Central bank ‘equity’ debunked

The equity of a corporation is the difference between its assets and liabilities. Under typical accounting practice for central banks, transferring cash directly to households would result in a decline in their accounting equity, because cash is treated as a liability. So one consequence of central bank direct support for consumption is a decline in their accounting equity. Does this matter?

Equity matters to private corporations because if their liabilities are high relative to their assets they may go bust, i.e. fail to honour payments to creditors, workers, suppliers etc. You may already be thinking that this doesn’t really apply to central banks. The central bank actually prints money (notes, coins and the electronic equivalent – bank reserves), so it is obvious that there is no circumstance where it doesn’t have the ability to meet a payment in domestic currency. The concept of ‘equity’ seems irrelevant.

As is often the case in this area of economics, that simple intuition is in fact correct, and economists who are often rigorous in their maths, lack anything approximating rigour in their semantics.

Economists are asking a separate question, ‘Does the central bank’s accounting equity affect its ability to meet its inflation target?’ We can frame this question more accurately. When central banks transfer cash to households in direct support of consumption, base money rises. So the question is really simple: does the central bank’s balance sheet ever constrain it from either contracting the stock of base money, or restricting the effects of base money on the banking system’s balance sheet growth? The answer to this is really clear. Central banks can always limit the effects of base money on inflation by either raising the amount of reserves that banks are required to hold and by using tiered reserves – i.e. having different interest rates on different classes of reserves. Accounting equity is not relevant.


1. This note is a response to discussions on social media inspired by this superb article by the Czech central bank on what central banks can do to support economies if interest rates are already low and recession strikes. They provide empirical support for the fact that there appears to be no link between central bank equity and inflation outcomes. I reach the same conclusion deductively.

About The Author

Eric Lonergan is a macro hedge fund manager, economist, and writer. His most recent book is Supercharge Me, co-authored with Corinne Sawers. He is also author of the international bestseller, Angrynomics, co-written with Mark Blyth, and published by Agenda. It was listed on the Financial Times must reads for Summer 2020. Prior to Angrynomics, he has written Money (2nd ed) published by Routledge. He has written for Foreign AffairsThe Financial Times, and The Economist. He also advises governments and policymakers. He first advocated expanding the tools of central banks to including cash transfers to households in the Financial Times in 2002. In December 2008, he advocated the policy as the most efficient way out of recession post-financial crisis, contributing to a growing debate over the need for ‘helicopter money’.

18 Responses

  1. Nick Rowe

    Eric: “Central banks can always limit the effects of base money on inflation by either raising the amount of reserves that banks are required to hold and by using tiered reserves – i.e. having different interest rates on different classes of reserves. Accounting equity is not relevant to either of these exercises.”

    True. But required reserves (that pay less than “market” interest rates) are a form of tax on commercial banks, with the central bank earning the tax revenue.

    But your general point is still correct: the central bank’s “assets” that appear on the accountants’ books are only a small part of their total assets. The Present Value of future seigniorage is a bigger asset that doesn’t appear on the books.

    • Eric Lonergan

      Thanks Nick. Calling an IOR a ‘tax’ or a ‘transfer’ is really semantics. Is ‘tax’ a legal definition? Otherwise, why bother calling it a ‘tax’. A zero IOR on required reserves is an odd type of tax because it doesn’t raise any revenue for the Treasury. I don’t really see the need to introduce the PV of seigniorage. The key point is that a CB can always shrink the stock of reserves or restrict the ratio of bank assets to reserves. And their accounting equity is irrelevant to this. In short, their accounting assets and liabilities, and the PV of their seigniorage are all irrelevant to their functioning.

      • Nick Rowe

        Eric: calling it a “tax” is a useful metaphor, rather than a legal definition. It’s like if the government monopoly (de facto or de jure) provides a service and prices it above the cost of provision. Or like a forced loan at 0% (or less than market) interest. (That’s assuming the government owns the central bank, and gets all the central bank’s profits, of course.)

      • Eric Lonergan

        Nick, I don’t want to labour the point, except that it may matter more than it should. I don’t find it a useful metaphor at all. Let me explain why. Taxes are fiscal policy. They are the domain of legislatures and treasury departments. Reserve requirements and tiered interest rates on reserves are monetary policy and the domain of central banks. Now, taxes and transfers can act like interest rates and vice versa. But conflating the two can cause confusion. And sadly it matters, because people start saying, ‘that’s fiscal, so it’s illegal’. I don’t really see what’s gained by the metaphor, but I see what is lost.

      • Deficit Owls

        “The key point is that a CB can always shrink the stock of reserves…”

        How can they do this and still uphold their commitment to a sound payment system and an elastic currency? Shrink the stock of reserves too much and banks won’t be able to meet reserve requirements or make payments to each other, which would just send the banks to the central bank to borrow reserves at the discount window (or its equivalent), if they aren’t supplied by automatic overdraft.

      • Eric Lonergan

        They would only do this if there was an inflation problem and they needed to slow credit growth. Of course they can also use macro-prudential controls. It really is hard to see a situation where there are ‘too many’ reserves and the CB loses control of inflation.

  2. Deficit Owls

    “They would only do this if…”

    But I’m trying to say that under the normal strategy of monetary policy implementation (keeping reserves scarce) they cannot do it. If the CB, say, sells a bond to try to reduce the supply of reserves, then that just creates an automatic overdraft, then/or sends a bank to the discount window, where the CB…promptly adds the reserves back. Failure to do so would basically cause bank failures. And I’ve never heard of any economist promote deliberately causing bank failures in order to reduce inflation, and I suspect that you wouldn’t either.

  3. Antti Jokinen

    Eric, in case you’re still following these comments:

    Isn’t CB equity a government/public asset? If it is (and I’m sure it is), then I don’t see that what you suggest would differ enormously from the Treasury debiting its account at the CB while it instructs the CB to give cash to people. That’s purely fiscal, a government handout in all but name. Should the Treasury’s account balance or CB equity become negative, that would add to public debt.

    • Eric Lonergan

      Antti, I don’t really believe that CBs have equity. They do have an ability to create base money. That ability is the definition of monetary policy, fiscal policy is something else. In Europe the central bank as a legal institution is in fact supra-national – so no government ‘owns’ it. The ability to produce money is a public good in the same way that language and the rule of law are public goods. What is curious in the history of economics is a repeated unwillingness to accept the uniqueness of money, ie to call is a ‘liability’ (ie a debt), or ‘fiscal’, or ‘equity’. It’s unique, so we have no accounting practice with which to identify its properties.

      • Antti Jokinen

        Eric, I don’t call money a liability or equity, so we have at least some common ground to build on. But unlike you, I see a lot of sense in the way we actually account for these things. I think the real problem is that we look at the accounting from a wrong angle; the interpretation is wrong, and you’re right in questioning that interpretation, ie. the language used — but not the accounting itself.

        You say you don’t believe the CB has equity. I don’t care what we call it, but it seems obvious that the Treasury holds some kind of residual claim on the Bank of England. The Treasury is officially the sole shareholder of BoE and receives dividends from the BoE. That is a fact, and not a matter of belief.

        In the highly unlikely case of winding up the BoE (it’s unlikely, too, that Apple would be wound up — yet you do believe Apple has equity), the Treasury is left with whatever is not sold by the BoE in exchange for reserves and currency in circulation. That could be buildings, that could be gold, or even government bonds. The public would own whatever is the residual. That’s why I call BoE equity a public asset. Drive equity to zero, and there would be nothing left for the public. All assets would end up in the hands of those with reserves/currency.

        What’s the difference between equity in Apple and equity in the BoE? It is that the Treasury as the sole shareholder of the BoE has de facto *unlimited* liability, whereas Apple shareholders have only limited liability. Should BoE equity become negative, the Treasury has to fill the gap.

        I think it is very hard to understand money. As you have rightly pointed out, money cannot be correctly understood if one follows the conventional interpretation of accounting. Whereas you as a consequence of this problem have chosen to ignore the accounting altogether, my solution has been to change the way I interpret the accounting.

        I don’t expect you to see things from my perspective, but you as a learned person might be able to admit that my solution, should it be workable, is preferable? With all due respect, I think you have ended up ignoring certain facts that don’t fit your understanding of money. In that, you’re of course in good company.

      • Eric Lonergan

        Antti – I think we agree and are probably talking at cross-purposes, I am ignoring the assets held by the central bank, such as building etc. I am simply looking at the power to create reserves, which I think is an essential and unique power. The control of this power (I’m not sure ‘ownership’ means much in this context) varies by jurisdiction. In the Eurozone, am extreme, it is a supranational entity which controls it. I don’t think introducing corporate accounting helps in understanding or analysing this power. In fact, it seems clear it creates huge analytical confusion.

      • Antti Jokinen

        Eric, thanks for the reply!

        If you say that the CB equity is not about financial strength, I agree with you (and the Czech authors). The public, through the Treasury, stand behind the implicit unlimited liability. The CB’s financial strength is thus synonymous with the economic strength of the society. It’s like Warren Buffett starting a small bank in a partnership form, so that if the equity of the bank becomes negative, uncle Warren will chip in. That bank is financially very strong, regardless of book equity. Right?

      • Antti Jokinen

        Hi again,

        I now read the full article from Hampl and Havranek. I’m slightly confused. Do they realize that ‘capital’ is always *shareholders’ capital*? For instance, in the case of the BoE, it is capital the Treasury has provided the Bank with. Once the (shareholder’s) capital falls below a certain floor — agreed beforehand by the Treasury and the Bank – the Bank must be recapitalized from the Consolidated Fund (Treasury’s account at the Bank). Debiting/charging the capital account doesn’t differ much from debiting the Consolidated Fund, which makes this operation nothing but *fiscal* in character.

      • Vangel Vesovski

        Let me be clear that I am not as smart as many on this site and sometimes have a hard time with what they are trying to say. But having said that, I think that there is a problem with the logic and definitions that are being used.

        As a simple engineer, I look at balance sheets and look at the difference between the value of the assets and liabilities as being the value of the equity. I do not think that is too controversial.

        But what gets to me is what is considered an asset and a liability and how the risks can play out. Correct me if I am wrong but when a central bank buys treasuries, corporate bonds, MBS instruments or other things, those go on the asset side. On the liability side is the currency that was issued to buy such assets and is in circulation.

        What happens if the market sees too much risk and the long rates start to go up? The asset side of the CB balance sheet shrinks as demand for such instruments goes down substantially. On the other side, the currency in circulation is not changing to reflect the problems with the asset valuation and the equity goes very negative very quickly. Wouldn’t that destroy the purchasing power of pensions, savings and the value of fixed income?

        As long as we do not back the currency with hard commodities or something tangible central banking will continue to be a Ponzi scheme that confiscates the purchasing power of savers, workers, and producers while it enriches the financial system that gets to create money out of thin air.

        I am willing to have someone explain why a simple common sense explanation is wrong. But I doubt that anyone can give a coherent argument that could explain how a fiat money standard can be stable.

  4. Eric Lonergan

    Antti, I honestly think the whole CB ‘capital’ debate is a distraction. It really doesn’t matter if the BoE has accounting capital or not. The trance arrangements are also trivial and could be changed in any case by legislation. The key point in my blog is that CBs can always create money and tighten money. This the crux, and does not require ‘capital’.

    • Antti Jokinen

      I agree that CBs can always create money and that the book value of equity (shareholders’ equity), no matter how low it is, doesn’ constrain this ability.

      However, a decline in the Treasury’s equity in the Bank does affect the financial position of the Treasury; ie. the decline matters. If the Treasury took a fiscal decision to grant a lump-sum ‘tax rebate’, say £3,000, to all citizens, the Bank would credit citizens’ accounts (it would “create money”, either through reserves or people’s CB accounts, should those be established). Simultaneously, the Bank would debit the Treasury’s account (known as Consolidated Fund in the UK.). That’s how government transfers to the public are performed. The Bank could never do this without permission from the Treasury. Why would it then be allowed, as our Czech friends suggest, to debit the Treasury’s equity holding in the Bank without permission from the Treasury? It could never happen, because it’s a fiscal matter, and outside of the Bank’s mandate to cover its normal operating costs.

      I can see how you’re eager to “just print money” when it would seem warranted to do so. But unfortunately that’s not how even the central bank works. “Printing money” is just the credit entry part of the transaction, and you always must debit some account, too. That is not just an accounting rule. The debit entry has real consequences for the financial position of the Treasury, whether the account debited is the Consolidated Fund, the capital account or an account created for a perpetual loan to the Treasury.

      A nation can of course change its laws, even accounting laws. But before we do that, we must understand why the law is as it is today. In this particular case, the requirement to debit an account is not some confused, silly rule, but one that has actual consequences, as I’ve tried to show above.

    • Oliver

      Hi Eric
      I think the question whether the CB has accounting capital on its books or not can be considered unimportant if one is of the opinion, as I am, that such a position can be negative without having a technical impact on the bank’s ability to perform its job.

      That is not the same as saying capital doesn’t matter, though. It is the equivalent of saying that book capital is is not a legally binding limit under a limited liability provision. In the case of the CB, it is the shareholders themselves, in this case the people represented by their government, who decide when enough is enough. It is not the automatic outcome if an arbitrarily set limit.

      Saying that capital doesn’t matter at all is saying that the ability of the CB to create money (and assumably for that money to have positive and somewhat stable value (?)) is completely independent of what the economy, i.e. the people, can and will deliver. That’s elevating money to a quasi religiuos phenomenon which I’m not sure is a helpful move. In my opinion it is better economics (and bettee accounting) to track capital, or maybe goodwill is the better term (?), back to those who express it and who must ultimately deliver the goods by which it is confirmed.

      • Oliver

        Another way to put this is that at the aggregate level, liability cannot be limited. That doesn’t mean it isn’t a liability, it is in fact everyone’s liability.

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