Can central banks go bust?

"Some misunderstandings are hard to cure." Barton Gellman

There is a great mystique associated with central banks. Possibly because of the principal role they play in society, or perversely, because of the move towards more transparency by the world’s largest central banks, economists and the like are now more interested than ever in the workings behind them. One of the most contentious matters surrounding these enigmas is whether central banks can go insolvent. With it quite a fashionable topic since the Fed started its QE program 8 years ago, media and economists alike have given their take on this issue. In this post, I show why the common retort regarding central bank insolvency is, in my view, incorrect.

The common misunderstanding of central bank solvency is shown in the following statement: “The central bank cannot go insolvent because it can just print money.” If this sounds plausible to you, don’t worry - you’re in good company. Countless trained economists in the media and public eye believe the same thing (see here and here for some examples). If you have done any economics, you should know that, as I wrote when talking about whether the UK Government’s debt is cancellable under QE, every agent in an economy must be resource constrained. In other words: there is no such thing as a free lunch!

The first thing to understand is central bank reserves. Reserves are a form of liability for the central bank - the money that private banks leave in their accounts at the central bank must be there when they want to withdraw them. Consequently, reserves are just another form of short term borrowing for the central banks (just like a current account in any normal bank). So when people say a central bank ‘prints money to finance its insolvency’ what they mean (or should mean) is that they issue reserves to these banks and are kept in their accounts, which can then be used to ensure the central bank's solvency. Bearing this in mind, the misunderstanding in this statement becomes more clear - the central bank printing money to fund its insolvency is another way of saying the central bank is borrowing forever, otherwise known as a Ponzi scheme.

As with any Ponzi scheme, if a lender realises that something he might be investing in is a Ponzi scheme, he will not invest. In other words, the bonds that a Ponzi scheme owner issues are worthless, as no-one wants to buy them. The weird thing about a central bank is that these bonds are reserves which the central bank must (by law) exchange one-for-one for currency (cash and similar instruments). So if these ‘bonds’ are worthless, its like saying that the currency central bank issues is worthless. And what’s the equivalent of saying currency is worthless? When the aggregate price level goes to infinity - otherwise known as hyperinflation. 

There have been numerous instances of super-high inflation rates in both emerging and developed countries historically. Interestingly, most of these hyperinflation instances have come as a result of fiscal crises, where the central bank has been called upon to print money to finance the deficit. As soon as investors realise what is happening, the value of the currency that these central banks issue go to zero, resulting in hyperinflation. 

Note that hyperinflation does not stop as soon as the central bank promises to stop issuing reserves. Instead, they tend to stop with fiscal reform - i.e. when it is clear that the central bank does not NEED to print money. This is one of the reasons why intergovernmental institutions insist on fiscal reform when they are brought into countries with hyperinflation. 

The bottom line

Just to be clear, this post is not to say that one year of the Federal Reserve, for example, printing money to cover its shortfall is going to lead to hyperinflation in the US. There is a large amount of credibility that the Fed has built up over many, many decades that will prevent this from happening (not to mention the laws and public scrutiny that it will come under). But I trust that this threat to the Fed’s existence is enough of a deterrent to prevent the Federal Reserve Governors to ever think about doing such a thing. 

This post does, though, show that from an economic perspective, in the long term (i.e. in equilibrium) a central bank CANNOT print money to keep itself solvent. And in doing so, it can indeed go insolvent. Though this may be said many, many times in all kinds of public forums, the common belief that central banks can print itself out of insolvency will likely continue. Indeed, some misunderstandings are hard to cure.