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Is it a currency board or a central bank? (guest post by Mike Sproul)

Posted By Kurt Schuler On April 21, 2014 @ 9:21 pm In Currency Boards | 138 Comments

(Mike Sproul responds to this post, part of a back and forth we have been having. Readers will pardon my inexpert formatting.)

A currency board gives a convenient way to explain the backing theory of money. In line (1) of Table 1, a currency board receives $100 of Federal Reserve Notes (FRN’s) on deposit, and it issues 100 of its own newly-printed paper pesos in exchange. By its nature, a currency board stands ready to redeem the pesos it has issued for the dollars it has on deposit, just as it stands ready to create and issue more paper pesos (line (2)) to anyone who deposits more dollars. It is clear from the table that whether there are 100 pesos backed by $100, or 300 pesos backed by $300, 1 peso will always be worth $1. This is an essential point of the backing theory: As we triple the quantity of pesos, we also triple the assets backing those pesos, so the peso holds its value as the quantity of pesos rises and falls. The quantity theory of money would imply that an increase in the quantity of pesos would reduce the value of the peso, because there are more pesos chasing the same amount of goods. But the quantity theory does not apply to this case, since the currency board is always able to maintain convertibility at the rate of 1 peso=$1. This idealized currency board thus gives the backing theory a foot in the door. Even someone who thinks that the quantity theory is correct for modern government-issued paper money must admit that the backing theory is correct in the case of a currency board.

Table 1

            ASSETS…………………………………..LIABILITIES

1)   $100 FRN’s………………………………..100 paper pesos

2) +$200 FRN’s………………………………+200 paper pesos

The obvious problem of the currency board in Table 1 is that it earns no interest, and thus cannot pay its operating costs. This problem is solved in line (3) of Table 2, where the currency board prints 300 new pesos and uses them to buy a $300, 1-year US government bond. (Table 2 duplicates Table 1, except for line (3).)

Table 2

            ASSETS…………………………………..LIABILITIES

1)   $100 FRN’s………………………………..100 paper pesos

2) +$200 FRN’s………………………………+200 paper pesos

3) +$300 bond……………………………….+300 paper pesos

With the purchase of such a bond, many of us would no longer call this institution a currency board. Currency boards are not supposed to make loans, but the purchase of a US government bond is a loan to the US government. Also, currency boards are supposed to offer immediate convertibility of pesos into US dollars. But if customers wanted to redeem all 600 of the pesos held by the public, they would have to wait for the bond either to mature, or to be sold for paper dollars. But perhaps this definition of a currency board is too literal. Currency boards often hold bonds, and they suspend convertibility every night and every weekend, and we still call them currency boards. So someone might still call our institution a currency board, even though it now looks more like a bank.

The purchase of the $300 bond doubled the quantity of paper pesos from 300 to 600, but it also doubled the currency board’s assets from $300 to $600, so the currency board is still able to maintain convertibility at 1 peso=$1. The backing theory still applies, and the quantity theory does not.

Table 3

             ASSETS…………………………………..LIABILITIES

1)   $100 FRN’s………………………………..100 paper pesos

2) +$200 FRN’s………………………………+200 paper pesos

3) +$300 bond……………………………….+300 paper pesos

4) +600 peso loan……………………………+600 paper pesos

In Table 3, our bank/currency board lends 600 newly-issued paper pesos to a local miller, who intends to buy wheat that he will grind into flour and sell within 30 days, at which point he will repay his loan with interest. If he fails to repay, then 600 pesos worth of his property (plus interest) will be taken from him in court.

With the loan in line 4, nearly everyone would stop calling this institution a currency board and start calling it a bank. It is backing its pesos with a loan, and the loan itself is payable in pesos, rather than dollars. But the backing theory is still just as true of this bank, and the quantity theory just as false, as ever. Even though some of the bank’s assets are now denominated in pesos instead of dollars, and even though the bank has once again doubled the quantity of pesos, the bank still has enough assets to maintain convertibility at $1=1 peso. Even if all 1200 of the pesos issued by this bank were returned to the bank at once by customers demanding payment in dollars, the banker could satisfy his customers with the following steps:

1. Delay redemption of 600 pesos for 30 days until the 600 peso loan is repaid in pesos, then retire those pesos as they are received from the borrower. This reduces the number of returning pesos from 1200 to 600, and the interest on the loan can be used to compensate customers for the 30-day delay.

2. Sell the bond for $300, and use the $300 to buy back another 300 returning pesos.

3. Use the remaining $300 of FRN’s to buy back the last 300 returning pesos.

Let’s take stock of where we are. We all agree that the backing theory is true of a currency board. We have found that the backing theory remains true if that currency board buys bonds and makes loans, even peso-denominated loans. In short, the backing theory remains true as the currency board is transformed into a bank.

Now consider one last change to our bank/currency board: Let it suspend dollar-convertibility. With the peso now floating against the dollar, it might seem that the backing theory has finally been made irrelevant. But suspension of dollar-convertibility is nothing new to this bank. We have already seen that convertibility can be suspended for a weekend or for thirty days, and as long as the bank’s assets remain untouched inside the bank, the peso holds its value at $1=1 peso. Also, we must remember that the peso was initially redeemable at the bank for either dollars, bonds, or loan repayments. The bank has suspended only dollar convertibility, but bond convertibility and loan convertibility remain in force. If the public wanted to return 900 pesos to the bank, the bank could buy back all 900 pesos in exchange for its bond ($300) and its loan (600 pesos), without ever touching its dollar reserves. Dollar convertibility would only matter after the bank had paid out all its non-dollar assets.

With the suspension of dollar convertibility, our currency board now operates like a modern central bank. It never trades its pesos directly for dollars, but it nevertheless uses its bonds and loans to either issue new pesos when the public needs more pesos, or to soak them up when pesos are excessive. The central bank’s assets are crucial to the process, since a bank without assets would have nothing with which to buy back its pesos on the occasions when pesos return to the central bank. Moreover, the central bank’s balance sheet still looks exactly as it looked in Table 3: 1200 pesos are still fully backed by $600 worth of FRN’s and bonds, plus 600 pesos worth of loans. The backing theory is still fully applicable, and the quantity theory is not.

We all agree that when it comes to currency boards, the quantity theory is wrong and the backing theory is right. It’s too obvious to deny. A modern central bank is nothing but a currency board that holds bonds, makes loans, and suspends one kind of convertibility. None of these things affects the validity or relevance of the backing theory, so the backing theory is just as relevant to a central bank as it is to a currency board.


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