Yes, Banknotes Are A Central Bank Liability

David Bholat recently wrote “How to Modernise Central Bank Balance Sheets: No Notes.” It is partly in response to this article. The idea is that banknotes (“dollar bills”/”pound notes” etc. issued by the government should not be classified as a liability, rather as some form of capital or possibly taken off the balance sheet. I have run into variants of this idea in the past (the stronger version being that all forms of the monetary base are not liabilities), and the root idea is that “monetary issue is good for the economy, so how can it be a liability?” Such a redefinition or removal of banknotes is either misleading or wrong.

Rather than attempt to digest the arguments of the article, I will point out why any redefinition is misleading. The article also argues that Bank of England accounting is archaic and stupid. Given that following archaic and stupid rules is a core part of Britain’s brand, I see no need to argue against such a claim. My interest is with central bank balance sheets more generally.

The earlier iteration of my arguments are found on page 93 of Abolish Money (From Economics)! (https://books2read.com/abolishmoney). This book is a collection of my rants about how people discuss money, and is an excellent Christmas gift for your friends (or enemies).

The Correct Answer

Central banks in free-floating (“fiat”) currencies are special. We need to understand why that is. Rather than start with the wrong answer (the monetary line items on the central bank balance sheet), I will start with the correct answer (the way central banks operate).

We arrive at the conclusions in three steps.

1. Negative equity (insolvency) only matters if the entity is illiquid — unable to meet current obligations.

2. Central banks of free-floating currency sovereigns cannot become illiquid.

3. Therefore, negative equity (insolvency) does not matter for such central banks.

(Any familiarity with online Modern Monetary Theory (MMT) wrangling leaves us with a couple of extensions. The first is that since the central bank is a subsidiary of the fiscal arm of government in modern democracies, central bank operations are the core reason why currency sovereigns do not face involuntary bankruptcy. The second is the definition of “currency sovereign” is somewhat fuzzy in the real world, and is tested by “Can this sovereign really be forced into bankruptcy?”)

In other words, it is a fundamental mistake to look at particular items on the balance sheet and claim they are the secret sauce to central bank power. Instead, the secret sauce is how they operate. This is a very close analogy to the mistake that Monetarists make: that the measured quantity of money in the economy has some form of analytical magic associated with it, when the reality is that the magic comes from transactions being denominated in the unit of account defined by monetary instruments.

Before we go any further, I will cover some basics.

Assets, Liabilities, Equity, and Capital

One of the useful properties of balance sheets is that they balance. At all times, the relationship:

Assets = Liabilities + (Owner’s Equity)

holds.

• Assets are what an entity owns. The value of assets on a balance sheet is typically the (depreciated) purchase price of the asset, although all assets need to be reviewed by accountants to see if their balance sheet carrying value can be justified.

• Liabilities are what a company owes. Although it appears that many people use “liability” and “debt” interchangeably, this is not proper accounting practice. Debts are a class of financial instruments that meet certain tests, and not all obligated future payments meet those tests.

• Owner’s Equity is the residual of (Assets - Liabilities), and tells us what the entity is worth to the common equity owners if the entity was liquidated at balance sheet values (a big valuation if).¹

Preferred shares are a hybrid — they look like liabilities from a cash flow perspective, but they are seen to be part of a firms “permanent capital.” (Capital is a term that is thrown around, but has a variety of meanings. I will discuss bank capital below.) Classical preferred shares are perpetual instruments (consols) that have a fixed payment. The reason why they end up classified as equity is that payments on them are optional in the sense that missed payments do not qualify the holders the right to force the issuer into bankruptcy, rather there are penalties (defined in the offering prospectus) that typically end up with the preferred shares being converted into equity (at rates disadvantageous to current common equity holders).²

If we put aside preferreds, the owner’s equity part of the balance sheet operates differently than liabilities. Although owner’s equity can rise/fall as the result of direct transfers between the firm and the owners (capital infusions/dividends, respectively), owner’s equity rises and falls every time there is a profitable/loss-making transaction. Other liabilities (and preferred shares) categories on the balance sheet only rise and fall in response to transactions that affect those instruments in particular.

The Life and Death of Banknotes

I will have to look into the exact mechanisms of the distribution of banknotes for my banking manuscript. But for my purposes, I just need to note that I see the transactions as not being charity transactions. The central bank does not give away banknotes to the private banks (and any other entity in the banknote distribution business) nor are the returns of old banknotes a charitable donation by the private sector. Banknotes are sold to/from the central bank, with the counter-party ultimately paying for the banknotes via a payment on some wholesale payments system (or via settlement balance change at the central bank, which is economically equivalent).

And note that these transactions occur effectively on demand by private sector banks — if they were unable to dump old banknotes on the central bank, they would refuse taking them, and banknotes would suddenly lose their value. This would be a default by the central bank on its customary obligations, and there would be a rather lot of angry voters that are party to the bankruptcy event.

Bank Capital

There are a variety of definitions of bank capital — new ones appear as soon as the old ones are discredited. Bank capital consists of owner’s equity plus various categories of instruments that are supposed to absorb credit losses ahead of depositors and other senior creditors: preferred shares, subordinated debt, conditional debts, etc. The theory is that the owners of bank capital instruments can get stuffed while the bank can continue operating normally.

Since debt instruments make their way into “bank capital,” we see it is a fuzzy category.

Can We Move Banknotes on Central Banks’ Balance Sheets?

We now turn to the question as to whether we can move banknotes from the nasty and dirty category of “liabilities” to some other category that has more positive vibes? Let us examine the possibilities.

• Assets? Lol, lmao. Assets need to be owned by the entity, and they have to economic value. A central bank does not own banknotes in somebody else’s pocket, nor does it have any way to sell them. They might get a warm, fuzzy feeling that they are greasing the wheels of commerce with money issuance, but the carrying value for warm, fuzzy feelings is nil. More importantly, moving them from Liabilities to Assets would mean that the balance sheet equation Assets = Liabilities + (Owner’s Equity) would no longer balance.

• Owner’s Equity? No, since they do not confer ownership of the central bank, nor rise and fall with profits and losses. Attempting to do this also has the side effect that central bank’s selling banknotes is pure profits and buying them is a pure loss — since the other side of the transaction is a transfer in the payments system, which is valued at par. This creates phantom profits and losses for exchanges at fair value for the central bank, even though its counterparty is engaging in a profit-neutral trade. This breaks accounting identities economy wide — which needs to be fixed by adding a “change in banknotes” plug into every equation involving aggregate income.

• Some new category that does not currently exist in accounting? I.e., central banks have Assets = Liabilities + (Banknotes) + (Owner’s Equity). There is nothing stopping someone from doing that, but nobody is going to take it seriously since this new category behaves identically to any other class of liabilities. The accounting profession is not going to recall every single accounting textbook to add a new balance sheet category that has one entry on one entity’s balance sheet.

• Move off the balance sheet entirely? This is impossible, since balance sheets would no longer balance. We cannot shrink Assets to match the drop in Liabilities, since none of the assets are impaired. The only way to get the balance sheet to balance is to stuff the entry into Owner’s Equity, which does not work.

• Move them to “Equity” like preferred shares? (Equity being Owner’s Equity plus preferreds). This is the only viable option, and nobody other than people who believe that money is magic would take it seriously. Preferreds are perpetual instruments, while banknotes are redeemed on demand.

• Bank Capital? The reason why we cannot reclassify banknotes as “bank capital” on the balance sheet (under the accounting conventions that I am familiar with) is that “bank capital” is a footnote. That is, it is a quantity that only matters for regulatory purposes, and is presented seperately.

So we are stuck with either a meaningless change (“banknotes aren’t liabilities, they are a new category that exists nowhere else in accounting”) or ideological zealots attempt to bludgeon accountants into accepting that instruments that may be redeemed on demand are the same thing as perpetual instruments whose payments may be deferred or even eliminated entirely (at the cost of equity conversion).

One side issue in the Bholat article is the notion of “expected returns.” Should banknotes get special treatment because they have a 0% expected return? This might have looked interesting in a world where interest rates are always positive, but our New Keynesian central banker friends destroyed any meaning attached to the 0% interest rate. An instrument paying 0% might eventually have a higher return than government bonds, and we can no longer use expected returns as a meaningful accounting test.

Banknotes are Not Perpetual

I have seen arguments to the effect that banknote (or money) issuance is a perpetual form of finance for the government. One looks at the balance sheet entry, and it grows forever.

This is not true, and this should be obvious to anyone familiar with European practices. Entire banknote issuances are routinely withdrawn from circulation. The pound notes I had from a trip to the U.K. in 2013 were withdrawn by the time I returned in 2023, and the only way to redeem them was to open a bank account or possibly visit the Bank of England. (I gave them to my sister-in-law.) Although some banknotes do disappear from circulation (lost or collected), the expectation at issue is that any banknote will be returned to the source at any time.

Ever-expanding balance sheets are not a sign that liabilities are not redeemed. If we look at almost any issuer of bonds that jumped from investment grade to default quickly, the bonds issued line item was most likely growing right up until default.

A Simple Thought Experiment

We need only look at a simple thought experiment to see why banknotes are indeed liabilities. There is no economic constraint that stops the Bank of Canada from loading up its fleet of B-52s and carpet bombing Canadian city centres with $10 quadrillion in new Canadian $20 bills. (I assume that there legal constraints against this policy, but laws can be changed by Parliament, while economic constraints cannot.)

The outcome of such a policy would be disastrous — everybody would rush to spend them as cash, and stuff them into private banks so that they can use them in electronic payments. The value of the Canadian dollar would disappear in a puff of hyperinflation.

It is easy to see why this is the case if banknotes are a liability of the Bank of Canada: it added $10 quadrillion in new liabilities, and no new assets. This implies that the BoC took a $10 quadrillion loss to its equity. This loss matches the $10 quadrillion gain in private sector balance sheets that fuels the hyperinflation.

But if we try to re-classify banknotes to something more benign or drop them from the a balance sheet, we see the problem immediately.

• If off balance sheet, the $10 quadrillion issue has literally no effect, and so it offers no explanation why the economy went pear-shaped.

• If we put banknotes as Owner’s Equity, we run into a conundrum — owner’s equity allegedly increased, but assets did not. So we get a phantom loss of $10 quadrillion that matches the alleged capital infusion, and so the balance sheet is unchanged. So why did the economy blow up?

• If we pretend that banknotes are equivalent to preferred shares, how is it possible that people are redeeming them via shipping them back to banks (who then ship them to the central bank)?

Dan Rohde responded to my argument on Bluesky by arguing that central banks do not operate this way — banknotes are only created on demand. However, this is only because central bankers know that banknotes are economically equivalent to liabilities.

Concluding Remarks

Central banks are privileged by how they operate. Understanding their privileges requires looking at the operation of the entire monetary system. Pestering accountants with novel theories because you do not like the sound of the word “liability” is not going to help that understanding.

Appendix: Do Central Bank Profits Matter?

One of the problems with progressives’ revolt against the terminology of “sound finance” is that they tend to take too rosy a view of government finances. I think it would be fairly easy to find arguments on the internet that profits and losses by the central bank do not matter, since the central bank is needed to further the public purpose.

Unfortunately, the “public purpose” collides with the ugly reality that central banks need to trade with unwashed and venal fixed income market participants. Trading is a zero-sum activity (cash flows from instruments make fixed income holding over time positive sum).

A central bank trading loss is somebody else’s trading gain. If the central bank manages to lose money, it has done something stupid that has transferred income to some actors in the private sector — either bondholders or banks. Does it serve the private purpose for unelected bureaucrats to transfer income to those people (with almost no useful oversight from elected officials)?

At this point, I can imagine some comments to the effect that monetary payments do not matter coming from online MMT activists that have not paid much attention to what the theory actually says. Although monetary transfers are not the same thing as real resource transfers, there is an inflation constraint. Transfers to one group represent an opportunity cost limiting transfers to another group. As such, even if the dollar amounts may not be the best guide to policy, central bank losses do matter.

1. As is fairly standard for introductory accounting texts, I use “owner’s equity” as a generic term that covers all possible ownership structures. Private bank balance sheets would label this using a term similar to “(common) shareholder’s equity.” Owner’s equity is split between contributed capital and retained earnings, which I am ignoring herein on the basis that anyone who knows the definition of retained earnings does not need to read my explanation of the “Assets = Liabilities + Owner’s Equity” identity.

2. Tax authorities (in the U.S., possibly elsewhere) made the distinction squishier. The payments made on preferred shares are considered dividends and not interest payments under tax law, and thus not an expense (which reduces taxes paid). The authorities decided that long-dated bond issuance was a way to issue pseudo-preferreds as instruments that had interest deductions. They decided to reclassify such debts into preferreds for tax purposes.