Sunday, March 23, 2014
Dismantling a central bank
In a previous post, I made the point that banknotes aren't Samuelsonian bubble assets, say like a chain letter or a ponzi scheme or bitcoin. Upon the dismantling of a central bank, each note has a senior claim on a central bank's remaining assets. Rather than being mere "oblongs of paper", as Samuelson described them, banknotes occupy the very top of the capital structure hierarchy, above stock and bonds. This quality of being "well backed" might be sufficient for notes to trade at a positive value in the first place, and also help explain subsequent fluctuations in the purchasing power of those notes. In this post I revisit these ideas.
The process of dismantling a central bank would go like this. Imagine that the Reserve Bank of Fiji announces that it will wind up operations next week and recall all notes. Its assets consist entirely of Fijian dollar-denominated bonds. With the eminent end of Fijian dollars, the entire Fijian economy will have to quickly re-denominate existing debts and contracts into a new unit of account, say U.S. dollars. After this redenomination, the Reserve Bank of Fiji now finds itself holding a large quantity of U.S. dollar-denominated debt. It proceeds to sell these bonds, as well as its printing presses and premises, for dollars, and then uses dollars to cancel all Fijian notes. The Reserve Bank of Fiji is no more, and neither are Fijian dollars.
Because the central bank's hypothetical dissolution would result in noteholders ending up with some ultimate quantity of U.S. dollars in their pockets, Fijians can use this terminal value as a basis for computing the present value of Fijian banknotes. They would go about doing this computation in the same that they would with a stock and bond, both of which also have hypothetical terminal values, or liquidation values.
The inestimable Mike Freimuth, who blogs here, pointed out that there is a problem with this. How can Fijian noteholders actually quantify the amount of dollars to which they are entitled upon dissolution? This is easy if the Reserve Bank of Fiji is already on a dollar standard (say it redeems notes for US$1). Once all of the central bank's assets have been sold for U.S. dollars, each noteholder would get US$1 until all Fijian noteholders had been satisfied, upon which less senior stakeholders like bondholders and shareholders would get their portion of the central bank's remaining stash of U.S. dollars.
However, if Fiji is on a floating standard, the task of valuing noteholders' claims gets quite thorny. While fiat notes may have a senior claim on assets upon dissolution, it isn't evident how many actual dollars this entitles noteholders too. And if their quota of remaining assets, or terminal value, is not known at the outset, how can Fijians arrive at a value for notes in the first place?
One answer to Mike's criticism is that Fijian note owners come up with their best estimate of how much dollars the central bank (or a judge) would decide to award them upon a hypothetical dissolution. If the market's collective guess is that no assets would be forthcoming, then Fijian dollars would be worth nothing upon windup. If Fijians on average assume that the sale of bank assets would net $100m, and they think a judge would award them half of that, then each Fijian banknote will earn a prorated share of $50m. If they think that the all assets will be awarded to them, then they'll get a prorated share of $100m.
While these expectations about the terminal value of notes would probably be sufficient to jumpstart the positive value of Fijian dollars in the first place, this isn't a very satisfying explanation for subsequent variations in the price level. After all, the Fijian price level on any given day would be a function of Fijians' many and divergent expectations concerning their as-yet-unstated share of some future pie. As noteholders take potshots at guessing what this unknown size of this slice would be, the Fijian dollar would fluctuate wildly, sort of like a penny stock. Penny stocks owners have wildly fluctuating estimates concerning their ultimate, and unfixed, share of the corporate pie, which is only determined after debtors have had their pickings.
However, the behavior of currencies is not like penny stocks—the former tend to vary only a little in price from day-to-day. To explain price level fluctuations, it would seem that something other than the terminal value of the Reserve Bank of Fiji's assets must be at work.
Here I would like to reiterate my point from an earlier post that once a banknote has been jumpstarted into having a positive value, the dissolution-value of a central bank assets will only have a distant influence on those note's subsequent value. By far the more immediate effect that central bank assets have on the value of notes emerges via their ability to be mobilized in the maintenance of price stability. By selling assets for notes and retiring them (or threatening to do so), a central bank can prevent the value of their notes from flagging. Alternatively, the income earned by those assets provides the central bank with the resources to pay more interest (on reserves at least), a feature that will also ensure price stability.
So it seems to me that any impairment to a central bank's assets will affect the value of notes not so much because it lowers their value come future dissolution, but because it limits the central bank's ability to repurchase notes and pay interest in the present so as to maintain their price target. If a central bank didn't provide a target supported by a repurchase facility, then the value of notes would be dictated by something like their terminal value—and prices would be much more volatile then they are now.