The Role of a Central Bank

This is a revised extract from my PhD thesis.

Correction and minor edit 10/8/2012.

Introduction
In a modern state, the government has a monopoly on physical force and so it is natural that the government should provide the final backing to contracts through the legal system. Moreover, the government can use physical force on its own account to enforce its own purchasing and debt-collecting activity, in which State or Central Bank Deposit Money (SBDM) is created and spent, circulates and is destroyed. By imposing liabilities in the form of taxes that must be paid in the money it has created, the state can control the quantity of this money in the economy. This also serves to establish this money as a unit of account and gives it the status of a means of payment. (1)

By insisting on credit payments of taxes taking place in central bank money, the central bank also forces the other banks to hold deposits with the central bank, these deposits being increased when the government makes a credit payment to one of their deposit-holders and decreased when a deposit-holder makes a tax payment in credit money. Transfers of credit money between banks can then occur via their deposits at the central bank, allowing them to settle asset-liability discrepancies that arise as deposit-holders transfer Commercial Bank Deposit Money (CBDM) between each other.

The Outward Path of SBDM
The central bank issues deposits with which the government credits commercial banks so that those banks can create deposit liabilities in the names of firms and individuals who provide goods and services, including labour, to the government. These liabilities for the commercial banks are thus matched by increases in the deposits the commercial banks hold with the central bank. Thus there is an equal increase in both the liabilities and assets of the commercial banks. Given reserve requirements either imposed by the central bank or chosen by the banks themselves to avoid costly overdrafts, the commercial banks then have the option of drawing down their increased central bank deposits and converting them into central bank notes, if required, or more profitable forms of assets such as government bonds. They can, of course, also use the additional SBDM as the basis for additional loans, in which further quantities of CBDM are created.

In many modern economies, there is no imposed reserve requirement, and so the nature of the assets held by commercial banks to offset their liabilities depends on their own assessment of their likely need to have central bank money available for the cash demands of their depositors and for their own transactions. This means that while there is clearly a relationship between the creation of loans (and thus the flow of CBDM into the economy) and the cost of access to reserves for commercial banks, it is by no means likely to be a mechanical and easily predictable one.

In our balance sheet example we have taken the case of Firm F at Time 0 in Figure 1 below, where it holds unsold output and still has an outstanding loan of £50. Households H hold liabilities of £50 they have received in the form of wages. We assume that the state purchases F’s output using SBDM at the price required to exactly cover Firm F’s outstanding loan to commercial Bank A. At Time 1 the SBDM deposits now form assets of Bank A, while there is an equivalent CBDM deposit forming a liability for Bank A and an asset for Firm F. This now allows Firm F to repay its loan to Bank A. At Time 2 Bank A is left with an SBDM deposit that matches the CBDM liability of the H deposit holding. While the SBDM deposit is clearly a more secure asset than the loan to Firm F, and can be converted into cash as demanded by Bank A’s depositors, it is also a lower-earning one and so there is incentive for Bank A to use part of its SBDM deposit to purchase or create higher-earning assets.

The Inward Path of SBDM
When tax bills become due, individuals and firms pay these from deposits with the commercial banks. Deposits held by the commercial banks are decreased by the amount of the tax bill, as are the deposits of the commercial banks held by the central bank. In this way both the liabilities and the assets of the commercial banks are decreased. For example, let’s refer to Time 2 in Diagram 1. If household H has a tax bill of £50 and they make payment to the government tax authority the £50 SBDM asset held by the bank is removed along with the £50 CBDM liability. Total liabilities and assets held by Bank B would return to zero.

In a democracy, the power of the state to issue money to make purchases and demand the payment of taxes must stem from the agreement of the population at large that this system is working to their overall advantage. For this to be the case the deferral of consumption that is represented by their acceptance from the government of central bank money must be compensated for by the additional future consumption that the actions of government, thus funded, will provide. In this way the justification for the creation of money by government transactions is exactly analogous to that for the creation of money by private transactions; except that while such transactions in the private sector depend on potential bilateral benefits, in the public sector they depend on perceived overall social improvement.

If the commercial banks guarantee to exchange state money (as cash or deposits) on a one for one basis then the value in terms of real goods and services of both commercial bank and central bank money will be identical, although individuals and other non-bank entities can only transact in cash or CBDM, and banks must complete all their transactions in SBDM.

Reserve Ratios and Transfers
Because of SBDM the importance of quantities of deposits depends on how they arrive on banks’ balance sheets. If due to loans they have created themselves, their deposit/reserve ratio is increased; if due to loans created by other banks their deposit/reserve ratio is decreased, since the arrival of these deposits is accompanied by transfer of reserves from the issuing bank.

[T]he rate at which the bank can, with safety, actively create deposits by lending and investing has to be in a proper relation to the rate at which it is passively creating them against the receipt of liquid resources from its deposits. For the latter increase the banks’ reserves…whereas the former diminish the reserves… (Keynes 1971[1930], p22).

If all banks expand credit together the strength of the banking system depends on the central bank issuing enough SBDM to keep reserve ratios at ‘prudential’ levels. If there is a compulsory reserve ratio for commercial banks of SBDM deposits to total assets, the credit potential of the banking system as a whole depends on this ratio, the quantity of SBDM, the compulsory reserve ratio and the preference of the public for cash versus deposits (Graziani 2003, p88). If there is no compulsory reserve ratio and the public do not generally require cash, banks can expand credit to the point that their perceived risk of default outweighs their interest income. Note that this risk of default is limited to the issuing bank by the mechanism of ‘loan write-offs’. The consequence of a loan default is that when the loan asset is ‘written off’ from the balance sheet there must be a compensating reduction in the liability side, and so the inflationary consequences of excessive loans are minimised.

Should the transfer to other banks of SBDM have the effect of reducing a commercial bank’s reserves below the compulsory or prudent level (according to the prevailing regime) the bank must acquire additional SBDM by borrowing at interest from other banks or financial institutions, or by the sale of government bonds, thus losing the return on these, or by borrowing from the central bank at the prevailing base rate.

The amount of reserves at the disposal of a single bank depends on the total amount of reserves created by the central bank and on the fraction of those reserves obtained by that bank – thus creating competition for depositing customers of other commercial banks, as they bring transfers of SBDM with them. The reserve requirement for a bank may be lower when that bank has a greater share of the market for deposits, since a greater proportion of deposit transfers will be between customers of that same bank and so will require no SBDM settlement.

The Role of Government Debt
As an alternative to removing SBDM from circulation by current taxation, the government can take the option of issuing bonds in exchange for SBDM. These bonds earn interest, so that they create an additional long-run burden of tax liability. This is putatively off-set by greater flexibility in the tax regime and by providing a way for the central bank to control the quantity of SBDM currently held by banks. The latter is achieved primarily by setting an interest rate for short-term loans of SBDM in which government bonds are used as collateral (so called repo transactions). A higher ‘bank base rate’ will discourage such borrowing, tending to reduce holdings of SBDM and the potential for the creation of CBDM. Overall liquidity in the economy is reduced. A lower base rate will have the reverse effect, increasing holdings of SBDM and tending to increase overall liquidity.

More drastically, particularly when the bank base rate is close to zero, government bonds and occasionally other secure assets can be directly purchased by the central bank as a way of increasing the quantity of SBDM held by banks and increasing liquidity. The process is reversible; the central bank simply reselling the bonds it has acquired and removing the base money it previously created.

Figure 2 below shows how the process of SBDM creation through bond purchase or repo arrangements takes place. At Time 0 Bank A holds loans of £70, matched by total CBDM liabilities of £70 held by Firm F and Household H. It holds secure assets in the form of £10 of CBDM reserves and £20 of government bonds, matched by a share capital liability of £30. Its current reserve to loan ratio is 10/70. If this is deemed prudent, then it cannot currently lend more CBDM. If at Time 1 £10 of bonds are exchanged for £10 of CBDM, Bank A now holds £20 in reserves and can now lend £140 (creating a total deposit liability of £140) while staying within its required reserve ratio. The reverse of this process, involving the purchase of bonds from the central bank would correspondingly reduce the reserves of Bank A and its lending power.

Monetary Policy and the Central Bank
Given that the main form of money circulating in the economy is that created by the commercial banks from their lending, it is clear that at best the control of the central bank over the money supply can be an indirect one.

[T]he central bank cannot ordinarily control the quantity of money. Any attempt to do so succeeds only in temporarily disrupting the smooth workings of the system until the dormant credit money system can be activated (Mehrling 1996, p331).

While it is true that the central bank could control the quantity of SBDM issued, the very performance of its regulatory and enforcement role (and deposit insurance) tends to reduce the practical need for banks to maintain high reserve ratios, and even if it did seek to restrict supplying its money to commercial banks desiring it, the immediate effect is not to reduce the purchasing power of wage-earners, but to restrict the production activities of firms. Modern central banks mainly operate by establishing a rate of interest to stabilise the system of notes and bank deposits, while making loans and accepting deposits at that rate as the lender of last resort (Nell 1996). Nor is the central bank limited to providing reserves to prevent a crisis but is an integral part of the monetary circuit (Rochon 1999). The central bank exogenously sets the real and nominal rate of interest over which other interest rates are a mark up. Even this limited role can be damaging:

Central bankers…believe that the consistency of the credit network requires the perfect stability of the value of money… Stabilising money prices of goods should protect wealth-holders against losses of purchasing power: money values of firms would thus rise; this increase in real wealth could support a sound increase in investment…The central bank’s own thriftiness thus sustains the rentier economy…where the generation of wealth is not dependent on investment expenditures (Parguez 1996, p183).

Summarising the Role of the Central Bank
It should be clear from the above analysis that the collective institutions of government and the central bank play a huge and largely autonomous role in the shaping of monetary transactions. The main features of this role are:

1. Provision of the legal framework that supports commercial banks in enforcing repayment of loans, thus ensuring that the CBDM arising from loan contracts is valued.

2. Provision of central bank money by which transactions between banks and between individuals or banks and the state can be settled in monetary terms. This potentially enhances efficiency and competition in the commercial banking sector.

3. The autonomous ability of the government to make purchases of goods and services for collective use, by the issue of central bank money. The commercial banks match this with their own issued money (CBDM) through adjustment of their balance sheets. There are various reasons why the government chooses to acquire the goods and services it requires in this way rather than simply by confiscation (which it has the physical power to do). Firstly there is the issue of equity. The resources government requires to fulfil its delegated functions may not be held equally by all. By issuing its money in exchange for goods and services, and then selectively confiscating this money in the form of taxation, the government can redistribute the burden of providing its resources. Secondly, for this system to be effective it of course essential that the money the central bank issues on behalf of the government is accepted. This is achieved by the requirement that almost all individuals and firms have some tax liability, and by the fact that central bank money and commercial bank money (itself demanded for loan repayment) are always interchangeable at a rate of one to one.

4. By ensuring a demand for its own money for the payment of taxes and the settlement of interbank transactions and by taking advantage of the demand of individuals for the portability and liquidity of cash by monopolising its production, the government may also hope to influence the quantity of CBDM issued. This is generally performed by setting prices (interest rates) for the central bank’s purchase and re-purchase of high-grade financial assets (open-market operations), and for the last-resort lending of central bank reserve money. This latter ‘lender of last-resort’ function together with regulations governing acceptable asset risk composition for commercial banks also gives the central bank a role in ensuring that commercial banks remain solvent and capable of allowing individuals access to their deposits at all times.

Footnotes

(1) The Chartalists see the whole monetary system as imposed by the state and argue that the state uses its coercive powers to force the acceptance of tokens in exchange for the goods and services that it requires to carry out its functions (Wray 1996, Tymoigne and Wray 2006). In my view the state is responsible for the imposition of central bank money and ultimately responsible for enforcing the contracts involved in commercial bank loans, but the use of tokens of these loans in general exchange is a voluntary act arising from their superior liquidity to any other means of exchange.

References

Graziani, A. (2003). The Monetary Theory of Production. Cambridge, UK: Cambridge University Press.

Keynes, J.M. (1971[1930). A Treatise on Money. Vol V of The Collected Writings of John Maynard Keynes, ed. D. Moggridge, London and Basingstoke: Macmillan.

Mehrling , P. (1996). The Relevance to Modern Economics of the Banking School View. In G. Deleplace & E.J. Nell (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches.(pp330-340) Basingstoke and London: Macmillan.

Nell, E.J. (1996). The Circuit of Money in a Production Economy. In G. Deleplace & E.J. Nell (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches. Basingstoke and London: Macmillan.

Parguez, A. (1996). Beyond Scarcity: A Reappraisal of the Theory of the Monetary Circuit. In G. Deleplace & E.J. Nell (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches, (pp. 155-199). Macmillan.

Rochon, L.-P. (1999). The Creation and Circulation of Endogenous Money: A Circuit Dynamique Approach. Journal of Economic Issues, 33, 1-21.

Tymoigne, É. & Wray L.R. (2006). Money: An alternative story. In P. Arestis and M. Sawyer (Eds.), A Handbook of Alternative Monetary Economics (pp1-16). Cheltenham: Edward Elgar.

Wray, L.R. (1996) Money in the Circular Flow. In E.J. Nell & G. Deleplace (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches, (pp440-464). Basingstoke and London: Macmillan.

© Diarmid Weir 2010