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Decimal Digest
19 Sep 2011

Invisible Money, Central Bank Balance Sheet Sizes and Price of Gold

Why money should best be invisible?

Money, as a medium of exchange and as a store of value, should always be invisible. Why should it be so? Let’s start with a utopian world where every human being completely and irrevocably trusts all other individuals, organizations and institutions. Conversely , no promise ever gets broken. In this world, the role of a Central bank will merely be to set interest rates. Central bank money will perform a role of unit of account only. There would be no need for coins or currency notes to be printed by a central bank, becausea promissory note issued by any person will be as good as any other promissory note. Also, in this world, commercial banks will not exist, as any lending will be risk free and the financial institutions will only be money transfer agents, physically remitting money (individual IOUs) from one location to another. In other words, in this utopian world, money will not exist as a separate physical (or electronic) item, other than as IOUs of individuals and organizations.

Now, let’s make this world a little bit dysfunctional. Let’s assume that 10% of humans are now deemed untrustworthy. Everybody knows who those people are. Now, suddenly, others will not accept IOUs from these “untrustworthy” people. Hence, for allowing trade to to take place among the whole populace, the central bank will start printing currency notes, which will function as a medium of exchange, in addition to being an unit of account. This means that now, the Central Bank will need to have some kind of balance sheet. Also, commercial banks will come up, promoted and managed by the “trustworthy” humans. These commercial banks will start extending credit, after due appraisal and security, to the “untrustworthy” humans. Since the commercial banks and central banks are deemed to be managed by trustworthy humans, the borrowing costs of commercial banks will be the same as the interest rate set by the Central bank. The commercial banks in this set-up will never fail; as these “trustworthy” commercial banks will always do a thorough job of risk evaluation, mitigation and pricing, and will always maintain sufficient capital buffer.

Why Central Bank Balance Sheet size shows level of trust in economy?

In the above partially-utopian world, as we increase the proportion of identifiable “untrustworthy” people, the size of Central bank balance sheet and the size of commercial bank operations will expand to support trade and credit in the economy. However, there will be two different identifiable parts, one part which operates in a risk free environment and another part which faces risk premiums on their borrowingsStill, no banks will ever fail, as these banks are being managed by identifiable “trustworthy” people.

Further, let’s remove the condition of prior identification. In this case, we know some people are untrustworthy, but we do not know who those people are. This closely resembles reality, where everyone has to use money, and everyone may want to channel credit through the safety of commercial banks. However, commercial banks may not be safe anymore. Although everyone, in his or her self- interest, will make attempts to identify trustworthy commercial banks, there is no assurance of success. However, Central Banks, may somehow retain trust because they have the backing of the entire society.

Why should Gold (or anything else valuable) matter?

Let’s now move to a dystopian world, where banks are perceived to have failed in their responsibility to perform proper risk evaluation, and have not carried adequate capital buffers; and as a result people start expecting bank failures. This dystopian world has been observed since 2007 in countries such as Iceland, the UK, the US, Ireland, Greece, Spain, and now France. The Central Banks, instinctively, to protect trade and savings, will start backstopping liquidity needs of maligned banks. Some of the liquidity needs of banks will be just that, mere liquidity needs; however, people will start suspecting that much of the liquidity need of these banks is actually solvency risk. As the magnitude of this popular suspicion increases, the balance sheet of Central banks would start expanding exponentially, because, now, Central bank money will start playing a role of “store of value”, which was earlier performed by commercial bank money.

Sometime at this stage, people will start doubting the sufficiency of the level of societal backing for Central banks as they expand their balance sheets exponentially, much beyond the level warranted by nominal GDP. Hence, the populace will start demanding that the Central Bank start holding hard assets – assets which are not liabilities of any other human institution. Luckily, in the current dystopian world, we have not reached this stage for major economies; at least, not yet. However, Gold is behaving as if this stage is not very distant in the future. Let’s hope, for the sake of the world economy, that the signals from the Gold market prove to be short lived.


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