A Half-Baked Attempt To Pull Banking Back In Before It's Too Late
AP Photo/Lisa Poole, File
A Half-Baked Attempt To Pull Banking Back In Before It's Too Late
AP Photo/Lisa Poole, File
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It comes from a central bank, yet is it money? This has taken too many years, but over the last several, interest in, and debate over, what bank reserves are and maybe ought to be has blossomed. Around the world, “monetary” authorities have linked their activities to real economic consequences: large scale asset purchases (LSAP) such as quantitative easing (QE) have been promised to deliver inflationary boosts to faltering economic conditions.

There has been an explosion in the number of QE’s undertaken and the (balance sheet) heights to which collectively they’ve achieved, yet no recovery leaving instead only an inflation “puzzle” that officials haven’t come any closer to solving even after twenty years.

And this despite uniformity ruthlessly enforced in the mainstream media; at its maximum, QE and its bank reserves remainder are breathlessly characterized as “money printing.” If not that, then otherwise in slightly less hysterical terms the policies are claimed to have been “highly accommodative” while “pouring trillions into the real economy.” The latter, as I noted on QE’s 20th birthday, was written for it on its very first and remains today in standard use notwithstanding any evidence for this.

A bank reserve is for accounting purposes a deposit asset for a commercial bank. The central bank most often purchases some financial asset from that depository firm and “pays” for it by increasing a ledger amount on the central bank’s books. These are the “reserves” the commercial bank now shows as its own asset in place of the one transferred (and why QE is nothing more than an asset swap).

This is quite different, however, from actual commercial bank deposits in our modern money-less age. Think about it this way: if you have a deposit account with that commercial bank this creates a liability for it. Upon demand, that bank is required to extinguish its obligation by delivering contractually obligated cash – this might take the form of Federal Reserve Notes (FRN), but more likely a wire transfer into the depositor’s successor bank.

Under the latter arrangement, the first commercial bank could settle its liability using bank reserves; the central bank deducts the balance from its reserve account crediting the same to the succeeding bank’s. The obligation is extinguished in the first instance if only to be transferred to another.

Bank reserves here act as little more than an internal, interbank scorecard.

What is the obligation of the central bank? Are bank reserves properly any liability?

On central bank books, reserves are counted that way as a technical matter. In hard money days this was as specific for authorities as it had been for commercial bankers; upon request, the holder could demand real money in possession (or otherwise obtainable) of that central bank. This was, in fact, the entire premise of early modern currency regimes where physical national currencies had written right on their paper how the holder was entitled to demand physical hard money delivery.

Thus, even in today’s Federal Reserve Notes, these aren’t – practically speaking – money liabilities obliging the Federal Reserve anything. If you showed up at its doors with a $100 bill demanding redemption, what you’d get back is another $100 bill (though more likely the service of the police expelling you from the grounds). Non-redeemable script.

Bank reserves have a similar purpose, with only the unused exception that under certain circumstances the demanding commercial bank can demand the Fed convert its reserve balance into deliveries of physical FRNs (as had happened in Florida during the precursor panic in the summer of 1929). Even in that instance, it’s nothing more than trading a ledger or virtual form of irredeemable currency for its physical equivalent.

The physical FRN currency like bank reserves is technically a liability of the issuing government agency but it is not, in any real sense, an actual liability. The obligation is, in fact, self-referential.

Who cares, right?

In the monetary realm, historically speaking, a liability had meant an undisputable and intuitively straightforward set of facts: a present obligation for one party to transfer an economically useful resource to another because of some prior exchange. In the case of any depositor and their bank, the inaugurating transaction is the placement of money or currency with the latter for safekeeping to be returned at a later date (whether on-demand or restricted by other means to be determined at the outset).

For the bank reserve, since they aren’t usable outside of the system the obligation really boils down to, essentially, conferring limited rights granted by the central bank to participate in what is a large-scale fiction. Because bank reserves serve regulatory and legal purposes regarding “liquidity” and reserve requirements, it is the furtherance of the original chartalist demand that money and currency is nothing more than what governments sanction.

According to these historical theories, if the government demanded tax payment in seashells, so would confer upon seashells the usefulness in money since private economy participants would be expected to develop further use for seashells predicated on this demand. Central bank bank reserves do the same if only for approved depository institutions; transacting with any commercial bank via bank reserves obligates the central bank only to recognize this commercial bank being a commercial bank under its definitions.

This, too, may seem tautological; a bank that is transacting with the central bank obviously is accepted as being a bank by the central bank, meaning the bank holding bank reserves is merely granted acknowledgement of this set of facts. But this view is too narrow; the central bank advertises what it wants the banking system to believe are special privileges for accepting its limited-use obligations.

You’re one of the club!

It’s hard to fathom today, but for most of human history no such exclusive club had ever existed. Currency and even bank lending was a private matter often at the smallest scales; remember our definition above, the promise to deliver an economically useful resource predicated on any kind of prior transaction. Rather than pleading with some bank for a loan, go to your neighbor and see if they have any economically-useful object they could lend since they know you better and are more likely to consider your reputation alone.

But what is or who determines “economically useful?” Bank reserves, obviously, aren’t even part of the conversation simply because what is here is what the economy finds useful; a completely separate matter from the central bank club and its accounting obligations or privileges.

If the economy finds commercial bank liabilities useful, and commercial banks find government bank reserves somewhat useful, then the two may interact so long as that usefulness is perceived as more valuable. In many ways, it has been due to laziness or inertia.  

It is often said that governments greedily exercise monopoly power over money. No. Private money has dominated throughout history, even in the second half of the 20th century when this fact was obscured and even lost on a public who didn’t know to pay any attention to the vast private money shadows cast all over the world (and only briefly became interested when it all broke down).

Gold and precious metals as the earliest form of widely accepted private money had meant that each were basically no-liability assets. Whomever possessed them owed nothing further to nobody (unless they were obtained as a matter of credit/borrowing). So long as they remained in your possession, nothing more than possession was required.

The problem, such that it was, would arise if or when these physical tokens (variously minted coins, for example, or individual paper currency) might be acceptable for use. In limited local or regional economies, not a huge impediment. As these grew more sophisticated and connected, coin and currency became a source of friction.

The “value” of the “club” proposition, like the central bank obligation, is formed on that peculiar basis. Central banks accidentally pioneered uniform currency and money regimes as government national interests and have maintained the illusion of value in them. What value bank reserves really had provided, and why commercial banks and the real economy tolerated such asymmetry, was some official sanction of stability as well as widespread acceptability in payments terms.

What if, however, the perceived value of being a bank connected to the government’s monetary authority is viewed as limited or even irrelevant? Maybe in some cases, a detriment.

A hypothetical: government bank reserves of such limited usefulness beyond conferring acceptance into that club leave those members in it unable to depend upon the club to maintain their active business lines. Useful elasticity is a problem due to ineptitude or even just good-faith policy mistakes, and with few other alternatives, “liquidity” remains a paramount risk and therefore a heavy burden of instability imposing restraint upon those operating within that system.

Quite naturally, we might expect members to seek alternatives elsewhere so as to be freed from such unnatural inexpedience. They may wish to remain in that club for whatever limited usefulness while at the same time more and more interested in any number of substitutes particularly as these become increasingly viable.

Viable simply means acceptance, one part of which is perception of solidity. Should these others bridge that divide, however, and become useful across any scale (geographical as well as transaction size), the government club easily loses its comparative conceptual advantage.

This right here is the driving force behind what’s called Central Bank Digital Currency (CBDC) projects.

As I very often say, these are not “native” crypto solutions to the world’s money problem. CBDC’s are not actually competition for either the US$ or something like Bitcoin or Ethereum. On the contrary, they seek to apply a virtual, updated veneer to the existing “obligation” of central bank bank reserves by extending them somewhat further.

One such CBDC mission is being developed in joint partnership between the Federal Reserve Bank of Boston and MIT’s Digital Currency Initiative. It’s already doomed, I believe, the website providing numerous examples as to why. For one:

“A CBDC is very different from existing electronic payment systems, because it is ultimately a liability on the central bank. This means the holder of CBDC does not have counterparty risk the way one does when one takes payments electronically through existing products and channels.”

A “liability on the central bank” is, as noted above, only advantageous where the arrangement confers more benefits than costs. What it actually means is their intent to try to extend official club membership beyond the borders of its current interbank limitations. To try to maintain an “official” currency in a world where widespread unofficial currencies aren’t just possible, they are already proliferating.

Native crypto is doing just that as private money always had been, a 21stcentury stab at a no-liability asset being driven mostly by this cost-benefit imbalance. Any digital currency carrying that “liability on the central bank” is both at a gross disadvantage as well as missing the point – unless the central bank can fix the issue. No inflation and more QE’s, misunderstood as they’ve been, only propel further doubts.

Having observed this conceit, it’s also not surprising that the project makes another perhaps even more crucial error:

“Before private-sector innovation is possible, numerous economic and public policy questions will need to be addressed and an extensive, separate policy process is required. However, this cannot be done without understanding the limits of the technology, both existing and new.”

Such arrogance is merely an attempt to justify the central bank liability remaining; feeding into this historically ignorant belief that all money belongs to one government or another. Again, not true. Never true.

Private sector innovation in digital money has been ongoing for more than a decade, and only now are central banks like commercial banks desperately trying to catch up having finally realized their lunacy (the Great Eurodollar Famine) and limitations had opened the door to these things in the first place.

CBDC’s, like bank reserves, would confer (or reinvent) only status in the sanctioned club. A no-liability digital asset that becomes widely useful will easily overcome that “liability.” Monetary officials have finally come around to contemplating just what this really might mean; they, and eventually commercial banks, are out of business.

In this other private money “club”, there’d be no need for such inefficient (and often harmful, in the case of information asymmetry) centralized structures – both banks and central banks. Ultimately, that’s the value proposition going the other way in the bank reserve model; central banks maintain some levers over influence and power (macroprudential than actual money). To participate in their club, you play by their rules (and what has that gotten the world over the last fourteen years?)

But banks, under the eurodollar system, in particular, have already established a solid foot outside of the official club – but did so using a denomination informally and very loosely tied to “central bank liabilities.” Its limitations may have been, as I would argue, having left the other foot inside.

Eurodollars are, after all, an informal arrangement of commercial bankliabilities whose obligations are ultimately similar to any central bank’s – you’re part of another club, only this one isn’t fully developed outside of the official realm. Like bank reserves, eurodollar money is an obligation to accept you as part of its structure.

In other words, for more than half a century, the banking system operated partway or even halfway out under quasi-official sanction (“benign neglect”). All that’s been missing is the no-liability money to pull the real economy the rest of the way out (or much of the rest of the way since governments aren’t going to give up the club lightly). Banks had unwittingly unleashed that possibility.

CBDC’s are a half-baked attempt to pull the banking system back in before it’s too late and private agents across the real economy realize they don’t need either club – they can create their own based on no-liability digital money assets having more appreciation for the instability undermining the “value” of the others. Official efforts to cut them off won’t work, in my opinion, because they can’t offer what native cryptos will be able to once they more fully mature.

The real economy, at least around the margins, had already been forced into a huge head start. This is largely what is driving the current crypto price bubbles, mistiming this process and the favorability of no-liability money.

With only further constraints and failures on these other forms of official and quasi-official liabilities, and I don’t mean failures in the form of inflation and dollar devaluation, even after this week’s CPI blowout, the real economy continues to more casually visit and revisit the liability question. Bank reserves aren’t money, they are a form of status which proves itself to be less and less valuable by the day counterintuitively the higher the exchange value of the US$ goes and illustrates the undermining of presumed stability.  

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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