Can a Central Bank go bankrupt and collapse the economy?

Welcome to Finance and Fury. Today we explore whether a Central Bank can go bankrupt and collapse the economy?

In the modern state of the economy, if fiat money fails due to central banking errors, what does this mean for the global financial system and central banks? Can they go bankrupt and bring the very global financial system down with them

To look at this – important to explain the role they play in the financial system and the economy.

1. A central bank is the term used to describe the authority responsible for monetary policies – in other words, the control of a nation’s supply of money and credit
   1. Modern central banks normally have three key goals of modern monetary policy
      1. First and primary is price stability in the value of money – inflation targets
      2. Secondary to this is a stable real economy – measured by low unemployment and sustainable economic growth

• The third goal is stability of the financial system – helping facilitate payments systems and prevent financial crises

1. Based around these metrics, they seem to be failing at these goals – regardless, they didn’t start out with this in mind

2. Central banking history – central banks go back at least to the seventeenth century
   1. Swedish Riksbank – Established in 1668 as a joint stock bank – the point was to lend the government funds and to act as a clearing house for commerce
   2. The next established is the most famous central bank of the era – the Bank of England in 1694
      1. founded also as a joint stock company to purchase government debt
      2. other central banks were set up after this Europe for similar purposes

• Banque de France was established by Napoleon in 1800 to stabilize the currency after the hyperinflation of paper money during the French Revolution

1. While early central banks helped fund the government’s debt, they were also private entities that engaged in banking activities –
   1. they held the deposits of other banks as a bank for commercial banks – this allowed them to become the lender of last resort where they could provide emergency cash to commercial banks in times of financial distress – such as bank runs
2. The transition – Modern central banks, like the RBA and the Fed are a much later wave of central banks that emerged at the turn of the twentieth century – mostly a centralised system to aid in the gold standard
   1. The pure gold standard prevailed until 1914 – under this system each country defined its currency in terms of a fixed weight of gold – this meant that central banks held large gold reserves to ensure that their notes could be converted into gold
      1. If a CBs reserves declined because of an import imbalance or other domestic circumstances, they would raise their interest rates – which in turn attracted foreign investment, bringing more gold into the country and increasing their reserves
      2. Under this system – the amount of money banks could supply was constrained by the value of the gold they held in reserve – the ratio of cash that was backed by gold determined the interest rate

• They did not worry too much about one of the modern goals of central banking—the stability of the real economy—because they were constrained by their obligation to adhere to the gold standard – the economy was left to its own devices as there was no way to increase the money supply without needing to increase interest rates to draw more foreign investment to sure up their gold reserves – increasing interest rates would slow business growth and hurt economic output

4. By this stage, a CB had never defaulted, even though commercial banks had – after World War I – around 1918 – CBs began to be concerned about employment, real activity, and the price level for the first time
   1. This shift was due to the changes in the political economy of many countries – By the 1920s, the Fed began focusing on both external stability – i.e. their gold reserves to currency issued, but also internal stability – i.e. inflation, output, and employment
      1. You cannot do both at the same time – due to this, the gold standard and reserves were at the forefront
   2. Unfortunately, the Fed’s changing monetary policy led to serious problems in the late 1920s and 1930s.
      1. called the real bills doctrine – changed policy where the Reserve Banks could only lend funds when banks had commercial paper for collateral – which meant that bank lending to finance stock market speculation was no longer possible – this tightening to offset the Wall Street speculation led to the beginning of recession in 1929 wish the crash in October
      2. But a further series of banking collapses followed between 1930 and 1933, the Fed failed to act as a lender of last resort – one of their primary directives at the time – worsening the depression that followed
   3. From the 1960s central banks began following a more activist stabilization policy – becoming more involved in the economy
      1. This is where central banks shifted their priorities from low inflation toward high employment – mostly due to the adoption of Keynesian ideas – that government spending through deficits can stimulate employment and the economy
      2. There was also an increase in the economic belief in the Phillips curve trade-off between inflation and unemployment – this is a theory where there is an inverse relationship between inflation and unemployment – if unemployment is high, inflation will be low; if unemployment is low, inflation will be high.
      3. Due to this – in an effort to reduce unemployment and stimulate economic growth – the era from the 1970s has been a low point in central banking history – as any restraining influence of the nominal anchors of monetary policy disappeared – being the introduction of purely fiat money – with the removal of the Brenton woods system – for the next two decades, inflation expectations took off – with a major shift in the monetary system – CBs were unaffected
      4. This saw the era of monetary tightening and the raising of policy interest rates to double digits – leading to a sharp recession
      5. Since the early 1990s the Fed has followed a policy of implicit inflation targeting, using the interest rate as the policy instrument to impact inflation
      6. But one problem that never went away was that the policy decisions from central banks have created asset pricing boom bust cycles
         1. Share market and housing price booms are often associated with the business cycle – but this is a mislabelling in my opinion – it should be called a monetary policy cycle – businesses doing well doesn’t artificially increase lending capacities – it creates real lending increases if employees are earning more – but wage growth has been fairly constant compared to credit growth

Given all of these policy failures – where either a bubble has been created, all for individuals, companies and commercial banks to then go bankrupt, has a central bank ever suffered the same consequences – the answer is no – all that changes is their balance sheet and profitability –

1. What has been the biggest game changer for financial markets and central bank balance sheets has been more of a recent phenomenon – in the wake of another financial crisis, central banks were given greater powers in the form of quantitative easing (QE) – this changed central banks’ balance sheets forever –
   1. back before the GFC – most central banks balance sheets were a fraction of where they sit today – as an example – In August 2007, the Fed’s balance sheet was about $900 billion; this year, it peaked at $9 trillion.
   2. What sits on a balance sheet – financial position, and is made up of assets, liabilities and equity
      1. Liabilities – all cash in circulation, plus reserve balances – Central banks control the price of money by adjusting the terms and availability of their liabilities – more money supplied lowers interest rates
      2. Assets – largest assets are often debt instruments they purchase using the funds that they issue to commercial banks, the treasury or financial markets to purchase debt instruments – such as treasury notes or government bonds
   3. Regardless of this balance sheet expansion – Central banks will not go bankrupt – as they are technically always in a net position between liabilities and assets –
      1. looking at the RBA, Assets and liabilities sit at $620 billion
      2. Whilst the Fed has $9 trillion in assets, they also have $9 trillion in liabilities
   4. but they can run at a loss in revenues – so it is worth considering when losses do and do not matter.
2. The revenues of central banks can differ from nation to nation – but generally, the equation to work out revenues is calculated by taking all the income generated through their OMO accounts, deduct any interest expenses, realized losses, and operating costs – any positive revenues are remitted to the Treasury department of each nation –
   1. Therefore, net income depends on the mostly fixed average coupon on assets that are held (government bonds and treasury notes), minus the share of liabilities that are interest free (physical paper currency), along with the level of reserves and repo balances, whose costs float with the policy rate
   2. One major difference between a private investor and a CB is that they do not mark their assets to market, losses on the portfolio are unrealized and do not flow through the income statement if they are held onto – But if assets are sold, such as what some banks are conducting at the moment – asset prices are realised the losses are realized, reducing net income
   3. With interest rates on the rise, the fixed incomes from coupon payments aren’t increasing, but the costs of a chunk of their liabilities are – plus, if CBs need to sell assets as part of QT, then the realise losses on these debt instruments if the price has declined
      1. As an example, the Fed’s net income has turned negative, and losses will deepen as the policy rate rises and bonds are sold off if the price has declined in these assets – For the Fed – the revenues went from close to $0 per year in 2007 but ballooned to $100 billion as the balance sheet grew to their peak, to now turn negative again –
   4. So, what does this mean? Can it collapse a central bank or reduce their ability to conduct monetary policy?
      1. Again, the answer here is a no – all that happens is that remittances to the Treasury ends – so governments are left to fund more of their expenses through deficit spending, further issuing debt –
         1. Central banks have the ability to just accumulate their losses and, rather than reducing its capital, creates a deferred asset – essentially a losses account so that when earnings turn positive again, remittances to the treasury stay at zero until the losses are recouped
      2. Unlike a private business when if central banks run at a loss – they keep on going
         1. If anything, these crisis’s benefit them – excuses to expand their mandates and more debt in governments need to be issued to cover the loss of income from central banks
         2. So, they never go bankrupt – but continue to influence financial markets, the economy and our daily lives

In summary – we will likely never be free of central banks and their influence for better or worse over the economy

1. Don’t get me wrong – their influence has had some positive impacts – massive asset price growth for anyone who has owned a property from the mid-1990s – but these gains come at the cost for the next generation – plus experiencing the boom bust cycles of monetary expansion and contraction
2. Regardless – concerns about CBs going bankrupt are unfounded – they can operate at a loss indefinitely – this is only a negative for governments directly – but indirectly it does mean that cash rates would be higher than the debt instruments held – meaning that investors may not be better off due to asset pricing declining
3. If you hadn’t gathered by now, I am no fan of the modern-day CB system – combination of reactionary political responses and centrally planned economies that never result in the best solution for you and I
4. There is no perfect solution – only trade-offs – but under a system where the very entity can get it wrong time and time again to only benefit from their incorrect decisions, at the expense of millions of people, something is flawed in the system