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But that last bit, about taking the form of electrons, is important.

Too many people assume it must take some tangible form, like paper.

Bill: Yep. And I just did a last-minute edit to add "or electrons" where I said the Bank of Montreal cannot issue irredeemable bits of paper (or electrons) and get people to use them as money. Simply because I didn't want people to get hung up on the idea that it is illegal for the Bank of Montreal to issue *redeemable* bits of paper that come too close to currency.

So are you saying central banks have a monopoly over currency and central bank reserves?

The Bank of Canada has a monopoly on Bank of Canada liabilities. The Bank of Montreal has a monopoly on Bank of Montreal liabilities. Nick Rowe has a monopoly on Nick Rowe liabilities. That's not what makes the Bank of Canada special. No, I'm not saying that.

I just remembered. Back on the I=S post, IIRC, some people were complaining I didn't talk about banks enough. OK, here's a post on banks.

If you want to understand what the Swiss and Japanese are doing, and why the Japanese have been able to withstand at times a seemingly infinite influx of capital without their exchange rate going to the moon, understand what Nick is talking about.

(And understand that the CAD-USD peg he's talking about in a theoretical sense is not impossible in reality in certain circumstances. Ask the Swiss, and ask what Flaherty what the last 2 paragraphs of the most recent G7 press release were all about.)

"The Bank of Montreal cannot issue irredeemable bits of paper"

It has been the case in the past where banks did issue notes used as currency, before a central bank was formed. These days BMO et al aren't allowed to issue notes. I, on the other hand, can issue IOUs, as my friends will attest. I'm good for them; trust me! :)

jesse: but your notes are redeemable. And they (probably) don't get used as money. In the olden days, when BMO was allowed to issue notes, they were redeemable (in gold? indirectly?).

"there's this utterly bizarre belief among many economists that it is the Bank of Canada that has the power to set Canadian interest rates, just by borrowing and lending. . . .

"There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency."

Hmmm. It sort of sounds like you have some approach to monetary theory in mind. ;)

All true but what follows from this? The Bank of Canada does set interest rates because it can borrow (from itself) at zero interest. The Bank of Montreal does not have this power. It has the right to say it will only borrow at a rate of zero, but it won't get any money in normal times.
Since we do not live in normal times and since central banks not only borrow in perpetuity from themselves at zero but lend at pretty much the same rate we are seeing the re-emergence in some currencies of cloakroom banking, where Swiss banks will charge you for the privilege of having them store your money. Obviously people would prefer to leave cash with the SNB rather than UBS or Credit Suisse, but the banking system has monopoly access to the central bank so that option is not open.
What I'm not clear about in your argument is whether you are saying there is any currency constraint on interest rates in a country which genuinely doesn't care what happens to the exchange rate.

"And the Bank of Canada would just call security if I tried to redeem it there."

Depends on who you are, I guess.

According to legend the line "I'll be back" might work wonders...

“The Bank of Montreal can refuse my request to open an account to convert my $100 Bank of Canada liability into a $100 Bank of Montreal liability. It is not obliged to redeem my money.”

That’s interesting.

On what basis could a Canadian chartered bank (or all Canadian chartered banks) refuse to open an account for somebody with Bank of Canada currency?

I.e. what unique basis other than that which might already preclude that same person from having an existing account with a Canadian chartered bank, from which to redeem into Bank of Canada currency?

Min: "Hmmm. It sort of sounds like you have some approach to monetary theory in mind. ;)"

I was asking myself the same question, after I had posted this. The *immediate* impetus for this post was some comments on my previous post. The Neo-Wicksellian approach of Woodford's "cashless" economy comes to mind, along with others. But I think the view I am opposing here is wider than any particular school. It might be better to ask the opposite question: which approaches *don't* say this?

Daphne: "What I'm not clear about in your argument is whether you are saying there is any currency constraint on interest rates in a country which genuinely doesn't care what happens to the exchange rate."

A country that doesn't care about its exchange rate can do *almost* anything it likes with monetary policy. If it does anything *too* outrageously wild people will stop accepting its irredeemable currency, resorting to another currency, or even barter. And it can't set real interest rates (or any real variable) in the long run.

JB: Good find! (Click on JB's name for the link.)

JKH: I don't think there's anything unique about it. If you come to me with a $100 Bank of Canada note and ask me to convert it into Nick Rowe dollars, I can just say "no". So can BMO. It can close all its branches and stop accepting deposits tomorrow if it feels like it. Usually, of course, it will accept your Bank of Canada dollars. Every business (in Canada) usually will. Bank of Canada dollars are the medium of exchange in Canada. We all choose to accept them, because we believe that everyone else will accept them from us. But we accept them on our own terms. Nobody can force me to sell my house, car, or services as an economist, for Bank of Canada Dollars, or anything else. But the Bank of Montreal is obliged to sell Bank of Montreal dollars for Bank of Canada dollars, at a fixed exchange rate (par).

Curses! That last sentence should read: But the Bank of Montreal is obliged to *buy* Bank of Montreal dollars for Bank of Canada dollars, at a fixed exchange rate (par).


My point was that any reason for BMO to refuse to accept BoC currency for one of its own liabilities would be a reason for BMO not to allow the same person a deposit account in the first place – e.g. a drug smuggler. So the exchange of a BMO deposit liability for BoC currency is moot in that case. It won’t sell BMO dollars for BoC dollars because it will already have refused to issue BMO dollars in the first place. It’s a symmetric result in that regard.

Conversely, anybody with an account through which BMO will redeem BoC dollars for BMO dollars is somebody for whom BMO will redeem BMO dollars for BoC dollars.

Once the account and the customer relationship are established, the redemption obligation is symmetric.

If/when the redemption obligation becomes asymmetric, the account has already been extinguished with respect to activity in either direction.

The chartered banks are distribution agents for BoC currency. The banks are responsible for the account creation and the account relationship, which is symmetric in the case of currency exchanges.

I suspect this gets complicated in a very unimportant way if we introduce private banks that can issue notes & coin, but which are restricted by the central bank (i.e. certain Scottish and Ulster banks).

It gets interested in a very interesting way if we assume these private banks (or indeed all private banks) can issue notes & coin without restriction, as in the 18th century. And, at that point, I defer to White & Selgin.


If you have a deposit account with BMO, BMO will definitely redeem your BoC currency for balances in that account - i.e. for BMO money.

If you don’t have a deposit account with BMO, BMO will assess your application for a deposit account with BMO, and if approved (mostly likely on the spot), BMO will redeem your currency for balances in your new account.

If you don’t have a deposit account with BMO, and BMO refuses your application for one (e.g. you are a drug smuggler), you won’t be able to redeem your currency for balances in a new account. And neither will you ever be in a position to redeem BMO money for currency, because you’ll never have balances in a BMO deposit account. So any potential asymmetry is moot. You can’t deal with BMO in either direction as far as currency conversion is concerned. It’s symmetric.

And if BMO literally shuts its doors as in your example, the idea of redeeming currency for BMO money is moot, because BMO for all intents and purposes is no longer a chartered bank. Moreover, existing deposit accounts will be paid out by CDIC - and almost certainly not in currency.


You’ve referred to two different types of redemption asymmetry.

One is with respect to the liability scope of the “redemption agent”. I obviously agree that the Bank of Canada doesn’t redeem its own liabilities for BMO liabilities, but BMO does redeem its own liabilities for Band of Canada liabilities.

The other is with respect to the directional scope of the “redemption agent”. Here, I disagree. The directional scope of BMO as redemption agent for Bank of Canada currency is symmetric, as I described.

The difference between the two symmetries is rooted in the fact that the chartered banks are distribution agents for Bank of Canada currency. That is the intended asymmetric institutional configuration, reflecting chartered banks as an extension of the central bank. An alternative would be a fully nationalized system where the existing chartered banks are subsumed as branch systems within a single national bank. In that case, currency redemption remains directionally symmetric. And the Bank of Canada (the only bank) sets all rates.

"And yet there's this utterly bizarre belief among many economists that it is the Bank of Canada that has the power to set Canadian interest rates, just by borrowing and lending. And that the Bank of Montreal, and ordinary people like me, somehow lack this special power."

Where does this come from Nick? What motivated this post?

You say there are economists out there that believe BMO doesn't set its own mortgage rates, or its own deposit rates, or its own prime rate?

Must be the same ones that believe the Bank of Canada doesn't set the Bank Rate.

"It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power. That's what makes central banks central."

The central bank will redeem bank reserve deposits for currency and vice versa.

That's what enables the chartered banks to be distribution agents for currency.


By virtue of not redeeming deposits, the Bank of Canada has no liquidity risk on its balance sheet. When it buys securities from the private sector, it therefore "cancels" liquidity risk. This is not true of other types of portfolio risk. When it buys term bonds from an insurance company, for instance, it reduces that company's portfolio duration risk; it also increases the duration risk of the Canadian treasury (assuming BOC profits are remitted there) and that treasury passes on the risk to private actors. The same is true of earnings volatility (credit and equity) risk.

There may be signalling effects to buying interest bearing, credit, equity or any other securities, but other than that, doing so will only change the private sector's aggregate liquidity risk. When this risk is a large component of portfolio risk (i.e. during financial crises), this has a large influence on private sector portfolio allocations. In normal times, the effect would be small as liquidity risk is the smallest component of aggregate portfolio risk.


In the 1800's, private banks suspended convertibility of their notes several times. I don't know, but I expect that several private banks must have issued dollars that promised redemption in the dollars issued by another bank. Neither of these things is a defining feature of a central bank.

Actually, I can't come up with a single feature of central banks that sets them apart from regular banks. They are just bigger, that's all.

Mike Sproul,

A CB has non-redeemability without consequences. Clearinghouses in the 1800's could get away with temporary forced deposit maturity extensions. Look at what happens when those maturity extensions are more severe: I found data for Argentina and Chile in the early 90's after an Arg. banking crisis. The Argentine deposit-to-gdp ratio fell to 9%; Chile's was 50%. I assume something like this happened in 2001 as well.

It’s worth mentioning that the REASON central bank irredeemable money is accepted and used is that the relevant country’s tax authorities require taxes to be paid in central bank money: else you go to prison. Which is a fairly persuasive reason.


Private banks suspend redeemability every night and every weekend without consequences. Sometimes suspension lasts months or years. As you say, people will often reduce their relative cash holdings as a result, but this gives a large gray area where we have to start asking what degree of irredeemability makes a bank "Central". Then we remember that Central banks sometimes maintain redeemability for decades.


I'm a landlord, and I sometimes buy groceries with bits of paper that I promise to accept for rent. Other than rent, the bits are irredeemable. Tenants must pay rent either in my bits or something of equal value. I can't put them in prison, but I can make their life unpleasant. Now it's true, I accept other forms of payment, but the government will also accept my house or car in payment of taxes.

Expanding on Mike's reply to Ralph, I have never found the "taxes must be paid in central bank currency" to be particularly convincing. The amount of money that would need to be circulated to pay taxes is relatively low compared to the amount of money that is actually around. People like central bank money and choose to use it in non tax-related transactions because it is relatively stable in value compared to the price of things they want to buy (because the CB makes it so) and because other people like to use it too (it is a natural focal point). Furthermore, it is conveniently denominated, easy to handle in physical form, and difficult to counterfeit.

Intrinsic value-based currencies lack some or all of these quantities (for example, physical gold is more difficult to handle and is less conveniently denominated, and gold in any form fluctuates wildly in value relative to things I want to buy).

Other fiat currencies (say, under a free banking system) may be able to work, despite the banks' constant temptation to issue too much currency to take advantage of seigniorage (slightly weaker for an arm's length CB).

As a point of historical interest only, in the days before 1935 with no Bank of Canada, banks operated on an indirect gold standard. The Dollar was defined in terms of gold in the Currency Act of 1871, in relation to the British Gold Sovereign and to the Eagle, the US unit of currency in gold. 1 Eagle = 10 Dollars and under the classic standard 1 Eagle = 0.5 ounces troy of gold, thus 1 ounce of gold = 20 dollars.

In practice it meant the Canadian dollar was defined to be identical to the US dollar. Redemption of banknotes into gold was the legal responsibility of the bank issuing the notes.

Banks issued their own currency notes, which was really an IOU redeemable in other chartered banks currency or coin. The IOU was backed by the capital of the bank, especially the shareholder's equity.

This backing network ended at the Bank of Montreal, which is special. The Bank of Montreal was the fiscal agent for the Government of Canada, it held the government's deposits. Thus the Bank of Montreal had the deposit-side characteristics of a central bank but not the lending side features. It did however act as a lender of last resort, of a sort, and often led bank crisis responses.

The Bank of Montreal held this position because it was and is the oldest and first bank in Canada, founded in 1817.

During and after WWI the Bank of Montreal's activities were complemented by a debt-based financing window operated by the Department of Finance. WWI upended everything.

Note that is was possible for a bank to "break the buck" and not honour it's notes in full; this actually happened often enough. It would lead to a bank either crashing and burning, such as the Home Bank did in 1923 or to a quiet takeover by a stronger bank, the preferred option if possible. This is what happened to the Bank of Hamilton which was taken over by the Canadian Bank of Commerce in 1922.

This is just historical information and not meant to make an economic point.


On physical currency, didn't the Spartans use iron currency? That's one way literally to reduce the velocity of money!


I am not aware of anyone among my friends and acquaintances who would pay taxes in central bank money (federal reserve notes in the US). They usually pay with a bank check or an ACH transfer. Some pay with their credit card. None of the above is paying "in central bank money". How a specific taxpayer's bank settles with the Treasury, in "central bank money" or in cowries, is of no concern to the taxpayer.

JKH: "You’ve referred to two different types of redemption asymmetry."

I think you have a (good) point here, that helps clarify my thinking and post. The first asymmetry (which we agree on) is the one I think is important. I am less sure on the second, and whether it matters much.

Mike Sproul: From your own perspective on monetary theory (backing theory) there would indeed be no (fundamental) difference between a central bank and any other bank. I can see where you are coming from, even though I disagree with your perspective.

"They [central banks] are just bigger, that's all."

Does anyone know if that's true in Canada? Aren't the big 5 each about as big as the BoC? (I'm not quite sure how I would define "big" in this context.)

Determinant: thanks for that historical background. It's useful in this context, as well as interesting in its own right.

David: I think i follow you there, and I think it sounds right to me.

JKH: "You say there are economists out there that believe BMO doesn't set its own mortgage rates, or its own deposit rates, or its own prime rate?"

If BMO suddenly starts charging much higher interest rates on its loans, the BoC (and the other banks) are unlikely to follow, and the BMO will disappear from the market. That's not true for the BoC.

vjk, the way the accounting people have explained that to me is that when a check is used to pay taxes, the demand deposit account is marked down AND the reserve account of the bank is marked down 1-to-1. That means central bank reserves are involved, which is one type of central bank "money". Also, when a demand deposit account and the reserve account are both marked down 1-to-1, that is equivalent to currency.

This all leads to medium of exchange. I like to use currency, central bank reserves, and demand deposits because there are too many definitions of "money". I think it should also lead to what types of demand deposits the central bank will accept for currency exchanges and for paying taxes.

Nick said: "The Bank of Canada has a monopoly on Bank of Canada liabilities. The Bank of Montreal has a monopoly on Bank of Montreal liabilities. Nick Rowe has a monopoly on Nick Rowe liabilities. That's not what makes the Bank of Canada special. No, I'm not saying that."

What about the likelihood of default on those three types?

And, "Bank of Canada currency is irredeemable."

Can it be considered "redeemable" (used loosely) for goods/services?

"That means central bank reserves are involved"

Sure they are, but the taxpayer pays in bank money which is a check, not in reserves( operationally he cannot) or currency although he may choose,but not obligated, to.

The credit card payment is even more interesting (to an MMT'er, not to an average person) because it is pure horizontal money, a loan, created by the credit card lending bank to let the taxpayer settle his tax obligations.

Of course, you can say that in each case the Treasury gets central bank money, but that's an uninteresting, to the taxpayer, implementation feature, not something he should care about much less be in fear of going to jail for his inability to procure federal reserve notes ;)

But what of cotton

vjk said: "Sure they are, but the taxpayer pays in bank money which is a check, not in reserves( operationally he cannot) or currency although he may choose,but not obligated, to."

I agree that the taxpayer is losing medium of exchange. Will the central bank/gov't accept any check for tax payments or only certain ones? I doubt if Nick's liability/check will be accepted unless it "clears" at a bank somewhere.

You might be interested in these two links:

MMP Blog #14: IOUs Denominated in the National Currency: Government and Private


Government and Private IOUs Denominated in the State Money of Account: Responses to Blog #14


Of course, bank notes from the Bank of England ARE redeemable. On the front of every £10 note it says "I promise to pay the bearer on demand the sum of £10" and it's signed by the Bank of England.
Go to the Bank of England and they will honour this promise by giving new a £10 note. If you ask really nicely they will even give you two fivers.
The power of legal tender is very great. This is shown by the occasional burst of inflation. Inflation is always a legal tender phenomenon, since if we had Hayekian multiple currencies people would always demand the strong currency and inflation measures would only tell us the relative exchange rates.

Actually, I can't come up with a single feature of central banks that sets them apart from regular banks. They are just bigger, that's all.

Central banks have an important feature that sets them apart: they are generally the ones that issue notes which the government will accept as legal payment for taxes.

This guarantees ongoing utility central bank notes no matter what happens to the economy and regardless of the balance sheet of the central bank. (barring a total collapse of GDP or a balance sheet so huge that it does not relate to GDP in a meaningful way anymore)

Mike Sproul:

I assume that in your groceries scenario you are the landlord of the grocery store. In that case, the bits of paper you issue are not really MONEY. Money is something which is GENERALLY ACCEPTED in payment for goods and services. Your bits of paper are only good for transactions between you and the person running the store. I think that is much nearer a barter transaction than a money transaction.

Mike and vjk:

Re the tax authorities accepting houses, cars, etc in payment of taxes, this is much the same as the tax authorities accepting a cheque drawn on a commercial bank. All these forms of payment are provisional or temporary – pending a transfer to the tax authority’s account at the central bank. I.e. if the car turns out to be worthless or the commercial bank goes bust before the above entry in the central bank’s books, then my understanding is that the tax authority will be after you. (At least, if the tax authority has its head screwed on, there will be some clause in the “car transaction” stipulating that if the car is worthless, the authority will be back to hound you.)


The fact that the amount of money needed to pay taxes is small compared to the amount needed for all other transactions does not matter. Reason is as follows. There is an intrinsic desire for any form of money because it’s more efficient than barter. That means that absent a currency, people will accept ANY form of currency as long as it is efficiently administered. For example, some shops issue savings tokens to enable people to store up spending power for Xmas. Absent a form of money, a supermarket chain could find most of its tokens used for transactions that had nothing to do with Xmas purchases at the supermarket.

Having said all that, I’m now having doubts about my claim that the power to make a form of money irredeaemable relies on the fact taxes must be paid in central bank money. The fact that taxes must be paid in central bank money gives that form of money a lot of clout and nearly always makes it the dominant form of money. As to irredeemability (e.g. coming off the gold standard), the power to do that rest on government’s power to make the laws and the fact that it controls the police, army, etc. I.e. anyone insisting on being given gold in exchange for a $100 bill is just told to shove off, and if they persist, they get taken to court and fined.

And now I’m off to see my psychiatrist beause this money business is giving me a nervous breakdown.


If you look at an IRS publication(http://www.irs.gov/taxtopics/tc202.html), you'll see this:

Tax Payment Options
Direct Debit from your bank account
Payroll Deduction from your employer
Payment via check or money order
Payment by Electronic Federal Tax Payment System (EFTPS)
Payment by credit card via phone or Internet, or
Payment by Online Payment Agreement (OPA)

Paying in FRNs (central bank money) is not even an option, much less an obligation.

Daphe Miller: "Inflation is always a legal tender phenomenon, since if we had Hayekian multiple currencies people would always demand the strong currency and inflation measures would only tell us the relative exchange rates."

A couple of questions:

1) How does that jive with Gresham's Law?

2) Before the Federal Reserve Act in 1913 the U. S. had many currencies. It was on the gold standard, but, as I have heard, there were something like 50,000 private currencies. There is a test bed. What happened with regard to inflation, then?


You have argued the Fed should buy equities. Given the discussion surrounding this "Central Banks are different" post, I have some questions:

Should a central bank experience a loss on risk assets, would it need more capital? What are the ramifications of central bank losses, if any, for price stability? Are central banks also "different" in that they can operate with negative net worth, or replenish their own capital without negative consequence? Is the true significance of Excess Reserves (and the IOR as a key policy tool) the potential future reversal of cash flows between Treasury and the Central Bank?

This was useful, but the nature of the link between price stability and CB capital could use more exploration:


Ralph Musgrave,

It is very obviously a credit transaction. The bits of paper are commonly referred to as IOUs. You're right about taxes and government IOUs.

It doesn't seem to me that asymmetric redeemability explains why there is any demand for Bank of Canada liabilities in the first place. Suppose Bank X offered tomorrow to redeem its notes in Kervick-bucks, if the holders of its notes so desired. And suppose that the issuer of Kervick-bucks, at the same time, refused to redeem Kervick-bucks for Bank X libailities. Would that give me, the issuer of Kervick-bucks, and power whatsoever over Bank X and its interest rates? Surely not in the absence of any other developments. There is no independent and pre-existing demand for Kervick-bucks, so nobody would take the bank up on its silly and gratuitous offer.

I don't think you can leave state power and law out of the equation when considering factors other than convention and habit that contribute to the demand for particular kinds of credits. The tax obligations Ralph mentions are a part of the basis for that demand. But so is the fact that everyone within a particular jurisdiction is required by law to accept certain credits as payment for debts, and that courts are empowered to determine whether some particular number of those credits constitutes payment in full.

The thing that makes a central bank central is not just asymmetric irredeemability but its role as the banker to the government. Access to government deposits and thus indirectly to tax revenues gives a central bank it's heft. A central bank can act as lender of last resort because it lends out tax deposits. Without this feature a central bank has no muscle.

This is why the Bank of England is the central bank of the UK; it has been the banker to the Government since the late 1600's. Similarly as I noted above prior to 1935 the Bank of Montreal was the Government of Canada's fiscal agent, it still is Canada's fiscal agent in London. That's why it often acted as lender-of-last-resort and was able to fund the famous $25 million loan to finish the Canadian Pacific Railway in 1885.

The Bank of Canada was created partly because the Royal Bank and a few others wanted to take away the government business from the Bank of Montreal for competitive reasons.

Similarly the Bank of Montreal was also the fiscal agent of the Government of Newfoundland and this gave it a strong presence there when Newfoundland was still separate. In order to deal with the Government of Newfoundland you had to deal with the Bank of Montreal.

David: I partly answer that question in my old post:

The biggest asset a central bank has is the present value of the future stream of seigniorage revenues. In an economy where NGDP is growing, that asset is usually worth a lot more than the value of the assets on the books. So even if the book assets became worthless, the CB could keep on setting monetary policy how it wanted, even without a capital infusion from the government. (But it might have to issue its own bonds so it could capture some of that NPV of seigniorage for the present).

Dan Kerwick: "It doesn't seem to me that asymmetric redeemability explains why there is any demand for Bank of Canada liabilities in the first place."

Correct. I agree. My post just assumes there is a demand for Bank of Canada currency, even though it's irredeemable. (It wasn't part of the topic of this post). But, as I argued in an earlier post, the "tax argument" is neither necessary nor sufficient for irredeemable paper money to have value. (Many economists, from many different schools of thought, disagree with me on that, which is OK; I side with the Austrians and monetarists on that one.)


Determinant: Central banks do 2 (main) things: they set monetary policy for the country; and (in abnormal times) they act as Lender of Last Resort. This post really concentrates solely on that first role, and ignores the Lender of Last Resort function.

A central bank that issues irredeemable paper can function much more effectively as a lender of Last resort, since it never runs out of gold (or whatever) reserves. Yes, there is a small risk (not so small in Eurozone right now) that it might lose all it's assets (inlcuding NPV of future seigniorage, see my response to David above) and be obliged to ask the government for recapitalisation.

Nearly all the time, however, central banks do not need any government funds. On the contrary, central banks give their seigniorage profits to the government. Except in extremis (like the Eurozone right now) the government's tax revenues need assistance from the Central Bank, rather than vice versa.


I may be confused but there are two types of seigniorage: 1) the difference between currency value and the cost to produce it; and 2) the interest earned on CB assets minus that paid on liabilities. The latter applies to traditional OMO's: the Fed takes on an interest bearing asset (T-Bills) and issues a non-interest bearing liability (bank reserves). My point is the second type of seigniorage changes with non-conventional OMO: the CB is now paying interest on reserves and faces losses from duration risk and from asset write-downs. Therefore it could now have a negative NPV. Of course, it won't, because its net worth is a liability of the Treasury. There's the rub: a negative net worth necessitates a legislative solution. The Fed is a creature of Congress and its powers of appropriation. A negative NPV means a loss of independence. It may also have an impact on the Fed's inflaiton-fighting credibility. Sort of a "reverse confidence fairy."

This is not an academic discussion. The ECB this weekend is faced with stepping up its risk asset buying or letting periphery countries default. It faces a real risk of losses on those buys.

Most CB risk asset buying proposals I have read imply, "assume CB buying of risk assets makes their value go up." I'm asking, what if it goes down a lot instead.

David: "I may be confused but there are two types of seigniorage: 1) the difference between currency value and the cost to produce it; and 2) the interest earned on CB assets minus that paid on liabilities."

I don't think you are confused. If you follow a central bank from the beginning of its life to infinity the PV of those 2 streams of 'seigniorage should be equal. But if you take a snapshot half way through its life, they will be different. Or if the central bank winds up without retiring its currency they will be different.

For example, if you start a central bank by issuing $100 currency to buy $100 bonds, then issue no more currency, the seigniorage revenue was $100, and the PV of the interest on the bonds is $100 also. But the PV of future printing will be $0. (I'm ignoring printing and operating costs and assuming the currency pays 0% interest in both cases).

Now suppose all the bonds default 100%, so they are worth $0. The CB cannot now retire its currency, but it can continue holding the stock of currency constant.

As long as the ECB never needs to reduce its stock of currency, it's OK. If it does, it's screwed.

Because currency pays interest (if any) less than or equal to the nominal growth rate of the economy, the long run budget constraint does not converge. It's a stable Ponzi, as long as it is never wound up.

The above is not as clear as it should be. I'm a bit tired.

"My post just assumes there is a demand for Bank of Canada currency, even though it's irredeemable."

But in offering to to explain the specialness of a central bank, Nick, you come down on the idea that a central bank, unlike other banks, can issue irredeemable bits of paper (or electrons) and get people to use them as money. A lot is packed into that "can". We really don't have an explanation of the specialness of a central bank until we understand the source of that remarkable power. The source lies in the desire or willingness of people to acquire these issues from the bank. So to complete the explanation, we have to understand the source of that desire or willingness.

In theory, the the issue from a particular bank might be valued purely out of expectations of exchangeability grounded only in habitual practice or convention. But surely in our actually existing modern societies, the demand for central bank issue is underpinned by the fact that these banks are yoked to state power, and their issues are mandated to play important and special roles as a matter of law. These mandates impose requirements on people that either demand, or at least strongly recommend, acquiring the credits issued and and disseminated by the central bank.

I agree that the tax role is neither necessary nor sufficient for a money to be demanded and have value. It's just one important causally contributing factor that may or may not be present in a given monetary system. I don't think there is any one single factor that does the job in explaining the ascendancy and stabilization in value of any particular type of money. Each kind of money that has existed has its own unique history, and there is usually an interplay of conventional factors, and institutional power factors, especially including the institutions of government, that account for its pervasiveness in exchange.

On the matter of interest rates, it seems to me possible in principle that a particular bank could achieve an overwhelmingly dominant economic role in a monetary and banking system, simply by virtue of the amount of its deposits, even if that bank were not the issuer of the established form of money. And if that were the case, wouldn't that dominant bank have the effective ability to set interest rates by virtue of its preponderant market role?

Dan: suppose, just suppose, that I had the power to issue irredeemable bits of paper that people would choose to accept and use as money. But suppose i chose not to exercise that power. Suppose instead that I chose to peg Nick Rowe money to Bank of Canada money (and that the Bank of Canada did not reciprocate). Then Canadian monetary policy would still be set by the Bank of Canada.

On your last paragraph: Let's suppose the Bank of Montreal had a monopoly on all borrowing and lending in Canada. But the Bank of Canada could still do standard open market operations in government bonds. And that any monetary liability of the Bank of Montreal were redeemable in Bank of Canada notes. Then I would say that yes, the Bank of Montreal would have the power to set interest rates on borrowing and lending in Canada (and presumably would put a big spread between them). But (and this is where you will very probably disagree with me, or think I'm totally incoherent) I would say that the Bank of Canada still controls monetary policy.

Monetary policy is not interest rate policy. And actually, that thought-experiment of BMO having monopoly power, is a lovely way to illustrate the difference. I must develop that idea further.

Scott Sumner has a response to my post along these same lines.


I agree with all the other things you say Dan. Especially liked your "nuanced" view of the role of government.

BOC sets the rate by having the power to issue unlimited amount of "tax credits" - money accepted as payment of taxes. Since tax credits are always desirable, BOC can issue as many as it takes to set the rate. BMO has no such power - when it issues too many of its liabilities (which are only worth anything because they are ultimately redeemable for Canadian dollars = tax credits) BMO sets itself in for a scenario where it cannot service its debts. BOC can never face such a scenario.

Dan Kervick: "And if that were the case, wouldn't that dominant bank have the effective ability to set interest rates by virtue of its preponderant market role?"

Probably. The cb has unlimited power to control rates in the market for interbank cash balances. In a competitive banking environment, this market determines the marginal cost of funds for all commercial banks, so the cb has total control over the risk free rate. But if one bank was totally dominant it might expect that deposits created via new lending would largely stay on it's own balance sheet and its own deposit rates might be a more significant contributor to the marginal cost of funds than the interbank market. This is certainly not the case in Canada, the US, or Europe. In most of the world the cb is fully in charge of the risk free rate.

Nick: wrote the above before I saw your last comment.

"Monetary policy is not interest rate policy"

Maybe. At the ZIRB, the composition of the cb balance sheet matters a bit. But contingent on a particular non-zero rate of interest the quantity of money doesn't matter. It is simply an endogenously determined variable that automatically compensates for changes in the velocity of money. Woodford rules :-) (Yes, that was fully intended as a provocative challenge just to help get you in the mood for your next post!).

Hi Nick,

I had a debate about banks "printing money" on another blog; I think what might be helpful is to follow the ledger of the BoC and compare it to BMO. I think the accounting is different, which is your point, but it might help to put it in tabular form. We can all balance chequebooks. A good question to ask is is there ever a point in which a central or chartered bank books an asset "out of thin air".

The US government has a big holding on the Fed's balance sheet. This is what enables the Fed to operate on the loan side. Of course the US Government should be paid for it, it made a deposit after all. But that deposit forms the core of a central bank's balance sheet.

Same for the Bank of Canada. Further, monetary policy is not just setting the interest rate for clearing interbank settlements, it includes the setting of the rate of interest through the control of government securities auctions.

This is how the Bank of England became a central bank.

If it isn't the government's banker, it isn't a central bank. It is the defining characteristic of a central bank.


I thought the Fed issued reserves in exchange for bonds, not currency. When demand for marginal bank reserves is zero, banks accumulate ER's. ER's pay the IOR. So the stock of Fed assets (bonds) could theoretically earn less than its liabilities (ER's and currency) pay: a negative NPV. If the private sector's demand for currency rose, that would help, but it would also be inflationary.

In any case, it would be interesting to hear your thoughts on whether Fed buying of risk assets just transfers duration/credit risk back to the private sector via the Treasury. If so, the portfolio balances effect is limited to the reduction in the liquidity risk held by the private sector. That leaves the purpose of buying risk assets as "signalling" future intentions. However, if the portfolio balances effect is small today, what "signal" would promising future QE send?


"It is simply an endogenously determined variable that automatically compensates for changes in the velocity of money."

I rather wish that was the case, because then we could close the book on macroeconomics as the study of monetary disequilibria and start studying something a little bit more down to earth, like the consumer behaviour of gypsies in the modern developed European nations. However, since we repeatedly seem to end up with monetary disequilibria, we'll have to press on and assume that Kaldor was wrong on this one (that's not to say that he was right about anything else).

If one needs an empirical refutation of the theory that the quantity of money is demand-determined, then I recommend Tim Congdon's "Keynes, the Keynesians and Monetarism" where he provides (a) an econometric reason to think that the money supply isn't demand-determined and (b) a reason to think that the microfoundations of theorists like Kaldor are atrocious e.g. they depend on strange (presumably psychotic, in fact) behaviour by bankers.

For the BMO monopoly post, did the BOC ever make submissions to government a couple years ago when all the banks were lobbying to allow themselves to merge?

The fact that people don't understand this is because they don't know about the time before Fed where every bank had its own notes. What happened then was that due to various political issues the governments monopolized the creation of money and everyone has to use one set of bank notes, the one issued by BoC and its monopoly is strengthened by the fact that it is legal tender.

Historians of banking: during the period of significant private money issuance in the US, Canada and UK, was it still the case that taxes were paid in the "official" currency?

Ralph Musgrave:

I wouldn't have to be the grocer's landlord. I might be the landlord of a farmer who sells peaches to the grocer. For my bits of paper to circulate as money, it is only necessary that I am well known.

I, like the government, would also accept rent payments in the form of houses, cars, beaver pelts, etc. If I'm owed $5 of rent, I'd accept a $5 sandwich in lieu of rent. I don't have to be paid in my own bits of paper, and neither does the government.

vjk: "Paying in FRNs (central bank money) is not even an option, much less an obligation."

Or really?! And if you are a bank how do you pay taxes then?

Surely one can not pay taxes (directly) using FRNs because commercial banks are agents for the central bank which is the agent for the government. But to say that you can not come to a bank and ask to make a money transfer (tax payment) with FRNs is intellectually dishonest.


... and this is why the ECB cannot act as an Effective Lender of Last Resort: European governments do not hold deposits at the ECB so the ECB can only loan out emergency funds if it is permitted via the political process.

Which is fragile and that kills any notion of it being an effective LoLR.

So the ECB is not an effective central bank - especially not at zero lower bound interest rates.

IMO this also partly explains why Trichet was so keen on increasing rates (at exactly the worst moment): his only real leverage as a central banker was a non-zero interest rate with plenty of space down - and ZIRP has been with us for 3 years and he wanted his (only) tool back, badly.


"Or really?! And if you are a bank how do you pay taxes then?"

Really, that's the operational reality, not pure MMT model.

As to intellectual or otherwise dishonesty, the bank is *not* part of the private sector and is *not* a representative taxpayer/agent. Think about it.

"What makes a central bank special?"

Well, one approach would be to look at the historical development of this institution, why it was created, and what role it plays. Look out your window.

A second approach would be to close the blinds and pontificate.

Central banks are called Reserve Banks. Their customers are other banks. Their primary role is to ensure that their customers can access the reserves they need. That is their essential nature, it is what makes them special. The need for this can be found in private attempts to set up clearinghouses that would match banks with excess reserves with banks with insufficient reserves, such as the Bank of Suffolk.

When banking crises became so large as to overwhelm the private Reserve banks, a government, or Federal Reserve Bank was created.

In the course of ensuring that banks have sufficient reserves, a side effect is to reduce banking failures, allowing the inside money supply to be more accepted, and allowing the money supply to be endogenous. Reserve Banking does not perfectly guarantee this -- you still need other things, such as a deposit insurance and good regulation, a payment system, etc.

So what makes a central bank special is that it allows currency to be irrelevant as deposits become perfect substitutes for it.

That is the evidence based, historical, operational description.

Sheer pontification can lead you to basically any conclusion, depending your priors. Why you would fixate on convertibility versus non-convertibility is puzzling. If you want gold for your money, you can always buy gold with it. A nation that pegs its currency to gold only guarantees you a fixed exchange value, it does not prevent you, as the individual, from converting your money into gold. But of course the price of gold versus other goods fluctuates wildly, so what value is this guarantee? Moreover, nations that peg their currency to gold are free to and often change the value of the peg. No peg is ever fixed -- it is up to the discretion of the government, based primarily on the forex policy. So in all cases, whether pegged or unpegged, you have a tension between freedom to offer a certain discount rate and the effect this has on current account. In a pegged regime, you are concerned about gold outflows, so if you de-value import prices rise and you may face inflation. In a non-pegged regime, if you lower the discount rate, you risk the same effect -- capital outflows and inflation.

So how can pegged versus non-pegged currencies tell you anything special about Reserve Banks?

They can't.

Reserve Banks existed during the gold-standard era, and they existed afterwards, playing essentially the same role in both cases, namely ensuring that their customers (other banks) were sufficiently liquid to make their liabilities equivalent to currency, allowing the quantity of money to be demand determined while the discount rate is a policy variable.

I should add that I agree that central banks in nations that peg are more constrained, and therefore less effective, then central banks that do not peg.

But the difference is one of quality not kind. In both types of nations, central banks have a special or essential role in supporting the domestic banking system, allowing deposits to be substitutable for currency.

The essential role of a central bank does not change when a nation abandons a peg, or moves from a peg that is changed only during crisis periods to a floating peg, or from a floating peg to a fully floating exchange rate.

Historians of banking: during the period of significant private money issuance in the US, Canada and UK, was it still the case that taxes were paid in the "official" currency?

As far as I can tell, taxes were payable by cheque or cash with Cash being an acceptable bank note. In Canada where the Government of Canada used the Bank of Montreal as its fiscal agent, BMO notes could be considered the "best" but any note drawn on a big Chartered Bank like the Imperial Bank or the Bank of Toronto were acceptable.

It would be better to say that notes drawn on banks in doubt could be refused, like a note drawn on the Home Bank which went bust in 1923.

Governments did not demand gold in direct payment and Dominion Note issues were for under $5.

The caveat is that income taxes came in as the chartered bank note era ended so the overlap is slim. WWI also complicated matters as it drove up taxes and made governments suspend the Gold Standard.

Determinant- thanks. I studied Canadian history as a minor course for a year at university, but we didn't get into the details of your banking system.

vjk: "As to intellectual or otherwise dishonesty, the bank is *not* part of the private sector and is *not* a representative taxpayer/agent. Think about it."

Any bank is an operational agent obliged to perform certain functions and comply with certain rules by its banking license. Think about it.

In the post I had BMO pegging its money to BoC money, which wasn't pegged to anything.

The real world, of course, can be more complicated. E.g.:

1. Money A is pegged to Money B, which is pegged to Money C, which is pegged to gold.

(That, roughly, is the Bretton woods system, where B is a national currency, and C is US dollar currency) Could we say that B is central wrt A, C central wrt B, and gold miners are ultimately in charge of monetary policy?

2. Money A is pegged to money B, and money B is pegged to the CPI basket of goods. But bank B can choose, if it wishes, to change that peg, and bank A cannot.

That, roughly, is Canada's inflation targeting regime. A is BMO, and B is BoC.

That asymmetry is pretty important. The fact that all dollars (US or C) are effectively backed by the central bank makes life a lot easier.

Before the US had a central bank, in the 19th century, any bank that wanted to could issue paper dollars. Of course, not all dollars were equal, and anyone who dealt with a lot of dollars looked them up in the Bank Note Reporter to find out what they were actually worth. (The dollars of less reliable banks were valued at a discount.) Interestingly, the Bank Note Reporter is still around, but more for people who collect paper currency the way others collect coins or stamps.

Can you imagine doing electronic commerce with this kind of system? It would be like having a whole slew of security certificate issuing authorities, some of greater probity than others. Oh, we do.

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