Banknotes: IOUs or not?

The building that housed the original Swedish Riksbank, the earliest European issuer of banknotes

In my previous post on bitcoin, I noted offhandedly that I don't consider modern central bank-issued banknotes to be fiat but classify them as liabilities of the issuing bank. By fiat, I mean unbacked, intrinsically valueless, inconvertible, unenforced bits of paper. In the comments section, monetary operations whiz ATR (who blogs here) challenged me to clarify the nature of the IOU attached to paper currency, and whether that IOU had any value.

It would be cheating to point out that the world's 160+ central banks all list banknotes as a liability on their balance sheet. The deeper reason that I prefer to classify banknotes as liabilities (i.e. IOUs, promises, claims, or obligations) rather than fiat bits of paper is the "fine print". The best place to find the clauses governing the IOU nature of banknotes isn't on their face, but rather in the various acts and legal documents that govern a given central bank.

Section 16.4 of the Federal Reserve Act, for instance, specifies that:

Federal Reserve notes issued to any such bank shall, upon delivery... become a first and paramount lien on all the assets of such bank.

In the notes to the 2012 audited financial statements of the Federal Reserve system, section 3(k), it says:

To satisfy the obligation to provide sufficient collateral for outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes issued to all Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks.

If we look at the Bank of Canada Act, Section 25 (1),

The Bank has the sole right to issue notes and those notes shall be a first charge on the assets of the Bank. 

Section 34.1 of the same Act says that:

...in no case shall the affairs of the Bank be wound up unless Parliament so provides, but if provision is made for winding up the Bank the notes of the Bank outstanding are the first charge on the assets.

So in the case of the two central banks that I'm most familiar with, banknotes are ultimately claims on whatever stuff the central bank happens to have in its vaults. This means that on the occasion of the winding down of the Fed or the BoC, note holders are entitled to receive real assets, in the same way that a bond holder or stock holder would have a claim on a company's property, plant, & other assets upon the dissolution of that company. Banknote holders have an added bonus of being senior to other claimants, since notes provide a "first claim" in the case of the BoC, and a "first and paramount lien" in the case of the Fed.

Now the idea of shutting down either of these central banks sounds like either science fiction or a free banker's wet dream. What about the long period between then and now? Here are a few other indications of the IOU nature of banknotes. When a central bank chops some zeros off of its existing inflating notes, it doesn't leave its old issue stranded. Holders are entitled to bring their legacy notes in for conversion. Nor do central banks try to wiggle out of their obligation to redeem mutilated currency. When a note gets so worn that it becomes unusable, the central bank will replace it with a crisp new note. Lastly, when central banks merge (as in the case of the Euro) or are succeeded by another central bank (e.g. the Central Bank of Russia replacing Gosbank), holders of orphaned notes are given a window during which they can convert into new currency.

If central banks had no liability whatsoever for their note issue, then redenominations, mutilations, and successions would result in large capital losses to stranded note owners. That they don't would seem to indicate the opposite.

However, in the long waiting period until ultimate dissolution, the most important interim IOU provided by central banks is the promise of stability. The corollary of this in the old days was the obligation to redeem notes with some fixed amount of gold, or, during Bretton Woods, some quantity of dollars. Nowadays, central banks promise to ensure that the value of notes doesn't fall more than x% against a CPI basket. They guarantee to buy back IOUs in a sufficient quantity with the assets held in their vaults if the x% limit is exceeded, to the extent that a central banker might conceivably buy back and cancel every single IOU to enforce their promise.

Some central banks like the Reserve Bank of New Zealand encode this promise into their constituting act, along with stipulated penalties in case of non compliance. Other central banks provide this guarantee more informally, either in the form of accepted practice, tradition, or repeated verbal promises. Take the ECB, for instance, which uses the small quota of characters available on its Twitter account to state that its "main task is to maintain the euro's purchasing power."

Are these good liabilities? Not really. The promise of a payout upon central bank dissolution is a distant promise. In the meantime, the obligation to maintain price stability is subject to all sorts of political pressures to weaken the price target, as well as being held hostage to the skills of the central banker in hitting his/her target. Other central bank policy goals including employment and growth targets may interfere with the sanctity of the price stability IOU. The dubious nature of central bank IOUs isn't a new phenomena. Even in the gold standard/Bretton Woods days banknotes were constantly being devalued or rendered inconvertible.

Bad IOUs central banknotes may be, but IOUs they are nonetheless.