
sovereign not because in this way only would the people have the
advantages of a uniform and dependable currency, but rather in order
that the sovereign might use his prerogative as a means of securing
profits. A common practice was that of making a high seigniorage
charge—a charge much more than covering the expenses of coinage.
When seigniorage is charged, more bullion must be deposited at the
mint than is contained in the coins received for the bullion. The
surplus bullion went as profits to the sovereign to be made into
coins for his own use. A more flagrantly unfair practice was that of
calling in all coins in circulation for recoinage into smaller coins.
Royal monetary
legerdemain
One who had thus
been forced to turn his money into the mint was repaid the same
number of coins, and the coins were of the same denomination, but
they were of lighter weight. The bullion taken out of the coins of
the people was made into money for the sovereign. It is probable that
in purpose and principle these transactions were not thought to be
the barefaced robbery which to us they seem to have been. Kings, like
other men, were misled by the notion that it was the royal stamp that
gave value to the coin. They believed and were often told by their
advisors that the new light-weight coins would be worth as much as
the old, and that they could thus reap profits without imposing any
real burdens upon their peoples. Of course such doctrines were and
are no better than pernicious nonsense. By no sort of monetary
legerdemain can wealth be created, as it were, out of thin air. The
recoining operations, it will be noted, resulted in an increase in
the number of coins in the country, just as when seigniorage was
charged, a given volume of metal was made ultimately into a larger
number of coins than would otherwise have been minted. The sovereign
obtained purchasing power that he otherwise would not have had. It is
absurd to suppose that he could have expended this purchasing power
for goods and services without correspondingly reducing the
purchasing power remaining in the hands of his subjects. The king’s
shillings, or florins, or whatever the coins might be, came into the
market, we may say, as new competitors of the coins of the king’s
subjects. Prices rose to a level which they otherwise would not have
reached.
Seigniorage, like
the debasement of the currency, thus operated as a tax upon the
people. Coins subjected to a seigniorage charge always fell in value.
Their purchasing power was determined, in the long run, not by what
they cost at the mint, but by the amount of bullion they actually
contained. Under such conditions, bullion was not brought to the mint
except under compulsion.
The fact is that a
seigniorage charge of any magnitude is not practicable. The point is
important, not so much because seigniorage is today a live issue, but
because precisely the same principles are involved in various
proposals to substitute for gold another type of standard money
consisting of irredeemable paper currency, that is, paper currency
which involves no promise to pay on the part of the government, nor
any governmental responsibility for maintaining its value. Such paper
money, sometimes called “fiat money,” is very much like metallic
money subjected to a 100 per cent seigniorage charge, if such a thing
can be imagined.
Precisely the same
considerations which counted so heavily against the policy of
charging seigniorage on the coinage of standard metal hold with
really fatal force against any proposal for a standard money of
irredeemable paper.
Credit and its big
role in business
We shall find it
convenient at this point to set aside for the moment these problems
of money, properly so called, and turn to the related subject of
credit.
Nine-tenths of the
business transactions in a country like the United States are
performed with the aid of credit rather than of money. From the
purely quantitative point of view, credit is vastly more important
than money. And yet that should not blind us to the fact that credit
without money is impossible.
Proposals to do away
with money and to use credit only as a means of payment reveal a
complete misunderstanding of the nature of credit and of its relation
to money. There is, in fact, so much confusion respecting the real
nature of credit that we shall do well to observe that credit is in
fact a very simple thing. Credit is merely the other side of debt! In
a borrowing transaction what appears to the lender as a credit,
appears to the borrower as a debt. Much confusion would be avoided
if, in discussing monetary problems, we should use the word “debt”
in place of “credit.” The real facts discussed would be
unchanged. But the mode of discussion would necessarily steer us
clear of a number of dangerous fallacies. For example, who would be
willing to say that we could dispense with money and get along very
well by the use of debts as means of payment? The objection is
obvious. A debt can hardly be a means of payment, for it itself is
something to be paid.
Institutions which
deal in debts
Nevertheless, we
shall see that there is a certain sense in which we may speak of
making payments by means of debts. But this is a misleading way of
stating the matter unless it is clearly understood that we are using
the words “making payments” in a rather loose way. Debts, very
naturally, are means of avoiding, rather than of making, payments.
And the greater the extent to which we can avoid immediate payments
by utilizing credit, the more we will be able to avoid the necessity
of making final payments, not because we fail to honor our debts, but
because the accumulated debts of persons in the community are offset
or canceled one against another. This cancellation or offsetting
process is accomplished easily and inconspicuously by the mechanism
of banking.
A bank is an
institution which deals in debts. It buys the debts of its customers
and sells its own debts. Its customers’ debts come to it in the
form of promissory notes and bills of exchange. A promissory note is,
of course, a promise to pay money either on demand or, more usually,
on or before a certain date. A bill of exchange or draft is an order
to pay, drawn by a creditor upon a debtor. When acknowledged or
accepted by the debtor, as by writing his name upon it, it becomes an
“acceptance”, and then, for all practical purposes, is like a
promissory note.
Growth in use of
bank acceptances
A bill of exchange
drawn by a jobber or manufacturer on account of a shipment of goods
and accepted by the buyer—a retail merchant, perhaps—is called a
“trade acceptance.” It may happen however, that instead of
accepting the bill of exchange on his own account, the buyer will
arrange with some bank to accept the bill of exchange on his behalf.
The bank, of course,
will be fully protected by the deposit of securities or by some other
satisfactory arrangement. The bank gets a small commission for thus
lending the use of its name and the buyer may get better interest
rates or more favorable terms of sale because he can furnish an
acceptance so satisfactory to the creditor.
Such “bank
acceptances,” as they are called, have a large and growing use in
financing international trade.
In exchange for its
customers’ debts, in the form of notes and bills of exchange, the
bank gives its own debts in the shape of bank deposits and
bank-notes. It will be worth our while to examine these two forms of
banking indebtedness rather carefully, for they play a very large
part in modern economic life. We are accustomed to think of a bank
deposit as “money in the bank.” In fact, however, it is nothing
but a claim or credit,—a right to receive money on demand from a
bank. A bank deposit is the depositor’s credit or asset and the
bank’s debt or liability. It often happens that when some rumor,
true or false, has started a run upon a particular bank, the
depositors who have stood in line, perhaps for hours, in order to
withdraw their deposits before the bank collapses, are perfectly
satisfied when they find the bank is able to pay them. They do not
want their money, they merely want the assurance that “their money
is still there.” Of course this shows a profound ignorance of the
nature of banking. No bank could afford to have on hand at any one
time cash sufficient to satisfy all of its depositors. A certain
amount of cash must be in its vaults or must be easily available
elsewhere,—somewhat more than enough to meet the ordinary
day-to-day demands of its depositors and creditors. This relatively
small amount of cash—10, 15, or even 25 per cent of the bank’s
debts to its depositors—is the bank’s “cash reserve.” The
proportion it should bear to the bank’s total deposit debts is
regulated in the United States by law, but in many countries it has
been found wiser to leave it to be decided by the practical
experience of the banks themselves.
Three ways of
obtaining a bank deposit
One may purchase a
bank deposit in any of three different ways. In the first place, one
may from time to time turn surplus cash over to the bank as many
merchants are accustomed to do daily. This may seem like actually
depositing money in the bank. But the real transaction is an
exchange: the depositor’s cash is paid into the bank, not with any
understanding that the cash shall be kept intact and separate, but in
exchange for the right to demand the same amount of cash, or any part
of it, from the bank at any time. Or, in the second place, a bank
deposit may be obtained by turning over to a bank checks signed by
depositors in the same bank or in other banks. It is clear that
transactions of this type merely result in transfers of deposit
credits from one depositor to another and, incidentally, from one
bank to another. The total volume of bank deposits within the
community is not affected by these transfers.
In the third place,
depositors’ credits are created by banks in favor of their
borrowers. The business man brings to his bank, let us say, his own
promissory note for $10,000, payable at the end of 90 days. Or it may
be a note which the business man has taken from one of his customers
and to which he has added his own endorsement, or it may be an
accepted bill of exchange representing a shipment to the customer.
The bank discounts the note or bill of exchange. In other words, it
buys it and pays for it, not its face value, but a somewhat smaller
sum. The amount of the difference or discount is substantially like
interest, except that it is deducted in advance from the face value
of the loan instead of being added to the principal of the loan at
its maturity. In the imaginary case under discussion, if the rate of
discount were 6 per cent per annum, the note or bill of exchange for
$10,000, running for three months, would be subjected to a discount
of $150 (one-fourth of 6 per cent of $10,000), so that the business
man would receive credit for $9850 and would be obligated to repay
$10,000. But it must not be supposed that the bank dips down into its
vaults and advances cash to every borrower. The common practice is
that the borrower is given the right to draw checks upon the bank up
to the agreed amount,—in this case $9,850. In other words, he is
given a bank deposit. The bank grants him the right to demand money
from it at any time in exchange for the right to demand from him or
from some third party a somewhat larger sum of money at a definite
future date.
Eighty-five per cent
of aggregate United States bank deposits due to borrowing
We may have gone
into unnecessary detail in describing these elementary business
practices, but it is because it is important that the reader should
understand the real nature of the operations of depositing and
discounting. These are the fundamental things in banking and are,
moreover, the fundamental facts that determine the amount and the
nature of the bulk of our present-day media of payment. This third
method of securing deposit credit at a bank is vastly more important
than the other two. Actual cash is continually flowing out of the
bank, just as it flows in, so that except in unusual periods, the
first method of making deposits referred to above does not have a
large net effect. The second method, as we have seen, involves merely
the transfer, rather than the creation, of deposits.
Probably as much as
85 per cent of the aggregate volume of bank deposits in the United
States (amounting to nearly $13,000,000,000 in national banks alone
in 1921) have been created by discounting and by similar methods of
making advances to borrowers. If we should examine the books of any
one individual bank we should hardly find as much as 85 per cent of
its deposits represented by advances to borrowers. But we must take
into account the fact that the deposits of any one individual bank
are created in no small part by transfers from other banks, and if we
should trace these transfer deposits back to their ultimate origin we
should find that in the beginning many of them started as borrowings.
Thus, although our statement is approximately true of the banks of
the country taken as a whole, it is not necessarily true of any one
individual bank.
The banks’
issuance of promissory notes
The other important
form in which the banks utilize or sell their debts is that of
bank-notes. A bank-note, like a bank deposit, is a bank’s promise
to pay on demand. There are important differences, however.
The bank-note passes
into general circulation; it passes from hand to hand without
indorsement; it is engraved and printed in a way that makes it a
convenient and a safe medium of exchange; in short, it really serves
in hand-to-hand payments as part of the money of the community. Banks
issue notes in very much the same way they make deposit credits,
with, however, a few differences of detail. Some borrowers, as for
example the manufacturer who has a large payroll to meet, may want
cash rather than the right to draw checks. Or it may be that
borrowers and other depositors are drawing so many checks upon a bank
that its cash reserve is becoming dangerously low; in such a case,
the bank may find it desirable to pay out its own notes over the
counter in lieu of other money. In this case, what really happens is
that a depositor who asks for cash is satisfied by having his deposit
claim against the bank exchanged for another form of claim—the
bank-note—which will serve his purpose as well as would any other
sort of money.
The difference
between deposits and bank-notes will concern us in other connections
in later chapters. It is well that we should observe at this point,
however, that, although they are alike liabilities or debts of a
bank, the ways in which deposits and notes respectively are actually
used creates problems peculiar to each. Thus, the depositor has an
opportunity to acquaint himself with the bank’s reputation and with
the character of its officials, and to learn what he can about its
probable solvency before he intrusts his funds to the bank’s care.
But if banknotes are to be in common use, if they are to pass from
hand to hand, they must come into the possession of persons who have
no knowledge of the particular banks which are responsible for them.
It is for this reason more than for any other that certain
governments, including that of the United States, have thought it
wise to impose certain restrictions upon the issue of bank-notes
while leaving the creation of bank deposits subject, within
reasonable limits, to the discretion of the banks themselves.
Some of these
matters we have been treating may be made clearer if the reader will
glance for a moment at the statement of the condition of a typical
national bank in a city of moderate size.
Most of the stated
resources and liabilities are self-explanatory. In the list of assets
there will be noted United States government securities.
Table 33.1 Statement
of the condition of a National Bank:
September 12, 1925
Resources
Loans and discounts
United States
government securities
Other bonds,
investments and real estate
Cash and exchange,
exclusive of lawful reserves
Lawful reserve with
federal reserve bank
Other assets
Total Resources
$655,920
165,150
53,400
65,151
30,816
27,565
997,565
Liabilities
Capital
Surplus and
undivided profits
Circulation
Demand deposits
Time deposits
Due to banks, and
all other liabilities100,000
74,426
100,000
167,062
542,524
13,553
Total
Liabilities 997,565
Some of these this
bank, as a national bank, is required by law to hold to cover its
note issue of $100,000, which appears among the liabilities under the
name “circulation.” In the cash the bank has on hand there is
included its “exchange,” consisting of checks payable by other
banks and other similar claims against them. Its “lawful reserve”
under the present laws does not include all of its actual cash on
hand, but consists wholly of deposit credit which this particular
bank has in a federal reserve bank. Loans and discounts, it will be
noted, constitute the most important item of the bank’s assets.
This item designates the sum total of the bank’s holdings of the
notes and bills of exchange of borrowers. Deposits, classified as
demand and time, bulk as large in the bank’s liabilities as do
loans and discounts in its assets.
Capital represents
the original investments of the bank’s shareholders. The undivided
profits are accrued earnings not yet paid out in dividends. For
these, of course, the bank is liable to its shareholders. Profits
come largely as the result of discounting and other lending and
investment operations. Profits which the bank’s officials have not
decided to pay out in dividends, thus reducing their cash or their
other resources, but which instead they have determined to retain in
the business as further investments of capital, are called “surplus.”
Banks are required by our law to accumulate a certain amount of
surplus. A large surplus is, generally speaking, a sign of strength.
Where surplus is large the depositors’ claims are a smaller
proportion of the bank’s liabilities than would otherwise be the
case, and thus the depositor is better protected.
But sometimes a
large surplus is a sign of weakness rather than strength. Bank
officials, knowing that some of their loans are non-collectible, or
that some of their other assets are not really worth the amount at
which they appear on the statement, may be unwilling to put an
increased strain upon the bank by paying dividends. The accumulated
profits—really only paper profits because they depend upon an
over-valuation of the bank’s assets—may be “passed to surplus”
without arousing suspicion or without affecting the bank’s strength
or weakness.
A surplus as large
as or somewhat larger than a bank’s capital is not uncommon and is,
in general, an indication of sound banking. But a bank with an
abnormally high surplus, four or five or even ten times its capital,
is one that should be investigated rather carefully by a depositor
before he intrusts his funds to the bank’s keeping. In general,
however, we can congratulate ourselves that the standards of honesty
in the conduct of the banking business are, as they should be,
somewhat higher than the standards which prevail in most other types
of business.
This is as it should
be, we say, because the bank is in a very real sense a public
trustee, performing an important and necessary public function.
This article explores legal and constitutional dimensions
of central banks’ powers to create money, ‘central bank reserves’,
through monetary policy operations. Despite the prominence of monetary
authority since the Financial Crisis, the law supporting the creation of
central bank reserves is very obscure, as is the role of law in
structuring constitutional authority over money. We de-mystify those
important matters in three steps. First, we explain, for a legal
audience, the role of central bank reserves in the financial system and
broader economy. Secondly, we analyse the legal basis for the creation
of central bank reserves in three prominent ‘North Atlantic’ monetary
jurisdictions: the US Dollar, Euro and Sterling systems. Thirdly, we
show how the legal structure of central banking intermediates the
constitutional state's authority over money through parts of the
financial system, focusing on high-profile policy proposals, including
‘QE for the people’, and the creation of central bank digital
currencies.
The monetary world is often divided into three types:
currency (notes and coins); central bank money (or central bank
reserves); and private credit money (deposits or loans).1
Within that division, central banks have sole legal authority to
create bank notes and central bank reserves, and they guide the creation
of private credit money by commercial banks. For the last decade,
monetary policy has been defined by outright asset purchases funded by
central bank money, leading to the creation of vastly more reserves than
notes and coins, in the Dollar, Euro and Sterling monetary systems.2
Despite their recent celebrity, central bank reserves appear
to be legal orphans, at least when compared to currency and private
credit money. Legislation governing currency follows patterns familiar
to lawyers and accessible by the citizenry. Statutory power is conferred
on public institutions to issue notes or mint coins, and that physical
currency is designated as legal tender: the state-sanctioned medium of
exchange.3
Legal power to create private credit money is partly governed by the
gargantuan statutes that regulate banks, via statutory permissions to
take deposits and issue credit, and partly governed by the general law
of contract, debt and property.4
Central bank reserves have no obvious legal parentage. No
US, UK or Eurosystem statute explicitly confers power on the Federal
Reserve Banks (FRBs), Bank of England, European Central Bank (ECB) or
the National Central Banks of the Eurosystem (NCBs) to create or retire
reserves. On the contrary, in each of those monetary systems the only
explicit legal authority to create reserves lies in general law powers
of commercial banks to deposit (whether mandatorily or voluntarily)5
funds into accounts held at the central bank. For this reason, the
source of central banks’ power to create reserves is highly obscure.6 This is an unsatisfactory position given the vital importance of central bank reserves to monetary policy,7 economic policy,8 political debate9 and financial entities’ earnings.10
To shed some light in dark corners, our core inquiries and
claims in this article are threefold. First, we explain the centrality
of central bank reserves to modern central banking and the broader
economic system for a legal audience. That explanation covers the role
of reserves in the payments system, the settlement of inter-bank debts
and the execution of monetary policy. The latter topic is particularly
salient, given the prominence of ‘unconventional’ monetary policy over
the past decade in the form of ‘quantitative easing’ (QE) operations.
While some of those details will be familiar to financial-market
participants, they are less well known by legal scholars, despite being
critical preconditions to understanding the significance of the legal
frameworks governing the creation of central bank reserves and the
nature of constitutional authority over money.
Secondly, we ask ‘what legal authority supports the creation
of central bank reserves?’ Our answer, ‘it depends’, reflects the
organisational complexity of modern central banking. Two distinct
pathways lead to the creation of central bank reserves. First,
commercial banks create central bank reserves by exercising general
legal powers to lend money to central banks by making deposits into
reserve accounts. Secondly, central banks create reserves as a
consequence of exercising statutory powers to ‘purchase’, ‘sell’, ‘buy’
or ‘deal in’ securities with, or ‘lend’ to, financial market
counterparties. In both cases, legal rules relating to settlement
finality shore up the function of central bank reserves as an apex
settlement asset in the relevant monetary system. This being the case,
we argue that central banks’ legal authority to create reserves is best
characterised as implied or incidental to central banks’
express powers to transact in financial markets. We explain why those
two regimes co-exist, and note some complexities of that co-existence,
including accounting for reserves as liabilities and paying interest on
excess reserves, despite the fact that the overwhelming majority of
reserves are monetary units made by central banks, rather than deposits
of commercial banks.11
Thirdly (in conclusion), we ask ‘what impact does the legal basis of central bank reserve creation have on the exercise of monetary authority:
the power of states to create, retire and control the value of money?’
We answer that question by explaining the role of law in intermediating
monetary authority through the private financial system: legal
institutions presently cabin basic authority over money by reference to
various fixed features of financial markets: willing counterparties,
marketable financial assets and consensual bargaining. We call this
‘intermediated monetary authority’ and illustrate its basic features by
reference to central bank operations in response to emergencies: the
financial crisis and the Covid-19 pandemic. We then explain the impact
of that form of monetary authority on several presently prominent topics
in legal, financial and political engagements with central banks: (i)
the relationship between central banks’ legal capacities and their
‘mandates’; (ii) the notion that central banks are ‘magic money trees’;
and (iii) proposals for the issue of digital currencies by central banks
to non-financial firms and the general public In that way, our
descriptive legal analysis of central banks is linked to foundational
issues in the design of constitutional institutions and major public
policy choices confronting national governments, central banks and each
populace to which they are ultimately accountable.
Our close analysis of the law of central bank reserve
creation is undertaken in light of the increased public awareness of
central bank operations since the adoption of unconventional monetary
policy techniques, particularly QE. While technical economic literature
tends to focus on the asset purchasing side of QE and its impact on
balance sheets,12 more popular accounts focus on the deployment of central bank reserves in QE as an act of money creation.13
Despite that prominence, there is no literature addressing the legal
framework surrounding central bank reserve creation and the impact of
that framework on the exercise of monetary authority. This article is
intended to fill that gap by reference to the three major monetary
jurisdictions of the ‘North Atlantic’ financial system.14
In so doing, we build on the work of central bank specialists
concerning the legal basis of monetary policy, the constitutional
position of central banks and the balance of power between the public
and private financial systems.15
SYSTEMIC FUNCTIONS OF CENTRAL BANK RESERVES
From the perspective of the general public and the law
courts, the most prominent form of central-bank issued money is physical
currency in the form of bank notes.16
Legal treatments of money have reflected that prominence, exploring
the legal status and character of bank notes in exquisite detail.17
From the perspective of economic policy-makers and financial-market
actors, the only type of ‘public’ money which really matters are the
credit balances in the accounts held by commercial banks at the central
bank: ie central bank reserves. In this opening part, we explain (for a
legal audience) the significance of central bank reserves to the
economic and financial system, before commencing our analysis of the law
which supports their creation.
Central bank reserves serve two critical economic functions,
namely, as the apex ‘settlement asset’ in the payments system and the
administrative item through which monetary policy operations are
executed.
Central bank reserves as inter-bank settlement assets
Legal entities in the both the financial and
non-financial economies (individuals and corporations) can use various
forms of money to execute their economic transactions. They can use
currency (notes and coins), other money-like commodities (say, gold or
letters of credit) or book entries in the accounts of commercial banks
at which they hold accounts. Measured by economic value, most payments
are made by book-entries in deposit accounts of commercial banks.18
In that sense, payments for the (vast) majority of value-weighted
economic transactions occur via the accounts of customers held at
commercial banks.
In any 24-hour period, payments via bank accounts produce
asymmetric settlement obligations of debit and credit for commercial
banks: some of that asymmetry arises from banks’ customers’ transactions
and some arises from the conscious choices of commercial banks. Bank
customer payments create unpredictable levels of credits/debits in the
commercial banking system because on some days, for example, more HSBC
customers have credited the accounts of Barclays’ customers, than
Barclays customers have credited HSBC's customers’ accounts, leaving
Barclays with a net liability to HSBC.19
Banks will also experience liquidity shortfalls as a result of various
profit-seeking activities, including ‘maturity mismatches’ in their
balance sheets which arise from cashflow gaps between receipts from
higher-interest rate (long) bank-lending and outgoings on lower-interest
rate (short) bank-borrowing.20
Commercial banks can meet their payment/settlement
obligations in various ways. They can draw on cash reserves, borrow
money from other commercial banks (inter-bank lending), sell assets
(often economically identical to inter-bank lending) or they can borrow
money from the central bank.21
If the last option is selected, the central bank generates the loan
proceeds through the creation of central bank reserves, crediting the
account of the commercial bank in need of bridging finance,22
and the commercial bank then credits the reserve account of the bank
to which it owes an outstanding settlement balance. The debts between
the banks are ‘settled’ because they accept the exchange of central bank
reserves as final satisfaction of their respective financial
obligations.23
Those reserves are the ‘apex’ form of settlement asset, because
central banks (unlike commercial banks) are unlimited in the amount of
reserves they can provide commercial banks seeking to settle. In that
way, central bank reserves are a form of government-provided ‘liquidity
insurance’: monetary units issued by a central bank to commercial banks
and other financial entities which have temporary shortfalls of
cashflow.24
The label ‘reserves’ attaches to those monetary units as a
result of the historical usage of central bank accounts as pools of
funds held by commercial banks in ‘reserve’ of their payment liabilities
under systems of fractional reserve banking.25
Legal requirements to maintain credit balances in those reserve
accounts (reserve requirements) as liquidity back-stops were gradually
diluted throughout the 20th century,26 and many monetary systems do not require commercial banks to hold fractional reserves.27
Despite reserve requirements now being obsolete, the monetary units in
central bank accounts are still referred to as ‘reserves’, and the
accounts into which they are transferred are called variously ‘reserves’
and ‘settlement’ accounts’28 , ‘Master Accounts’,29 or, simply, ‘current accounts’.30
Whatever the terminology, ultimate settlement of inter-bank payment
obligations occurs through the transfer of those monetary units
(reserves) between accounts maintained at the central bank.
Central bank reserves and monetary policy operations
Central bank reserves are also critical to the
functioning of monetary policy, being the policies adopted by
governments and central banks to influence the volume and price of
credit in order to achieve various economic and social objectives:
stable prices, maximum employment and rescue measures in moments of
economic crises.31 Monetary policy takes different forms at different times, in different jurisdictions,32
but in the monetary systems of the North Atlantic, an influential
division has developed between conventional (pre-financial crisis) and
unconventional (post-financial crisis) monetary policy.33
Conventional Monetary Policy
Pre-financial crisis, ‘conventional monetary policy’
generally referred to the achievement of stable inflation (price
stability), with a two per cent annual growth rate in the price of
consumer goods as a typical target.34
Central banks sought to hit that target by setting interest rates in
the financial economy through influencing the rate at which commercial
banks could obtain finance on the inter-bank market or from the central
bank.35
Interest-rate targeting was executed via several
different types of transactions. The most common were ‘repo’
transactions: contracts for the sale and re-purchase of securities
(often government bonds) by a discrete set of counterparty banks or
securities dealers.36 Repo transactions provided ‘overnight’ financing for commercial banks,37
and the difference between the sale and re-purchase price of a
security represented the interest rate on central bank credit which
underpinned headline interest rates transmitted to the broader financial
system via supply and demand dynamics in the inter-bank lending market.38
Interest rates were also targeted through direct lines of credit to
commercial banks, sometimes called ‘discount window’ facilities, through
which central banks lent reserves to commercial banks on a
collateralised basis.39
Like the difference between sale and purchase price in repos, the
interest rate of those credit facilities represented the interest rate
on central bank credit which could pass through into the general economy
via money market dynamics.
Finally, conventional monetary policy was also legally
executed by central banks making outright purchases/sales of financial
assets to provide/absorb liquidity in the inter-bank market, and thus
influencing the credit-offering behaviour of commercial banks.40
Purchasing assets (usually government bonds) from commercial banks
lead to a durable increase in the number of reserves in their accounts,
and a longer-term easing of frictions in the inter-bank market, making
banks more likely to lend. By remaining on central bank balance sheets
indefinitely, outright purchases were distinct to repo, but their volume
was less economically significant.41
Unconventional Monetary Policy
During the financial crisis, commercial banks ceased
lending to one another and central banks were forced to lower interest
rates close to, or nominally below, zero per cent: the ‘zero-lower
bound’.42
Thereby, the primary tool for influencing price stability was
sterilised and the operational tools for interest targeting fell into
disuse: repo transactions radically decreased, and standing facilities
were deployed to bail-out banks, rather than set-interest rates.43
Mid- and post-crisis, ‘unconventional monetary policy’ assumed a more
nebulous set of goals, including: ensuring the inter-bank credit market
continued to operate; making markets for highly-distressed asset classes
(such as mortgage-backed securities in the US); preventing deflationary
pressures from overwhelming the general economy; and fighting against
the collapse of the payments system. The principal method for achieving
those diverse objectives was to purchase debt securities on an enormous
scale: QE.44
The net impact and efficacy of QE as a transmission mechanism for monetary policy are topics of continuing discussion,45 and central banks’ own explanations of QE's objectives have subtly changed over time.46
Despite those shifting sands, two objectives have appeared to be
relatively stable although they remain debated: increased liquidity in
both the banking system and the general economy;47
and re-allocating private-sector asset portfolios, as the price of
assets purchased through QE shifted relative to assets excluded from QE.48
Legally, QE was structured as simply an expanded
program of outright purchases and in that sense was a continuation of
conventional monetary policy operations. A similar mix of debt
securities were purchased by central banks and the counterparties for QE
trades were the large commercial banks and securities dealers that were
repo counterparties in more conventional times. Economically,
financially, and politically, however, QE represented a landmark change
for modern central banks, as the volume of assets purchased and the
volume of central bank reserves created to fund those purchases were
several orders of magnitude greater than the outright purchases of
conventional monetary policy operations.
The Federal Reserve's assets (ie the securities held
on its balance sheet through repo and outright purchase) stood at ∼five
per cent of GDP in 2008; after five years of QE, they stood at ∼20 per
cent of GDP.49
The same enormous expansion in central bank assets can be found in the
UK (∼five per cent of GDP in 2008; ∼24 per cent in 2014)50 and the Eurosystem (0.2 per cent in 2008; 39 per cent in 2019).51
QE also embroiled central banks in the fiscal fortunes of central
governments, as the vast majority of assets purchased through QE
programs were government debt securities. Between 2009 and 2019, around
20 per cent of US, Eurosystem and UK government debt became owned by the
FRBs, the Eurosystem's NCBs and the Bank of England.52
Because QE asset purchases were funded by central bank reserves
created by central banks, those asset purchases were mirrored by an
equally momentous expansion in the supply of funds held by the financial
sector.
For our purposes, the central bank reserve creation
that underpinned QE exposed (to all observers outside the financial
sector) the relative unimportance of physical currency (bank notes and
coins) as the other type of ‘public’ money. Even before QE, central
banks were creating reserve balances in quantities which vastly
overshadowed the supply of physical currency to the non-financial
economy. (Figure 1)
Figure 1
shows the gross amount of reserves created under conventional monetary
policy operations through short-term repo ($1.9 trillion) and outright
security purchases ($50 billion) transactions in the US, vs the
face-value of Federal Reserve banknotes on issue ($720 billion) in 2004.53
As under QE, the US central bank issued vastly more reserves than
notes, but the short-term nature of the financing transactions they
supported meant that full extent of the reserve creation was not
revealed on the annual balance sheet. The same proportional mix of
reserves to banknotes was observable in comparable monetary systems
before QE.54
The critical point is to observe the emergence of central bank
reserves, rather than hard currency, as the apex public-monetary units
of the contemporary financial system.
Central bank reserves in modern central banking
The following table provides an overview that reveals the
centrality of central bank reserves to the functions of modern central
banks:
Central bank function
Policy objective
Transaction
Use of central bank reserves (CBRs)
Payments/ settlement
Settlement facilities
Commercial banks
borrow from central
banks to settle debts
CBRs lent by the central bank to
commercial banks
Payments/ settlement
/monetary policy
Reserve requirements
Commercial banks
deposit proportion of
liabilities with
central bank
CBRs lent by central banks to
commercial banks/ deposited by
commercial banks with the central
bank
Conventional
Monetary Policy
Interest-rate targeting
Repo transactions
CBRs are used to settle sale and
re-purchase transactions
Collateralised lending
CBRs are lent by the central bank to
commercial banks
Outright purchases
CBRs are used by the central bank to
purchase assets
Unconventional
Monetary Policy
Quantitative Easing
Outright purchases
CBRs are used by the central bank to
purchase assets
Central Bank Reserves: Function, Policy, Transactions
Central bank reserves are critical to all functions of
modern central banks. Most economic activity ultimately relies on a
stable supply of central bank reserves to the financial sector. If
central banks stop issuing reserves, commercial banks cannot reliably
settle their debts. If commercial banks cannot reliably settle their
debts, individuals cannot make payments in the general economy. If
payments cannot be made, the financial basis of economic exchanges is
removed. In that sense, central bank reserves are the most important
form of money directly controlled by public institutions. Despite that
importance, the legal basis for reserve creation has never been clearly
identified, nor has the role played by that law on the constitutional status of monetary authority. We turn to those tasks in the following two parts
LEGAL AUTHORITY FOR RESERVE CREATION
The law of central bank reserve creation has three central elements in the Dollar, Sterling and Euro zones:
Deposits by commercial banks: commercial banks create
credit balances in their reserve accounts by exercising legal powers to
make deposits. This creates a legal relationship of creditor
(commercial bank) and debtor (central bank).
Loans and asset purchases by central banks: central
banks create credit balances in reserve accounts as a consequence of
exercising statutory powers to enter into transactions (to ‘buy’
securities and make ‘loans’ or ‘advances’) with financial market actors.
Finality of central bank settlement: contractual and
statutory law permits commercial banks to transfer credit balances in
their reserve accounts finally to discharge their debts by making those
transfers final and irrevocable both between the commercial banks and
against third parties.
In this part, we explain the legal details of each element,
explain how they co-exist in modern central banking, and observe some of
the institutional and analytical complexities of that co-existence. The
first two elements could be characterised as distinct ‘pathways’ to the
creation of new central bank reserves, ie different ways of creating
new Dollars, Pounds, or Euros on the balance sheet of the central bank,
and hence on the balance sheet of commercial banks and ultimately in the
broader economy. Both ‘pathways’ rely on the third element, settlement
finality.
Reserve creation through commercial bank deposits
The most basic element of central bank reserve creation
is the legal framework which permits commercial banks to make deposits
into reserve accounts at central banks. As noted above, central bank
accounts were historically used as pools of funds against commercial
bank liabilities: liquidity back-stops under fractional reserve banking.
Although that systemic function of reserves is obsolete, the legal
framework underpinning it continues to be influential in modern central
banks, as we explain by reference to US, Eurosystem and UK law.
In each jurisdiction, law facilitates reserve creation
via commercial bank deposits in two ways: legal rules permitting or
obliging commercial banks to open accounts at the central bank; and
legal rules establishing a contractual relationship of debtor (central
bank) and creditor (commercial bank) in respect of the contents of those
accounts.
Legal Basis of Central Bank Reserve Accounts
The permission or obligation to open a central bank
reserve account generally flows from legislative rules, supplemented by
contracts between central and commercial banks governing the finer
details of reserve account usage.
US legislation obliges commercial bank members of the
Federal Reserve System to open reserve accounts with their FRB and to
deposit a given ratio of their liabilities into those accounts. Since
1913, member banks have been obligated by (the frequently amended)
section 19 of the Federal Reserve Act to ‘maintain reserves against
[their] transaction accounts’ as prescribed by the Federal Reserve
Board.55
The ‘composition’ of those reserves ‘shall … be in the form of …
balances maintained … by such depository institution in the Federal
Reserve bank of which it is a member or at which it maintains an
account’.56 The granular rules for those reserve accounts are provided by standard-form contracts issued by the FRBs.57
Similar requirements can be identified in the
Eurosystem, through a complex interplay of supra-national and national
law. European law imposes general obligations on commercial banks to
meet reserve requirements by making deposits at their NCB and assumes
the existence of accounts into which those reserves can be deposited.58
National law provides the granular rules concerning the system of
accounts at the NCBs and the use of those accounts by commercial banks
of the commercial banking system.59
Like the US, the detailed rules of reserve accounts at the NCBs are
provided by contracts between the NCBs and commercial banks.60
The same mix of legislation and contract undergirds
reserve accounts in the UK. Access to accounts at the Bank of England is
voluntary, and the relationship between the central bank and commercial
banks is governed by contract. Banks wishing to have access to the UK's
apex payments settlement system are obliged by contract with the Bank
of England to open and maintain a Sterling denominated current account
at the central bank,61
and monetary policy counterparties (repo and outright purchase
transactions) treat that current account as a ‘reserve account’.62
The Bank of England provides, operates, and supervises the digital
infrastructure underlying UK's apex wholesale payments settlement
system, the ‘clearing house automated payments system’ (CHAPS).63
In that way, reserve accounts are used to settle interbank debts and
receive central bank reserves issued through repo, loans and
asset-purchase transactions.64
While the legal framework of reserve accounts in the
UK appears largely contractual, it operates within a broader system of
parliamentary legislation. The Financial Markets and Insolvency
(Settlement Finality) Regulations 1999 allows for CHAPS to be mandated
as a ‘designated system’ for settling transactions and the Financial
Services (Banking Reform) Act 2013 (UK) regulates CHAPS as a payment
system. To that extent, reserve accounts in the UK (as in the US and
Eurosystem) are ultimately regulated by legislation.
Legal Basis of Deposit Balances in Central Bank Accounts
Each of the US, UK and Eurosystem legislative
frameworks assumes that reserve accounts receive deposits by commercial
banks with central banks, rather than monetary units created by central
banks and transferred to commercial banks. That legal position is
reflected in central bank accounting treatments of reserve accounts as
‘deposit’ accounts.65 In that way, the deposit pathway of central bank reserve creation mirrors the legal treatment of deposits at commercial banks.
In Anglophone common law jurisdictions, a deposit is
legally modelled as a loan from the customer to the bank upon which
interest is paid: the legal relationship created upon deposit is one of
creditor (customer) and debtor (banker).66
So much has been explicitly recognised by the US Supreme Court: ‘[t]he
relationship of bank and depositor is that of debtor and creditor,
founded upon contract’,67
with the consequence that receiving a deposit ‘consists of nothing
more than a promise to repay, from the bank to the customer.’68 English courts have been equally clear, stating that the obligation of a banker to a depositor is one of ‘money lent’.69
Major Eurosystem jurisdictions characterise bank
deposits in a broadly similar way, through the Civilian category of the
‘irregular deposit’.70 Where a depositary must usually return the deposited goods in individuo,
the depositary of a so-called irregular deposit of fungible goods only
has to return a like number and quantity as those received. German law,
for example, treats bank deposits as ‘irregular custody agreements’ (unregelmäßige Verwahrungsverträge) under §700 of the German Civil Code.
Title in the goods deposited passes to the deposit-taker. When money is
deposited, the transaction is treated as a ‘loan agreement’ (Darlehensvertrag)
subject to §488, such that the deposit-taker is obliged to return money
of an equivalent sum to the depositor. French law also treats deposits
as contractual relationships between the bank and the depositor, namely a
dépôt irrégulier governed by Article 1935 of the French
Civil Code. Again, title passes to the bank, and an obligation is
created to pay the depositor an equivalent sum.71
Thus, although the formal legal categories are subtly distinct to the
common law, the Civilian law of bank deposits is functionally identical:
making a deposit at a bank imposes a legal obligation on the bank to
make payments (rather than re-deliver the specific items of property
deposited) to the customer.
Central banking law adopts the same legal device,
treating the contents of central bank reserve accounts as ‘deposits’ of
account holders, which represent a financial liability on central banks’
balance sheet. As we explain below, there are difficulties with that
treatment in light of the other pathway for reserve creation, in which
central bank reserves are created by central banks, rather than
commercial banks making any kind of deposit.
Reserve creation through central bank transactions
Today, most central bank reserves are created by central
banks’ own transactional behaviour, rather than commercial banks making
deposits. The law supporting central banks’ powers to create reserves
has two main features: (i) express statutory powers of central banks to
‘buy’ and ‘sell’ assets or ‘engage in credit transactions’; and (ii)
implied statutory powers to create the monetary units necessary to carry
out those transactions. Again, we explain both features by reference to
US, UK, and Eurosystem law.
Legal Basis of Central Banks’ Reserve-Creating Power
In each of the US, UK and Eurosystem, statutory law
confers express powers to engage in two types of transaction, which
carry an implied legal power to create the monetary units (central bank
reserves) necessary for settlement: asset purchases and loans.
US legislation confers on the FRBs the general
corporate power to make ‘contracts’ and specific legal authority to
‘make advances to any member bank’ providing collateral, thereby
authorising the issue of central bank reserves via extensions of credit.72
The FRBs’ legal power to create reserves via asset purchases is
slightly more elaborate. Section 14 of the Federal Reserve Act confers
power on ‘[e]very Federal Reserve bank … to buy and sell, at home or
abroad, bonds and notes of the United States’ with the limitation that
US debt securities must be purchased on the ‘open market’.73
Exercises of those powers must comply ‘with the direction of and
regulations adopted by the Federal Open Market Committee’ (FOMC).74
FOMC's regulations are codified in Chapter 12 of the Code of Federal
Regulations which established the System Open Market Account (SOMA),75
provides for the selection of a single FRB to execute ‘Open Market
Operations’ (OMOs) and directs the selected FRB to buy and sell US
government securities on the open market for the SOMA account.76
Annually, the FRB of New York (FRBNY) is selected to execute OMOs and,
under that delegated authority, it selects the counter-parties for, and
executes, repo and outright transactions.77
Through that patchwork of legal instruments, the FRBNY is empowered to
engage in transactions which imply the creation of central bank
reserves as the purchase proceeds for the transactions that constitute
monetary policy operations.
A combination of inter-jurisdictional legislation
confers power on the Eurosystem NCBs to engage in loan and
asset-purchase transactions which imply the creation of reserves. At the
level of European law, Article 18 of the ECB Statute empowers the ECB
and NCBs to ‘operate in the financial markets by buying and selling
outright … or under repurchase agreement’ and to ‘conduct credit
operations with credit institutions and other market participants, with
lending being based on adequate collateral’. Because most central
banking operations are legally carried out by the NCBs, rather than the
ECB, European legislation provides the general framework for the
creation of Euro-denominated reserves and much important detail is
contained in domestic EU-member state legislation.
The constitutive statutes of many NCBs resemble
section 14 of the Federal Reserve Act by conferring power to purchase
and sell assets. For example, section 19 of the Bundesbank Act re-states
Article 18 of the ECB Statute, conferring power on the Bundesbank to
‘grant loans backed by collateral and trade in the open market by buying
and selling claims, marketable securities and precious metals outright
(spot or forward) or under repurchase agreements’. Similarly, section 8
of the statute governing the Netherlands NCB, the Bank Act 1998, confers
power to ‘effect transactions in the financial markets, including
receiving current account deposits from account holders, accepting
securities and other valuable items for safe custody, and effecting
credit transactions insofar as these are covered by adequate
collateral.’ Other NCBs rely directly on the authority conferred by
supra-national European law to buy assets.78
Befitting an old central bank, the Bank of England's
legal powers to transact are located in very dusty legislation. Basic
legal authority to make loans and purchase assets is contained in its
constitutive Royal Charter from 1694, which authorises the Bank to
‘purchase and acquire … sell, grant, demise, alien and dispose of …’
bills of exchange.79
The Bank of England Act 1694 imposes a general prohibition on the Bank
of England from dealing and trading; however, section 27 provides that
nothing in the Act shall be construed to limit the corporation's legal
powers to ‘[deal in] bills of exchange, or in buying or selling Bullion,
gold or silver or in selling any Goods, Wares or Merchandize
whatsoever, which shall really and bona fide by left or deposited with
the said Corporation for Money lent and advanced thereon.’ Although one
has to peer very closely at them, those ancient legal texts confer
authority on the Bank of England to engage in the transactions which
create central bank reserves, but they leave most of the important
details of those transactions to contractual bargaining between the Bank
and the financial sector.80
In conclusion, these US, European and UK legislative
rules provide the basic legal authority for central banks to execute
transactions which lead to the crediting of reserve accounts. In this
manner, a basic implied legal authority to ‘create’ reserves is
conferred on central banks. In the US and Eurozone, the funds supporting
the asset purchases of QE were impliedly authorised by the FRBs, ECB
and NCBs directly exercising those legislative authorities. The legal
structure of QE in the UK was subtly different: the Bank of England
exercised its legal power to create reserves by way of a ‘loan’ to a
separate legal entity established as an ordinary trading corporation
(the Bank of England Asset Purchase Facility Fund Limited), and that ‘QE
subsidiary’ performed the asset purchases of the UK's QE program using
the reserves created by its central bank parent.81
Final settlement of debts using reserve balances
The final legal institution supporting the creation of
central bank money (by whichever pathway) is a set of fairly obscure
statutory and contractual rules concerning finality of payments in
central bank reserve accounts. This set of rules transforms the credit
balances created by the exercise of legal powers into assets held by
commercial banks which can be used in final settlement of their
inter-bank obligations.
Settlement finality is protected by two types of legal
rules. The first type protects inter-bank finality by preventing banks
which participate in central bank settlement facilities from contesting
the legal validity of transactions within those facilities. The second
type protects transactions in central bank settlement systems from
third-party challenge by disapplying otherwise generally applicable
legal rules which permit economic transactions to be unwound upon
insolvency. Together, those legal rules operate to ensure that a
commercial bank's use of the credit balances in its reserve account
provides a complete discharge from payment obligations.
Although the granular rules of each jurisdiction vary,
the basic legal regime comprises a set of legislation (primary and/or
delegated) and contractual law. Under US law, a combination of
legislation (primary and delegated)82 and standard form contracts issued by FRBs,83
protects payments made by US reserve account holders via the Federal
Reserve's payments system, ‘Fedwire’, from inter-bank and third-party
challenge.84
The overall result is that, once a credit balance in a reserve account
of a Federal Reserve member bank has been transferred to another bank's
reserve account, the debt between the two commercial banks is finally
extinguished.
In the Eurosystem, supranational law governs both
inter-bank and third-party finality via the Settlement Finality
Directive of 1998, which provides that a transfer order sent through a
central bank settlement system: (i) ‘may not be revoked by a participant
in a system, nor by a third party, from the moment defined by the rules
of that system’; (ii) and ‘shall be legally enforceable and, even in
the event of insolvency proceedings against a participant, shall be
binding on third parties’.85
The same result is achieved in the UK though a
combination of delegated legislation and contract. Inter-bank finality
is achieved by a contractual agreement between the Bank of England and
each reserve account holder that ‘any payment instruction, payment or
transfer to or from any Account may not be revoked by the Account Holder
after the Bank [of England] has credited the Account.’86
Third-party finality is achieved by delegated legislation (made by the
UK's Treasury) which explicitly disapplies insolvency legislation which
permits the voiding of payment transactions executed on the day of a
bank's insolvency:87 so-called ‘zero-hour’ rules.88
The legal frameworks governing the finality of payments
in central bank settlement facilities sketched above throw up a number
of interesting issues, including their possible characterisation as a
form of ‘legal tender’ law for central bank reserves. The important
point for now is that in each jurisdiction, legislative and contractual
rules provide the foundation for using credit balances in central bank
accounts in the final settlement of inter-bank liabilities. In that way,
law provides the basis for the use of central bank reserves as the apex
settlement asset of the financial system.
Complexities of the law of central bank reserve creation
The law governing the creation of central bank reserves
has an elusive quality because each of the three elements (deposit,
transaction, and finality) co-exist as a matter of the internal practice
of central banks. Take the Federal Reserve's system of ‘Master
Accounts’ which serves the multiple purposes of clearing funds, meeting
reserve requirements, receiving advances and clearing the proceeds of
securities transactions.89
Under that system of accounts, a FRB may indebt itself to a commercial
bank by accepting deposits into the Master Account (under the general
law of contract); it may create a debt in the commercial bank by
crediting a commercial bank's Master Account (exercising statutory power
to extend credit); and it may simply transfer reserves into a Master
Account (exercising statutory power to purchase assets). In each of
those three cases, the same monetary unit (a central bank reserve)
passes through the same account, despite the clear juridical differences
between each transaction.90 The co-existence of the various elements of reserve creation reflects the path dependency of 20th
century monetary law, rather than conscious choices on the part of
either central bankers or legislatures, but that co-existence can create
confusion (outside the financial cognoscenti) about the basic
legal and financial nature of central bank reserves, particularly in
relation to the status of reserves as ‘deposits’ and ‘liabilities’ of
the central bank.
Path Dependence of Monetary Law
Under a convertible-metallic monetary system, there could
be little confusion in identifying the contents of reserve accounts as a
deposit liability owed by the central bank to the commercial bank
account holder. Juridically, gold standards were created by legislative
rules which fixed the value of monetary units to a given quantity of a
metallic commodity, required or permitted the ‘payment’ of bank notes by
delivering that commodity and required central banks (as custodians of
the gold stock) to maintain a certain ratio of gold to their
liabilities.91
Accordingly, under a metallic-convertible monetary system, the content
of reserve accounts was obviously a monetary unit representing a
deposit qua an obligation to pay or purchase gold. At the
inception of the Federal Reserve System, member banks of the Federal
Reserve System met their reserve requirements by the physical deposits
of gold, gold certificates or ‘lawful money’ (physical notes issued by
the US Treasury and Federal Reserve Notes)92 with their Federal Reserve Bank.93
As the US monetary system morphed, between 1913 and 1972, from a
convertible, to a non-convertible but gold-backed, to a full-fiat money
system,94 reserve requirements could be met by maintaining credit balances in the member bank's Master Account at the Federal Reserve.95
In a monetary system without convertibility rules, however, treating
the contents of reserve accounts as ‘deposits’ is less straightforward.
When central banks are relieved of any legal obligations to exchange
notes for, or maintain stock of, metal (or foreign currency), a reserve
account simply becomes an index of the transactions executed by
commercial banks with central banks.
Throughout the changes of the past century, however, the
idea of a ‘deposit’ as an element of central bank reserve creation has
remained remarkably durable. Its contemporary relevance can be seen in
the continuation of financial reporting conventions that treat credit
balances in reserve accounts as deposit liabilities. The Federal
Reserve, ECB and Bank of England all record the contents of commercial
banks’ reserve accounts as deposit ‘liabilities’ in their consolidated
balance sheets: they are treated as ‘other deposits held by depository
institutions’ in the Federal Reserve's consolidated balance sheet;96 ‘deposits’ in the Bank of England's combined balance sheet;97 and ‘current accounts’ and ‘deposit facility’ in the ECB's consolidated balance sheet.98
That balance sheet treatment is predicated on the assumption that
central bank reserves are created by commercial bank deposits and
represent a debt owed by the central bank to the depositing commercial
bank. That is so despite the facts that: (i) a credit balance in a
reserve account does not entitle the commercial bank account holder to
‘payment by the central bank’ in any meaningful sense; (ii) the
overwhelming majority of central bank reserves are created by central
banks crediting reserve accounts, rather than commercial banks
transferring deposits into reserve accounts; and (iii) that, at least
since March 2020, many central banks have reduced reserve requirements
to zero per cent.99
In the context of commercial banking, a ‘deposit’
functions as money because it is treated as a transferrable claim for
payment against the bank at which the account is held.100
It is strongly contestable whether that notion of a deposit translates
into the context of central bank reserve accounts. Economists,
accountants and jurists have all noted the difficulties of
characterising monetary units created by a central bank under ‘fiat’
regimes as ‘claims’ on, or ‘liabilities’ of, the central bank.101 Rather than answer that deep question here,102
it suffices to note that the continued practice of accounting for
those purchases as ‘deposits’ demonstrates the intellectual durability
of the ‘deposit pathway’ of thinking about the creation of central bank
reserves.
The payment of interest on excess reserves (IOER) also
reflects this path dependency. Since the commencement of QE, the
accumulated central bank reserves created to purchase assets have been
labelled ‘excess’ reserves,103
and central banks announced they would pay ‘interest’ on those excess
reserves as an additional monetary policy transmission mechanism.104
Of course, the idea that IOER represents interest on debt obligations
owed by central banks to commercial banks account holders is highly
artificial. The financial reality of IOER is that central banks are
simply paying additional sums to financial market participants in
volumes which are referable to the quantity of reserves issued via QE
programs. Despite that financial reality, the description of the payment
of ‘interest’ on those reserves indicates that central banks continue
to rely on the idea of a loan agreement between a commercial bank
(creditor) and central bank (debtor) in their characterisation of a
reserve account.
Pathways to Exercise Monetary Authority
Our detailed analysis above exposed the somewhat
obscure law behind the creation of central bank reserves. Consideration
of this law shows that the creation of central bank reserves is legally
authorised in different ways, none of which exactly reflects
conventional understandings. Reserves are created by commercial banks in
dealings that follow a ‘deposit pathway’ and by central banks in
dealings that follow a ‘transaction pathway’. These rest on powers
implied from the ability to take deposits and engage in transactions,
respectively. Both legal bases for reserve creation co-exist in modern
central banking law. However, since the advent of QE (and probably
earlier), the only pathway that really matters is the transaction
pathway. This means that the dominant type of legal authority is the
implied legislative power of central banks to create reserves through
transactions with counterparties. This analysis holds implications for
the contemporary exercise of monetary authority in the systems under
study, and it is to these implications that we now turn.
RESERVE CREATION AND MONETARY AUTHORITY
This concluding part evaluates the impact of our legal
analysis of central bank reserves on key issues concerning ‘monetary
authority’, being the authority of the constitutional state over money.
We argue that the legal structure of reserve creation reflects a type of
‘intermediated monetary authority’ wherein the state's authority over
money is legally contingent on the existence of a particular set of
financial market attributes: willing counterparties, marketable assets,
and a particular type of payments system. We then explain the impact of
that argument on two presently prominent topics in monetary law and
practice: the scope of central bank ‘mandates’ and the conception of
central banks as ‘magic money trees’. We close the article by mooting
the potential impacts of ‘central bank digital currencies’ on our model
of intermediated monetary authority.
Intermediated monetary authority
The most important consequence of our analysis of central
bank reserve creation is to observe how the law which empowers central
banks to issue the apex monetary asset of the modern economy assumes the
existence of financial intermediaries between the central bank and the
non-financial economy.105
In one sense, this observation is suggested by the conventional
description of central bank account balances as ‘reserves’, ie monetary
units being held in reserve of commercial bank liabilities. More
important than this vestigial terminology, however, is the fact that the
intermediated nature of reserve creation flows directly from the legal
instruments that confer authority on central banks. Those statutes only
confer authority to create reserves by implication from express grants
of power to engage in financial market transactions: collateralised
extensions of credit; and purchases of securities. In granting the power
to create reserves in those terms, the relevant legal instruments
assume a number of stable features of financial markets.
First, central bank statutes assume the existence of a financial market participant
as the counterparty to an asset purchase or the recipient of credit.
Most of the time, those counterparties will be commercial banks holding
reserve accounts, but not always. The most prominent examples of
non-commercial bank counterparties are the investment banks within the
group of ‘primary dealers’ which transact with the FRBNY, and the
‘gilt-edged market-makers’ who transact with the Bank of England (and
its QE subsidiary),106 through the implementation of monetary policy operations.107
Although the distinction between commercial banks (with broad
deposit-taking and retail lending businesses) and investment banks
(without a large deposit footprint and a focus on complex financial
transactions and advising businesses) is often blurred,108 a number of central bank counterparties run pure investment businesses as specialist dealers in government securities.109
Irrespective of their precise categorisation, those banks sit as
intermediaries between central banks and the economic actors in the real
economy that are the ultimate targets of monetary policy operations:
households, consumers and non-financial firms.
Secondly, statutory grants of power to create reserves assume the existence of a marketable asset,
in most cases a financial asset such as a debt security. Because of the
implied nature of that power, the central bank needs something to buy,
sell, or pledge in order to create reserves. The contemporary preference
is for essentially risk-free assets (mostly government bonds) that are
functionally immune to market and asset-specific risk and therefore can
be assumed to trade at par.110 Thirdly, grants of legal power to create reserves assume a particular type of payments system
in which the vast majority of payments occur via deposit accounts held
with banks who seek clearance and credit facilities through their
central bank. In other words: central bank reserves only obtain their
monetary status as a result of the use, by commercial banks, of central
bank accounts as the chief clearing house in the payment system. The
status of central banks as the ultimate settlement institutions,
however, is not guaranteed – for example, apex settlement facilities in
the Hong Kong SAR are shared between the Hong Kong Monetary Authority
and three commercial banks.111
Finally, and most importantly, grants of legal power to
create reserves assume that the relevant financial market transactions
will be voluntary. Although central banks are public agencies,
the legal powers granted to them are powers to engage in consensual
transactions with other economic actors. This allows us to contrast
unconventional policy measures such as QE with alternatives such as
direct fiscal stimulus. Direct fiscal stimulus can be delivered to any
economic actor (including individuals and ordinary firms), does not
require a collateral asset, such as government bonds, does not
presuppose or require any particular payments system, and can be
involuntary.112
These preconditions combine such that the money-creating
powers of central banks are contingent on the intermediation of the
financial sector. Central banks’ legal authority to create money is
conditioned on demand for that money in the economy, and the nature of
the demand will influence the nature of the money that is created. Put
differently, reserve creation can take various forms depending on the
type of transaction and assets involved (for example repo versus
outright purchase, public versus private sector assets, and longer
versus shorter maturity) and depending on the frictions existing in the
relevant financial market.113
The impact of financial market actors on the exercise of
monetary authority under the current legal frameworks of central bank
reserve creation is vividly illustrated at times of crisis. Before the
financial crisis, conventional exercises of monetary authority assumed a
particular type of financial market profile and the abrupt shift in
that market brought an equally abrupt shift in the exercise of monetary
authority by central banks.114
Interest rate setting operations assumed that repo counterparties were
willing to accept duration-limited reserve balances (ie loans of
reserves). As their balance sheets were punctured by failing assets,
those counterparties became less willing to execute repos and central
banks were forced to change the exercise of their monetary powers to
replace time-limited (repo) with permanent (outright purchases) balances
under QE. Although different lessons may be learned by economists, the
difficulty of executing monetary policy at the zero-lower bound teaches
jurists that monetary authority is heavily contingent on the behaviour
of financial market actors.
The same lesson was reinforced during the Covid-19
pandemic. The Federal Reserve's first response to the pandemic was not
to expand QE, but to expand its credit provision via repo,115
thereby exercising monetary authority by providing time-limited credit
to the financial system via the financial firms which are the FRBNY's
designated open-market operation counterparties: the Primary Dealers.
The Federal Reserve only shifted to outright purchases when the Primary
Dealers refused to assume the re-payment burden of repos:116 thereby exercising monetary authority by providing permanent increases in the financial system's reserve balances.
As the Federal Reserve's Chair explained:
liquidity had become
very strained in Treasury … markets, and we decided to offer very large
quantities of term and overnight repo to address that. That makes it
easier to finance the purchase of … Treasuries. So we did that, and …
the take-up was not as high as many had expected, and …we did learn
something from that. … [W]hat we learned was that we needed to go direct
here rather than trying to intermediate through the dealers.
And so we realized at
that point that we would need to actually purchase securities for our
portfolio, so we did that on Friday. We bought – the next day, Friday,
we went in and we bought across the curve, and we bought, I think, $37
billion worth of securities …117
Those remarks emphasise the reality of intermediated
monetary authority: central banks’ institutional authority to create
money is confined to consensual financial market transactions and
heavily influenced by the decisions of private market counterparties.
Future scholarly effort will be required to explore the
full ramifications of our conclusion that existing legal frameworks
create an intermediated form of monetary authority. Interesting issues
will surely arise in applying our model of intermediated monetary
authority once one takes account of the existence of ‘shadow banks’
(credit issuing institutions without reserve accounts or deposit
insurance)118 and the reality of the US Dollar as the de facto global reserve currency.119
In both contexts, the role played by domestic legal institutions in
funnelling monetary authority through the financial system is
complicated by the role of hegemonic states and non-traditional
financial actors. A further complex of issues is likely to arise in
determining the different ways that intermediated monetary authority is
exercised during economic and financial crises: where legal, political
and economic conditions may operate to deprive money of most of its
legitimate ‘authority’.120
Finally, a discrete set of legal, financial and constitutional issues
arise in relation to the use of central banks’ money creation powers to
fund public expenditure (aka, ‘monetary financing’), where monetary
authority is ‘intermediated’ through national treasuries, rather than
commercial banks.121
Rather than pre-empt answers to those broader questions,
we close our analysis by illustrating the concrete impact of our concept
of intermediated monetary authority on three prominent topics in
central banking and economic policy: the relationship between central
banks’ legal powers and their ‘mandates’; the descriptive accuracy of
the idea that central banks are ‘magic money trees’; and the potential
impacts of ‘central bank digital currencies’ on the monetary authority
of the constitutional state.
Central bank mandates and ‘the magic money tree’
Most economic and policy debates on the scope of central
banks’ monetary authority focus intensely on the rigidity/flexibility
and appropriateness of ‘mandates’. Central bankers, politicians,
practicing economists, and academics use the concept of a mandate as a
proxy for the ‘core institutional objectives’ of central banks: the
ultimate tasks they must perform. The usage fits the private financial
market origins of central banking wherein the concept of a mandate has a
rich history, representing the legal constraint on the scope of
authority held by a banker (or investment professional) in the
management of a client's funds.122
Despite the clarity of the
concept in financial practice, the precise relationship between a
central bank's ‘mandate’ and its governing legal framework is not always
clear. Some central bank statutes explicitly provide a set of
overarching objectives which match the bank's own understanding of its
‘mandate’. An example is the US Federal Reserve System's legislative
‘monetary policy objectives’:
The Board of Governors
of the Federal Reserve System and the Federal Open Market Committee
shall maintain long run growth of the monetary and credit aggregates
commensurate with the economy's long run potential to increase
production, so as to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.123
Other central bank mandates are less decisive. For
example, the Bank of England's monetary policy mandate mixes price
stability with a nebulous command to ‘support the economic policy of Her
Majesty's Government, including its objectives for growth and
employment’.124
From one perspective, mandates limit the way central banks can lawfully exercise their powers.
For example, the power to create central bank reserves is cabined by
the central bank's price stability objectives. In other words, the
‘mandate’ of the central bank determines the purposes for which the
central bank can use its legal powers.125 In itself, this is relatively obvious and not particularly interesting.
A more interesting inquiry is whether central bank mandates are limited by central banks’ legal powers:
does a mandate to pursue, for example, price stability merely impose a
duty on the central bank to use its powers to pursue that objective, or
do the central bank's powers grow to fill its mandate. In our view, it
is clear that the limits of an entity's legal powers will restrict the
ways in which it can pursue its institutional objectives. The police,
for example, are given a broad ‘mandate’ to investigate crimes, that
broad objective is limited by the legal capacities conferred on
individual police personnel which are expressly granted and strictly
circumscribed. The same reasoning applies to central banks. As agencies
wielding public authority, central banks are duty-bound to pursue broad
public policy objectives, but the practical means at their disposal are
limited to those expressed or implied in the relevant legal framework.
The mandate may inform the interpretation of empowering legislation, but
the imposition of (say) a duty to pursue an inflation target does not
per se entail an extension of the central bank's legal power and
capacities.
On our analysis, the central banks we have studied can,
at present, only execute their mandated objectives (for example
price/financial stability, full employment, and economic growth) through
financial market transactions that involve commercial banks (and other
private entities) as willing counterparties. It is only through such
transactions that central banks are able to create reserves, the core
monetary unit of the modern economy. So, again, the authority of central
banks to pursue their ‘mandates’ is intermediated, in a crucial, but
under-appreciated, sense through financial markets. That view of the
legal limits of central bank mandates carries weighty implications for
prominent policy questions concerning central banks’ response to
financial crises. For example, proposals of ‘QE for the people’126 or ‘helicopter money’ (ie direct monetary stimulus to individuals)127
might hit against legal constraints – or, more accurately, falter due
to an absence of a legal power on the part of the central bank.
Ultimately, the intermediated
nature of monetary authority has broader implications on academic and
political understandings of the nature of central banks’ powers. A
persistent idea is that central banks exercise the power of governments
to ‘create money’, that such powers are unlimited, with the consequence
that states (via central banks) have unlimited monetary resources. The
dominant academic/institutional sentiment regarding central bank's
powers of money creation is captured by the following:
A central bank is the
monopoly supplier of base money in its jurisdiction and can create such
money at will, instantaneously, and at virtually no cost. And its
customers are required to accept it. Accordingly, a central bank does
not face the liquidity constraint faced by commercial banks and other
entities, including the government.128
In popular discourses, the same notion is more pithily expressed: central banks are ‘magic money trees’129 that ‘print money’130 at will.
Monetary authority appears less infinitely extensible
from the perspective of the existing legal structure of central banks.
Unless fundamentally re-modelled, central banks are legally built to
exercise monetary authority via the private credit system, and their
chief functions of providing liquidity insurance and settlement
facilities assume that the vast majority of real economic transactions
are funded by (or paid via accounts held at) commercial banks. Under the
current institutional conditions, proposals to utilise central bank
powers to execute monetary policy directly with the non-bank public are
fraught with legal risk.
Dis-intermediation of monetary authority via ‘central bank digital currencies’
Our depiction of intermediated monetary authority is built on the law governing the current
monetary system. It likely, however, that the monetary status quo will
soon undergo a significant change through the introduction of ‘central
bank digital currencies’ (CBDC), electronic monetary units issued by
central banks to non-financial firms and the general population, thus
distinct from both extant forms of central bank money (ie, cash and
reserves). We conclude by discussing the potential implications of CBDC
on our model of intermediated monetary authority.
Rapid developments in information technology and social
acceptance of electronic transactions appear to make CBDC an
inevitability.131 In 2019, following several years of academic study,132
CBDC became a topic of intense institutional focus after a proposal by
a large US information technology company to create its own digital
currency that would compete with national currencies.133 By the end of 2020, all major central banks inside (and outside)134 the OECD indicated that they were exploring or would adopt some form of CBDC,135
and the International Monetary Fund released a detailed analysis of
the legal changes necessary to adopt CBDC in advanced and emerging
economies.136
At early 2021, the precise legal and financial forms of CBDC remain
topics of investigation and debate, and proposals differ along a number
of axes. Several design characteristics of particular importance are
whether the proposed CBDC: (i) is wholesale or retail; (ii) follows an
‘account-based’ or ‘token-based’ model; (iii) forms a direct (one-tier)
or indirect (two-tier) system between the central bank and the user;
(iv) is centralised or de-centralised; and (v) could be ‘programmable’
and ‘interoperable’.137
Given the strong momentum behind its adoption, special
caution should attend an evaluation of CBDC's total impact on the
monetary system, central banks and the constitutional societies they
serve. There is no ‘particular innovation in the provision of electronic
access to money, as debit and credit cards, internet banking and their
union in online shopping have all been available for some time’.138
Nor is there any novelty in the use of electronic money in central
banking, as all modern central bank payment systems operate through
computer hardware and software that permit the creation, transferral and
recording of credit and debits in digital form, rather than making
physical entries in hardcopy account books or (literally) moving money
from one reserve account to another.139 All the central bank reserves created since, at least, the turn of the 21st
century exist only as entries in computer systems. To that extent, a
form of CBDC is already an entrenched feature of modern monetary
systems.
CBDC does, however, hold transformative potential because
it could be designed to permit non-financial firms and individuals to
interact directly with central banks. In financial-sector parlance, that effect would be achieved by ‘retail’ CBDC,140
ie, digital currency issued by a central bank to individuals and firms
that transact outside the ‘wholesale’ financial system composed of
central banks, commercial banks, security dealers and other large
financial firms.141
Insofar as a retail CBDC's design features permitted ordinary people
and firms in the real economy to by-pass commercial banks (and other
non-bank financial firms) in making payments and obtaining credit, some
dis-intermediation of monetary authority would be a natural consequence
of its adoption.
Predicting the final, concrete, impact of CBDC on the
financial system is fraught with difficulty. Incrementalism has been
adopted as a ‘foundational principle’ for the roll-out of CBDC by the
central banks of the G7;142 ‘[c]entral banks have a mandate for stability and proceed cautiously in new territory’.143
Central banks have also indicated that CBDC should coexist with the
other monetary units of the contemporary economy: ‘[d]ifferent types of
central bank money – new (CBDC) and existing (cash, reserve or
settlement accounts) – should complement one another and coexist with
robust private money (for example commercial bank accounts) to support
public policy objectives.’144
In line with those policies, actual implementation of CBDC in advanced
mixed economies has been confined to very narrow pilot projects.145
In light of the protean nature of current CBDC proposals,
we present the potential impact of CBDC on the model of intermediated
monetary authority as existing on a spectrum between: low
dis-intermediation and high dis-intermediation, according to its
eventual design features. At the ‘low dis-intermediation’ end of the
spectrum, retail CDBC could simply expand the set of transactions
processed by central bank payments systems, by including consumer and
non-financial sector payments.146
That effect would be achieved by supplementing or replacing physical
currency (physical banknotes and coins) with retail CBDC, thereby
permitting lower-value payments in the real economy to be executed
through electronic systems operated by central banks. That alteration of
the monetary system would only have a marginal impact on the
intermediated nature of monetary authority.147
Commercial banks and other financial firms would retain their
systemically critical position as the principal providers of credit
(and, thereby, money) to individuals and non-financial firms, and would
retain a role in processing consumer payments made via commercial bank
accounts. Monetary policy would remain principally orientated towards
financial sector counterparties. Monetary authority would remain
strongly intermediated. As we note above, this minimally invasive
approach to CBDC is the apparent preference of central banks in the
OECD. At the ‘high dis-intermediation’ end of the spectrum, retail CBDC
could lead to the replacement of financial sector entities (commercial
banks and securities dealers) with ordinary people and non-financial
firms as the principal monetary policy counterparties of central banks.
For that effect to be achieved central banks would need to adopt retail
CBDC as the primary monetary unit to settle extensions of credit and
asset purchases with a view to influence broader economic conditions.
That use of retail CBDC would radically dis-intermediate monetary
authority, creating direct financial relationships between central banks
and private individuals. It could also lead to a ‘total separation of
banking and credit issuance functions of private banks’,148 which some scholars believe could create real economic benefits.149
Monetary policy operations would no longer assume the existence of
financial sector counterparties (commercial banks and securities
dealers). Monetary authority would be largely dis-intermediated.150
The most in-depth mapping of that wide dis-intermediation
of monetary authority via CBDC appears in Omarova's ‘People's Ledger’
proposal for the United States monetary system.151
Under that ‘blueprint for the comprehensive restructuring of the
central bank balance sheet’ Omarova ‘advocates the issuance of
general-purpose CBDC (the “digital dollar”), the concurrent migration of
all transaction deposit accounts from private banks to the Federal
Reserve’ and explores ‘the full range of new monetary policy options the
proposed structural shift would enable’.152
The principal monetary policy tool in such an approach to
dis-intermediation would become CBDC accounts held by all economic
agents, as the central bank ‘modulate[s] the aggregate supply of money
and credit by directly crediting and debiting the accounts of all
participants in economic activity, without interposing
intermediary-banks’ to implement both interest-rate setting and
unconventional monetary policies (like QE).153
Under Omarova's proposal, the central bank would still conduct some
monetary policy operations with the private financial sector, but only
with a view to permitting commercial banks to access credit for lending
to the real economy (rather than providing leverage for financial
engineering) via a ‘conditionality’ rule on central bank credit which
maximises ‘the flow of publicly-subsidized private credit to productive
enterprise, as opposed to socially sub-optimal speculative activities’.154
As Omarova recognises, such a re-organisation of the
monetary system would have a profound impact on the structure of the
financial system.155
It would transform commercial banks into ‘non-depository lenders’
reliant on very targeted credit from the central bank or private capital
markets to fund their lending activities and ‘remove the principal
rationale for the continuing reliance on primary dealers’.156
Within our model of intermediated monetary authority, the proposed
implementation of CBDC would remove financial sector intermediaries
(commercial and investment banks) almost entirely from the scheme of
monetary authority and would obviate the need for marketable assets in
the execution of monetary policy. Under Omarova's proposal, the
volitional aspect of the current scheme of monetary authority could also
be removed, as a person's CBDC accounts could simply be
credited/debited directly by the central bank without the person
consciously deciding to execute a transaction with the central bank.
Whether CBDC brings the minimally invasive changes
currently preferred by central banks, or the more fundamental changes
proposed by Omarova will depend on three legal and institutional
factors. The first factor is whether access to central bank accounts and
payment systems is extended to non-bank financial firms and, more
importantly, non-financial firms and individuals. The second factor is
the degree to which non-financial firms and individuals have access to
central bank credit and asset purchase facilities, rather than simply
being permitted to use their central bank accounts as participants in a
payments system. The third factor is whether central banks use credit
extensions and asset purchases with non-financial firms and individuals
as instruments to execute monetary policy.
Amending central bank and national currency statutes to
permit individuals to maintain central bank accounts may be a
technically demanding legal exercise, but is unlikely to transform the
organisation of monetary institutions. If those amendments were made,
however, the more momentous decision whether to execute monetary policy
operations directly with individuals and non-financial firms would
require very little legal adjustment, but an enormous change in the
intellectual predicates of central bank personnel, implying a
root-and-branch re-think of a number of fixed assumptions about the
nature of the relationships between public institutions, private
financial institutions and ordinary people in mixed economies. It would
also inaugurate a fundamental shift in the balance of power between the
financial and real economies, the boundary between monetary and fiscal
power and the balance of economic power in society more generally.
Reasonable minds will differ on whether the issue of electronic
currencies by monetary institutions could catalyse such tectonic shifts
in social institutions, and there is no guarantee that any CBDC actually
deployed would fundamentally ‘democratise’157
central bank operations. At this stage, our analysis is agnostic to
the relative merits of expanding central banks’ powers to permit
innovative deployments of their monetary authority. It is, however,
critical not to lose sight of those deep institutional issues, despite
the current sense of urgency and inevitability surrounding CBDC.
Notes:
∗ Associate Professor, Law School, Australian National University. This article was prepared as part of the ‘Legal and Economic Conceptions of Money’ project under the auspices of the ‘Rebuilding Macroeconomics’ research initiative of the Economic and Social Research Council (ESCR) and the National Institute of Economic and Social Research (NIESR). The authors wish to thank the ESCR/NIESR and acknowledge the support, inspiration and insights of the other members of that project team: Professor Rosa Lastra, Simon Gleeson, Dr Michael Kumhoff and Professor Saule Omarova. This article was inspired by seminars given by the authors to the Federal Reserve Bank of New York and the Bank of England in January 2020, and the authors greatly appreciated the penetrating questions asked by staff at both institutions. Finally, the authors are immensely grateful for the insightful comments provided by the anonymous MLR reviewers which significantly improved the article. Except where otherwise stated, all URLs were last visited 23 August 2021.
† Senior Research Fellow, Humboldt-Universität zu Berlin.
1 See for example M. McLeay, W. Radia and R. Thomas, ‘Money Creation in the Modern Economy’ Bank of England Quarterly Bulletin No 1/2014 (14 March 2014).
2 Central banks throughout the world have also adopted similar asset purchasing policies as emergency responses to the Covid19 pandemic: P. Cavallino and F. De Fiore, ‘Central banks’ response to Covid-19 in advanced economies’ Bank of International Settlements Bulletin, No 21 (5 June 2020).
3 For Sterling-denominated bank notes and coins, see Currency and Bank Notes Act 1954 (2 & 3 Eliz II, c 12), ss 1 and 3; Coinage Act 1971 (UK), ss 3 and 4; for US Dollar-denominated currency, see Federal Reserve Act 1913 (US), s 16(1) (12 USC §411); 31 USC §5112; for Euro-denominated currency, see Treaty on the Functioning of the European Union, Art 128; Protocol (No 4) on the Statute of the European System of Central Banks and of the European Central Bank (ECB Statute), Art 16.
4 For US federal banking legislation, see 12 USC chapter 2; for the UK, see Financial Services and Markets Act 2000 (UK), ch 3; for the general law which applies to the creation of deposits by commercial banks, see R. Cranston et al, Principles of Banking Law (Oxford: OUP, 2018) 160; Bank of Marin v England 385 US 99, 101 (1966); Citizens Bank of Maryland v Stumf 516 US 16, 21 (1995); Foley v Hill (1848) 2 HLC 28 [9 ER 1002].
5 As we explain below, the US and EU have mandatory ‘reserve requirements’, while the UK does not: see text accompanying n 55 below and following.
6 The major anglophone texts on monetary law only touch briefly on central bank reserves: S. Gleeson, The Legal Concept of Money (Oxford: OUP, 2018) 4.41, 6,10-6,12, 6.58; C. Proctor, Mann on the Legal Aspect of Money (Oxford: OUP, 7th ed, 2012,) 2.75-2.76, 33.57.
8 W. Buiter ‘The Simple Analytics of Helicopter Money: Why It Works – Always’ (2014) 8 Economics: The Open-Access, Open-Assessment E-Journal 1.
9 A. Jackson and B. Dyson, Modernising Money: Why Our Monetary System Is Broken and How It Can Be Fixed (London: Positive Money, 2012).
10 M. Demertzis and G.B. Wolff, ‘What Impact Does the ECB’s Quantitative Easing Policy Have on Bank Profitability?’ Policy Contribution No 20 (Brussels: Bruegel, 2016); J. Montecino and G. Epstein, ‘Have Large Scale Asset Purchases Increased Bank Profits?’ Institute for New Economic Thinking Working Paper No 5 (March 2015).
11 See D. Archer and P. Moser-Boehm, ‘Central Bank Finances’ BIS Papers No 71 (April 2013).
12 See for example V. Curdia and M. Woodford, ‘The Central Bank Balance Sheet as an Instrument of Monetary Policy’ National Bureau of Economic Policy Working Paper No 16208 (July 2010); C. Pattipeilohy, ‘A Comparative Analysis of Developments in Central Bank Balance Sheet Composition’ Bank of International Settlements Working Paper No 559 (April 2016).
13 See for example McLeay, Radia and Thomas, n 1 above.
14 For the significance of the idea of ‘North Atlantic Finance’ to domestic and international politics and constitutionalism, see: A. Tooze, Crashed: How a Decade of Financial Crises Changed the World (London: Penguin, 2019) ch 3; T. Bayoumi, Unfinished Business: The Unexplored Causes of the Financial Crisis and the Lessons Yet to be Learned (Cambridge, MA: Yale University Press, 2017) Part I.
15 R.M. Lastra, International Financial and Monetary Law (Oxford: OUP, 2006) ch 2; C.A.E. Goodhart and R.M. Lastra, ‘Populism and Central Bank Independence’ (2018) 29 Open Economics Review 49; D. Small and J. Clouse, ‘The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act’ Board of Governors of the Federal Reserve System Working Paper (19 July 2004); M. Friedman and C.A.E. Goodhart, Money, Inflation and the Constitutional Position of the Central Bank (London: Institute for Economic Affairs, 2003); P. Conti-Brown, ‘The Institutions of Federal Reserve Independence’ (2015) 32 Yale Journal of Regulation 257; R. Hockett and S.T. Omarova, ‘The Finance Franchise’ (2017) 102 Cornell Law Review 1143.
16 Coins are also currency and the legal framework governing them is replete with esoteric legal issues: see for example Proctor, n 6 above, 1.18-1.27. We put coins aside here for two reasons: (i) in most jurisdictions they are not issued by a central bank, but by a national treasury or mint (an exception is the Eurosystem); and (ii) they make a negligible contribution to modern economic life: for example in January 2020 the face value (and proportional share) of central bank issued money in the Eurozone stood at: ∼€30illion coins (one per cent of the face value of monetary instruments issued by the ECB); ∼€1.2trillion bank notes (40 per cent of the total); and ∼€1.8trillion central bank reserves (60 per cent of the total): data from https://www.ecb.europa.eu/stats/policy_and_exchange_rates/banknotes+coins/circulation/html/index.en.html; https://www.ecb.europa.eu/pub/annual/balance/html/index.en.html
17 See for example J.S. Rogers, ‘Early English Law of Bank Notes’; H. Siekmann, ‘Deposit Banking and the Use of Monetary Instruments’; K.G.C. Reid, ‘Banknotes and their Vindication in Eighteenth-Century Scotland’all in D.Fox and W.Ernst (eds),Money in the Western Legal Tradition (Oxford: OUP, 2016).
18 Because data on the precise mixture of different payment media is scarce, that statement is inferred from the fact that deposit balances in commercial banks far exceed the face value of bank notes on issue: McLeay, Radia and Thomas, n 1 above, 15.
19 See generally, T. Kokkola (ed), The Payment System: Payments, Securities and Derivatives, and the Role of the Eurosystem (Frankfurt am Main: European Central Bank, 2010) ch 1.
20 The financial rationale and economic effects of those mismatches are discussed in: M. Stigum and A. Crescenzi, Stigum’s Money Market (McGraw-Hill Education, 4th ed, 2007); Kapadia et al, ‘Liquidity Risk, Cash-Flow Constraints and Systemic Feedbacks’ Bank of England Working Paper No 456 (June 2012).
21 Hypothetically, banks could also issue equity to obtain settlement funds, although the time-critical nature of payments systems would likely make that an impossibility.
22 Liquidity is provided to a broader set of financial sector counterparties, most prominent investment banks and securities dealers that specialise in the sovereign debt markets: see n 36 below.
23 We explain the legal basis of ‘settlement’, n 81 below et seq. For an admirably clear account from the financial system perspective, see Kokkola, n 19 above, chs 1, 6 and 7.
24 Bank of England, ‘Liquidity Insurance at the Bank of England’ Media Release, October 2013 at https://www.bankofengland.co.uk/-/media/boe/files/markets/sterling-monetary-framework/liquidity-insurance-at-the-boe.pdf . For the mechanics behind those applications of central bank reserves, see Committee on Payment and Settlement Systems, Bank of International Settlements, ‘The Role of Central Bank Money in Payment Systems’ Report, August 2003 at https://www.bis.org/cpmi/publ/d55.pdf
25 See, Hockett and Omarova, n 12 above, 1152 citing C.A. Phillips, Bank Credit: A Study of the Principles and Factors Underlying Advances Made by Banks to Borrowers (New York, NY: Macmillan, 1920) 165-169; P. Samuelson and W. Nordhaus, Economics (McGraw-Hill, 2009, 19th ed) 464-465; J. Stiglitz, Economics (New York, NY: W.W. Norton & Co, 2d ed, 1997) 732-734.
26 See U. Bindseil, Monetary Policy Implementation: Theory, Past and Present (Oxford: OUP, 2005) ch 6.
27 Where reserve requirements still exist, they are viewed as a monetary policy tool, rather than a fractional-reserve liquidity back-stop: see generally Y.-Y.C. Obrien, ‘Reserve Requirement Systems in OECD Countries’ Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54 (23 July 2007).
28 As in the UK, see Bank of England, ‘RTGS Account Mandate Terms and Conditions’.
30 As in the Bank of Japan, see Institute for Monetary and Economic Studies, Functions and Operations of the Bank of Japan (Tokyo: Bank of Japan, 2012) 104.
31 Goals reflected, with varying precision, in some central bank’s legal ‘mandates’: Federal Reserve Act 1913 (US), s 2A; Treaty on the Functioning of the European Union, Art 127; Bank of England Act 1998 (UK), s 11.
32 For the pre-20th century history of monetary policy, see Bindsel, n 7 above, 43-44; M. Friedmann and A. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton, NJ: Princeton University Press, 1971) 127-128, 151-152; U. Bindseil, Central Banking Before 1800: A Rehabilitation (Oxford: OUP, 2019).
33 See for example Bank of International Settlements, ‘Unconventional monetary policy tools: a cross-country analysis’ Committee on the Global Financial System Papers No 63 (October 2019) 8-9; P. Conti-Brown, The Power and Independence of the Federal Reserve System (Princeton, NJ: Princeton University Press, 2016) ch 6; U. Bindseil, ‘Evaluating Monetary Policy Operational Frameworks’ 31 August 2016, 6 at https://www.kansascityfed.org/∼/media/files/publicat/sympos/2016/econsymposium-bindseil-paper2.pdf?la=en
35 Bindseil, n 7 above, ch 4. For excellent accounts of pre- and post-crisis monetary policy from a legal perspective, see Lastra, International Financial and Monetary Law, n 15 above, chs 2 and 7, Conti-Brown, n 15 above, ch 6-7; Proctor, n 6 above, 2.76
36 Most monetary policy operations in the US and UK are limited to a very select group of financial sector counterparties that market-make in sovereign debt markets (in the UK: ‘Gilt-Edged Market Makers’ at https://www.dmo.gov.uk/responsibilities/gilt-market/market-participants/ and in the US: ‘Primary Dealers’ at https://www.newyorkfed.org/markets/primarydealers). The group of eligible monetary policy counterparties in the Eurosystem is far broader: Task Force on the Use of Monetary Policy Instruments, ‘The use of the Eurosystem’s monetary policy instruments and its monetary policy implementation framework Q2 2016 – Q4 2017’ European Central Bank Occasional Paper Series No 209/April 2018.
37 Although ‘term’ repos were also conducted, with holding periods of up to three months: see the entries for longer-term repos in the balance sheets of the Federal Reserve System, the ECB and the Bank of England: Bindseil, n 7 above, 232-234.
38 That is a necessary simplification of the deep complexity of interest-rate setting operations. For accessible explanations of the ways that central banks executed interest rate setting through repos, see A. Kroeger, J. McGowan and A. Sarkar, ‘The Pre-Crisis Monetary Policy Implementation Framework’ Staff Report No 809, Federal Reserve Bank of New York (May 2018) and Bindseil, n 26 above, chs 4 and 5.
39 For the various types of ‘discount window’ transactions, see Bindseil, ibid, 106-108.
40 On the role of outright transactions pre-crisis see Kroeger, McGowan and Sarkar, n 38 above, 10; Bindseil, ibid, 153-156.
41 Taking the US as an example, in 2004 only $50billion of securities were purchased outright, compared to $1.5trillion of repo transactions: Kroeger, McGowan and Sarkar, ibid, 10.
42 For masterful accounts of the ultimate and proximate causes of the financial crisis, see Tooze, n 14 above, Parts I and II; Bayoumi, n 14 above, Part I. For more detailed economic treatment, see L. Gambacorta, B. Hofmann and G. Peersman, ‘The Effectiveness of Unconventional Monetary Policy at the Zero Lower Bound: A Cross-Country Analysis’ (2014) 46 Journal of Money, Credit and Banking 615.
43 For a non-technical multi-jurisdictional analysis of the relationship between financial crises and unconventional monetary policy, see S. Potter and F. Smets, ‘Unconventional monetary policy tools: a cross-country analysis’ Committee on the Global Financial System Papers No 63, Bank of International Settlements (October 2019).
44 Various iterations of repo and standing facilities continued to exist after the adoption of QE: see for example the Federal Reserve’s ‘Primary Dealer Credit Facility’ Federal Reserve Bank of New York, Term Sheet for Primary Dealer Credit Facility, 17 March 2020 at https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200317b1.pdf , the Eurosystem’s ‘Targeted Longer-Term Refinancing Operations’ (Guideline (EU) 2015/510 of the ECB of 19 December 2014 on the implementation of the Eurosystem monetary policy framework (ECB/2014/60), Art 7); and the Bank of England’s ‘Discount Window Facility’, ‘Operational Standing Facilities’ and ‘Contingent Term Repo Facility’ Bank of England, ‘Sterling Monetary Framework: SMF Operating Procedures’ (3 June 2019)).
45 Samples of that discussion over the last three years are collected in B. Broadbent, ‘The History and Future of QE’ Speech given to the Society of Professional Economists, London, 23 July 2018, fn 16 and A. Haldane, M. Roberts-Sklar, T. Wieladek and C. Young, ‘QE: The Story so Far’ Bank of England Staff Working Paper No 624 (19 October 2016).
46 A collection of transmission mechanisms for QE can be found in S. Potter, ‘The Federal Reserve’s Experience Purchasing and Reinvesting Agency MBS’, Remarks at the Bank of England, London (7 March 2019).
47 J. Gagnon, M. Raskin, J. Remache and B. Sack, ‘Large-Scale Asset Purchases by the Federal Reserve: Did They Work?’ Federal Reserve Bank of New York Staff Reports No 441 (March 2010); J. Christensen and J. Gillan, ‘Does Quantitative Easing Affect Market Liquidity?’ Federal Reserve Bank of San Francisco Working Paper No 26/2013 (December 2019).
48 Sources are collected in Broadbent, n 45 above, 10.
50 Data from Federal Reserve Bank of St Louis FRED: Bank of England Balance Sheet – Total Assets in the United Kingdom (BOEBSTAUKA) at https://fred.stlouisfed.org/series/BOEBSTAUKA
52 See the ‘Bruegel database of sovereign bond holdings’ developed by S. Merler and J. Pisani-Ferry, ‘Who’s afraid of sovereign bonds’ Bruegel Policy Contribution 2012|02, February 2012 (updated 29 April 2020). Those holdings had precipitate impacts on the monetary financing of public expenditure by central banks: see further, W. Bateman, Public Finance and Parliamentary Constitutionalism (Cambridge: Cambridge University Press, 2020) ch 7 (Bateman, Public Finance); W. Bateman, ‘The Law of Monetary Finance under Unconventional Monetary Policy’ (2021) Oxford Journal of Legal Studies (advance) gqab008 at https://doi.org/10.1093/ojls/gqab008
53 Repo and outright figures from FRBNY, ‘Pre-Crisis Monetary Policy Implementation Framework’, 10; figures on banknotes from Board of Governors of the Federal Reserve System, Annual Report 2004, 316. The figure displays total bank notes on issue, rather than bank notes issued in 2004: the latter was a much smaller number, further emphasising the relative insignificance of bank notes in comparison to reserves.
54 The same balance of currency and reserves generalises beyond the US. Pre-financial crisis in the UK, the Bank of England issued vastly more reserves for interest-rate setting operations (£1.08trillion in 2006) compared to banknotes on issue (£36.9billion in 2006): repo data from Bank of England, Bankstats, YWDB23C, ‘Daily changes of Central Bank sterling new weekly operations for monetary policy’; UK banknote data from Bank of England, Annual Accounts 2006, 110.
55 Federal Reserve Act, s 19(b).
56 Federal Reserve Act, s 19(c), also confersi permission to hold a proportion to reserves in vault cash. The same concepts carry through into Regulation D12 CFR §204: ‘(a)(1) A depository institution … shall satisfy reserve requirements by maintaining vault cash and, if vault cash does not fully satisfy the institution’s reserve requirement, in the form of a balance maintained … (i) In the institution’s account at the Federal Reserve Bank in the Federal Reserve District in which the institution is located.’
57 Federal Reserve Banks, ‘Operating Circular No 1: Account Relationships’ (effective 1 February 2013).
58 The ECB Statute, art 19(1) confers power on the ECB’s Governing Council to require banks to hold minimum reserves on account with their NCB. That power was relevantly exercised by Guideline (EU) 2015/510 of the European Central Bank of 19 December 2014 on the implementation of the Eurosystem monetary policy framework (ECB/2014/60).Reserve accounts are assumed to exist in all EU central banks in Directive 98/26/EC of the European Parliament and Council (19 May 1998) on settlement finality in payment and securities settlement systems. For the pre-Euro position in major European central banks, see U. Bindseil, ‘Reserve Requirements and Economic Stabilisation’ Deutsche Bundesbank Discussion Paper 1/97 (January 1997).
59 See for example Article 141-8 of the Code monétaire et financier (for the Banque de France); §22 of the Bundesbankgesetz and VG Frankfurt am Main, Urteil vom 11.02.2010 - 1 K 2319/09.F.
60 See for example ‘General Terms and Conditions of the Deutsche Bundesbank’ Banking Regulations 5, 1 January 2019), in English translation at https://www.bundesbank.de/ resource/blob/618354/a269ec70dc21688e3444d027d19e94da/mL/bundesbank-gtc-data.pdf ; and the Banque de France’s TARGET2-Banque de Franc Agreement, in English translation at https://www.banque-france.fr/sites/default/files/media/2016/11/09/2016-10-25_convention_pm_psr_en.pdf
61 CHAPS Reference Manual 29 March 2019, [2.1.1]. The amount of reserves deposited into that account is in the discretion of a CHAPS member bank, but must be sufficient to meet that bank’s settlement obligations.
62 Bank of England, ‘RTGS Account Mandate Terms and Conditions’ and ‘Reserves Account Annex’ (February 2019); Bank of England, ‘Sterling Monetary Framework: SMF Operating Procedures’ (3 June 2019); Bank of England, ‘Terms and Conditions for Participation in the Bank of England’s Operations under the Sterling Monetary Framework’ (18 March 2019).
63 Meaning ‘Clearing House Automated Payments System’for which terms and conditions for participation are provided in the Bank of England RTGS Account Mandate Terms and Conditions (February 2019).
64 Bank of England, ‘Bank of England Settlement Accounts’ (March 2019), [18]; Bank of England, ‘SMF Operating Procedures’ (3 June 2019), [3.13].
65 See for example Board of Governors of the Federal Reserve System, Federal Reserve Banks Combined Financial Statements for the Years Ending December 31, 2019 and 2018 and Independent Auditors Report (Washington, DC: KPMG, 2020) 4; Bank of England, Annual Report and Accounts 2017-
2018 32.
66 Cranston, n 4 above, 160.
67 Bank of Marin v England n 4 above.
68 Citizens Bank of Maryland v Stumf n 4 above.
69 Joachimson v Swiss Bank Corporation [1921] 3 KB 110; Foley v Hill n 4 above. Banks enjoy a variety of legal protections not available to other debtors, including exemption from the normal obligation proactively to meet loan obligations (but to await an instruction from a customer) and the right to re-coup customer debts without recourse to litigation (the right to combination): Cranston, n 4 above, 165.
70 For an extended analysis of the irregular deposit and its similarities and differences to the loan contract, see J. Huerta de Soto (M.A. Stroup trans), Money, Bank Credit, and Economic Cycles (Auburn, AL: Ludwig von Mises Institute, 3rd ed, 2012) ch 1, ‘The Legal Nature of the Monetary Irregular-Deposit Contract’ (arguing that the two are different, but accepting that the conventional analysis treats them as equivalent).
78 Prominent examples are the Banque de France and Banca d’Italia which rely on European (rather than French or Italian) law to authorise their operations: see for example Statuto della Banca d’Italia, Art 34.
80 Bank of England, The Bank of England’s Sterling Monetary Framework: Updated June 2015 (2015), 6.
81 A fuller analysis of the legal structure of QE in the UK is contained in Bateman, Public Finance n 52 above; Bateman, ‘Law of Monetary Finance’ n 52 above.
82 Federal Reserve Act, s 13 (empowering each FRB to accept deposits), Regulation J: ‘Collection of Checks and other Items by Federal Reserve Banks and Funds Transfers Through Fedwire’ §210.26(e); §210.26(i), incorporating the definition from the US Uniform Commercial Code, § 4A-103 via §210.25 (incorporating Uniform Commercial Code, Art 4A and prescribing that payment is final when a FRB receives a payment order by a Master Account holder and credits another Master Account).
83 Operating Circular No 6 ‘Funds Transfer Through the Fedwire Funds Service’ (20 December 2019), is issued by each FRB pursuant to the authority in Regulation J §210.25 to govern ‘the details of its funds-transfer operations’.
84 Third-party challenge is protected by the absence of a statutory zero-hour rule applying to Federally-chartered banks,see the Federal Reserve Systems response to the Bank of International Settlements’ Committee on Payment and Settlement Systems, Core Principles for Systemically Important Payment Systems: ‘The Fedwire Funds Service: Assessment of Compliance with the Core Principles for Systemically Important Payment Systems’ July 2014, 13 at https://www.federalreserve.gov/paymentsystems/fedfunds_coreprinciples.htm#core110.
85 Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems, Art 5. The Directive has been transposed into the national law of Member States through bespoke legislation: See Commission of the European Communities Directorate General for Internal Market – Budget, Final Report: Study Into the Transposition by Member States of Directive 98/26/EC (19 February 3003).
86 RTGS Account Mandate Terms and Conditions, cl 7.1.
87 The Financial Markets and Insolvency (Settlement Finality) Regulations 1999, Part III.
88 See generally P. Paech, ‘Close-Out Netting, Insolvency Law and Conflict-of-Laws’ (2014) 14 Journal of Corporate Law Studies 419.
89 See for example the use of Master Accounts in the Federal Reserve System as the accounting vehicle to record reserve requirements (deposits of commercial banks) and advances (loans of the central bank): Federal Reserve Bank, ‘Operating Circular No 10: Lending’ (effective 16 July 2013).
90 The same can be said of the Bank of England’s system of ‘settlement’ and ‘reserves’ accounts (Bank of England, RTGS Account Mandate Terms and Conditions, cl 2) and the payments module of the Eurosystem’s TARGET2 real-time gross settlements system.
91 For example Gold Reserve Act 1934 (US), s 2, amending the Federal Reserve Act 1913 (US), s 16: ‘Every Federal Reserve bank shall maintain reserves in gold certificates or lawful money of not less than 35 per centum against its deposits and reserves in gold certificates of not less than 40 per centum against its Federal Reserve notes in actual circulation.’; see generally M. Bordo and A. Redish, ‘Putting the “System” in the International Monetary System’ in D. Fox and W. Ernst, Money in the Western Legal Tradition: Middle Ages to Bretton Woods (Oxford: OUP, 2016) ch 27.
92 Pre-1914 US currency was something of a menagerie,including civil-War era ‘greenbacks’,silver coins, silver certificates and ‘national bank notes’ (issued by commercial banks, but backed by US government securities): E.C. Simmons, ‘The Concept of Lawful Money’ (1938) 46 Journal of Political Economy 108, 115; Friedman and Schwartz, n 32 above, 20-49.
93 See Board of Governors of the Federal Reserve System, ‘Operating Circular No 10 of 1914’ and First Annual Report of the Federal Reserve Board 1914, 167; Friedman and Schwartz, ibid, 194.
94 For the interaction of monetary law and central bank operations over that period, see K. Dam, ‘From the Gold Clause Cases to the Gold Commission: A Half Century of American Monetary Law’ (1983) 50 University of Chicago Law Review 504.
95 See now Federal Reserve Banks Operating Circular 1, ‘Account Relationships’ (effective 1 February 2013).
96 Board of Governors of the Federal Reserve System, ‘Quarterly Report on Federal Reserve Balance Sheet Developments May 2019’, 4.
97 Bank of England, Annual Report and Accounts 2017-2018 32.
98 European Central Bank,‘Consolidated balance sheet of the Eurosystem as at 31 December 2018’, C2.
99 For example Board of Governors of the Federal Reserve System, ‘Federal Reserve Actions to Support the Flow of Credit to Households and Businesses’ Press Release, 15 March 2020 at https://www.federalreserve.gov/monetarypolicy/reservereq.htm
100 See the enlightening discussion of ‘deposit’ creation in A. Young, ‘The Mystery of Money’ in P.G. Mehrling and R.J. Sandilands (eds), Money and Growth: Select Papers of Allyn Abbott Young (London: Routledge, 1999) 273.
101 See Proctor, n 6 above, 25; E. McKendrick, Goode on Commercial Law (London: LexisNexis, 4th ed, 2009), 487; Gleeson, n 6 above, 4.4.6; W. Buiter, ‘Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap’ NBER Working Papers, No 10163 (2003), and K. Olivecrona, The Problem of the Monetary Unit (New York, NY: Macmillan, 1957) 63; D. Archer and P. Moser-Boehm, ‘Central Bank Finances’ BIS Papers No 71 (April 2013); B. Bossone, M. Costa, A. Cuccia and G. Valenza, ‘Accounting meets economics: towards an “accounting view” of money’ DSEAS Working Papers No. 18-05 at https://doi.org/10.2139/ssrn.3270860
102 For a paper devoted exclusively to arguing that central bank reserves are not ‘liabilities’, ‘share-holder equity’ or ‘assets’ of central banks in fiat money systems, see: M. Kumhoff, J. Allen, W. Bateman, S. Gleeson, R.M. Lastra and S.T. Omarova, ‘Central Bank Money: Liability, Asset or Equity of the Nation’? Cornell Legal Studies Research Paper 20-46 at https://ssrn.com/abstract=3730608.
103 T. Keister and J. McAndrews, ‘Why Are Banks Holding So Many Excess Reserves?’ (2009) 15 Federal Reserve Bank of New York: Current Issues 1.
104 D. Bowman, E. Gagnon, and M. Leahy, ‘Interest on Excess Reserves as a Monetary Policy Instrument: The Experience of Foreign Central Banks’ Board of Governors of the Federal Reserve System: International Finance Discussion Papers No 996 (March 2010); C. Borio and P. Disyatat, ‘Unconventional Monetary Policies: An Appraisal’ BIS Working Paper No 292 (November 2009) 6, 12.
105 In developing this constitutional argument, we owe a great debt to the work of Hockett and Omarova, who clearly articulated the dynamic interdependence of public and private monetary entities in their paradigm-shifting work on ‘The Finance Franchise’, n 12 above.
108 Many large commercial banks exist within corporate groups which include investment banking subsidiaries, including the following contemporary examples of FRBNY and Bank of England counterparties (drawn from the lists at n 107 above): Barclays Capital Inc; Citigroup Global Markets Inc; HSBC Securities (USA) Inc; and Lloyds Bank Corporate Markets plc; and NatWest Markets plc (in the UK).
109 Pure investment banks that are central bank monetary policy counterparties in 2020-21 (also drawn from the lists at n 107 above) include:Amherst Pierpont Securities LLC;Cantor Fitzgerald & Co; Daiwa Capital Markets America Inc; Jeffries LLC; and Nomura Securities International Inc (as FRBNY counterparties); and Winterflood Securities Limited (as a Bank of England counterparty).
110 This preference is strongly expressed in QE operations: in credit operations (repo and collateralised credit lines) a broader set of financial assets are accepted by central banks in exchange for reserves, particularly in the Eurosystem: see K. Tamura and E. Tabakis, ‘The Use of Credit Claims as Collateral for Eurosystem Credit Operations’ ECB Occasional Paper Series, No 148 (June 2013); U. Bindseil, M. Corsi, B. Sahel and A. Visser, ‘The Eurosystem Collateral Framework Explained’ ECB Occasional Paper Series, No 189 (May 2017) and the data at ‘Eurosystem Collateral Data’ at https://www.ecb.europa.eu/paym/coll/charts/html/index.en.html
111 Which provide RTGS settlement in three foreign currencies: HSBC (US Dollar settlement), Barclays (Euro settlement) and Bank of China (Hong Kong) (Renminbi settlement).
112 As it was in Australia where a citizen sued the national government to prevent it from depositing AUD200 into his bank account through a direct fiscal stimulus program in 2009: see Pape v Federal Commissioner of Taxation (2009) 238 CLR 1.
113 See A. Haldane, M. Roberts-Sklar, T. Wieladek and C. Young, ‘QE: the story so far’ Bank of England Staff Working Paper No 624 (October 2016) 7-8.
114 As we explained above in the section headed ‘Systemic functions of central bank reserves’.
115 Federal Reserve Bank of New York, ‘Operating Policy: Statement Regarding Repurchase Operations’ Policy Document, 11 March 2020 at https://www.newyorkfed.org/markets/opolicy/operating_policy_200311; Federal Reserve Bank of New York, ‘Operating Policy: Statement Regarding Treasury Reserve Management Purchases and Repurchase Operations’ Policy Document, 12 March 2020 at https://www.newyorkfed.org/markets/opolicy/operating_policy_200312a
118 See T. Adrian, A. Ashcraft, H. Boesky, and A. Pozsar, ‘Shadow Banking’ Staff Reports no 458, Federal Reserve Bank of New York (July 2010).
119 S. Murau, ‘Shadow Money and the Public Money Supply: the Impact of the 2007-2009 Financial Crisis on the Monetary System’ (2017) 24 Review of International Political Economy 802; S. Murau, J. Rini and A. Haas, ‘The Evolution of the Offshore US-Dollar System: Past, Present and Four Possible Futures’ (2020) Journal of Institutional Economics 1.
120 J. van ‘t Klooster, ‘Democracy and the European Central Bank’s Emergency Powers’ (2018) 42 Midwest Studies in Philosophy 270; Bateman, Public Finance, n 52 above, chs 7 and 9.
121 See generally Bateman, ibid, chs 1, 5 and 7.
122 See for example Cranston, n 4 above, 140 for a discussion of the various meanings of mandate in English law.
123 Federal Reserve Act 1913, s 2A.
124 Bank of England Act 1998 (UK), s 11.
125 That approach to the relationship between mandates and central bank power underpinned the case law of the Court of Justice of the European Union concerning the legality of QE under European law: C-62/14 Gauweiler v Deutscher Bundestag ECLI:EU:C:2015:400; C-493/17 Weiss and Others ECLI:EU:C:2018:1000.
127 J. Galí, ‘The Effects of a Money-Financed Fiscal Stimulus’ The National Bureau of Economic Research Working Paper No 26249 (September 2019); W. Buiter ‘The Simple Analytics of Helicopter Money: Why It Works – Always’ (2014) 8 Economics: The Open-Access, Open-Assessment E-Journal 1.
128 D. Archer and P. Moser-Boehm, ‘Central bank finances’ BIS Papers No 71 (April 2013) 8.
131 An additional driver was the popularisation, post-2008 of , euphoniously branded, ‘cryptocurrencies’ and the prominent first-mover, ‘Bitcoin’: for a canonical text in that eclectic tradition, see, S. Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ Working Paper 2008 at
http://bitcoin.org/bitcoin.pdf
132 See for example J. Barrdear and M. Kumhof, ‘The Macroeconomics of Central Bank Issued Digital Currencies’ Bank of England Staff Working Paper No 605 (July 2016); M. Kumhof and C. Noone, ‘Central bank digital currencies – design principles and balance sheet implications’ Bank of England Staff Working Paper No 725 (May 2018).
133 In 2019, Facebook Inc proposed the creation of a digital currency named ‘Libra’ which would be backed by a number of national currencies, but pegged to none. After 12 months of intense scrutiny and opposition from central banks and financial regulators, Facebook withdrew the Libra proposal and replaced it with an online payments platform named ‘Diem’: Libra Association Members, ‘White Paper v2.0’ April 2020 at https://www.diem.com/en-us/white-paper/#cover-letter; J.L. Maniff, ‘How Did We Get Here? From Observing Private Currencies to Exploring Central Bank Digital Currency’ Federal Reserve Bank of Kansas City, Payments System Research Briefing (February 2020).
134 By the end of 2020, the People’s Bank of China had begun issuing Renminbi-denominated CBDC to residents of Shenzhen on a trial basis and introduced legislation to facilitate the permanent issue of RMB-CBDC: R. Auer, G. Cornelli and J. Frost, ‘Rise of the Central Dank Digital Currencies: Drivers, Approaches and Technologies’ BIS Working Papers No 880 (August 2020) 22-24.
135 See the Joint Report by The Bank of Canada, European Central Bank, Bank of Japan, Sveriges Riksbank, Swiss National Bank, Bank of England, Board of Governors of the Federal Reserve and Bank for International Settlements entitled ‘Central Bank Digital Currencies: Foundational Principles and Core Features’ Report no 1 In a Series of Collaborations from a Group of Central Banks (9 October 2020). See also C. Boar and A. Wehrli, ‘Ready, steady, go? – Results of the third BIS survey on central bank digital currency’ BIS Papers No 114 (January 2021).
136 W. Bossu et al, ‘Legal Aspects of Central Bank Digital Currency: Central Bank and Monetary Law Considerations’ IMF Working Paper WP/20/254 (November 2020).
137 See for example Joint Report published by the BIS, n 135 above; U. Bindseil, ‘Tiered CBDC and the financial system’ ECB Working Paper No 2351 (January 2020); Bossu et al, ibid, 9, However, for a critical discussion of the ‘account’ versus ‘token’ dichotomy, see A. Milne, ‘Argument by False Analogy: The Mistaken Classification of Bitcoin as Token Money’ 25 November 2018 at https://ssrn.com/abstract=3290325 or https://doi.org/10.2139/ssrn.3290325
138 Barrdear and Kumhoff, n 132 above, 5.
139 See Gleeson, n 6 above, 150.
140 R. Auer and R. Böhme, ‘The Technology of Retail Central Bank Digital Currency’ BIS Quarterly Review (March 2020) 85.
141 See the Joint Report published by the BIS, n 135 above, 6, fn 4.
142 Board of Governors of the Federal Reserve System, European Central Bank, Bank of Japan, Bank of England writing with the Bank of Canada, Sveriges Riksbank and the Bank of International Settlements.
143 Joint Report on Central Bank Digital Currencies, n 135 above, 10.
146 Central bank payment systems process high-value payments in the financial sector, rather than low-value payments in the real economy: see Committee on Payment and Settlement Systems, Bank of International Settlements, n 24 above.
147 Although it would imply rather complex technical considerations for payment system providers.
148 Gleeson, n 6 above, 153-154.
149 For example Barrdear and Kumhoff, n 132 above, 5.
150 Because central banks are public sector agencies, monetary accommodation provided by central banks to national governments raises thorny issues in determining the extent of intermediation of monetary authority: see text accompanying n 118 above.
152 ibid, 1, 24, 25. Omarova proposes that some private deposit accounts held at ‘community banking institutions’ could operate as ‘pass-through’ accounts to CBDC at the central bank: ibid, 34-35.
153 ibid, 26.
154 ibid, 40-41: under that proposal, central bank credit would be extended to commercial banks under collateral eligibility and specific activity limitations of debtor banks aimed at ‘explicitly preferencing certain categories of assets (such as, for example, loans to small and medium-size non-financial enterprises and minority-owned businesses, student loans, credit supporting development in underserved communities, bonds issued by firms in certain sectors of the economy, etc).’
155 Omarova deals extensively with the economic and social policy arguments for and against a transformation, ibid, II and III.
156 ibid, 51, fn 224.
157 D. Woodruff, ‘To Democratize Finance, Democratize Central Banking’ (2019) 47 Politics and Society 593.
