Quantitative easing: Who’s backing currency?

Pierpaolo Benigno, Salvatore Nisticò 15 June 2015



Unconventional monetary practices after the Crisis

In the aftermath of the Global Crisis, ‘unconventional’ purchases of risky securities by many central banks around the world have uncovered a ‘new style’ of central banking, which entails possible losses on central bank’s balance sheets and contrasts with the existing conventional view.1

Since the birth of paper money, a lively debate has developed on how to control the value of money – the inverse of the price level – in connection with the assets that central banks hold in their balance sheets. At the beginning of the debate, gold was advocated to provide the appropriate backing of currency. Then, mixed fractional systems emerged, later replaced by holdings of reserves denominated in certain ‘strong’ currencies. As time goes by, what seems to be the prevailing view shares common traits with the ‘real bills doctrine’, according to which central banks should issue money backed by short-term securities free of risk.2 In a system of this kind, it is understood that the central bank can control the value of money by setting the interest rate on the safe assets held in its portfolio. Moreover, if central banks are monopolists in issuing money, they are also profitable otherwise, if a sort of ‘free-banking’ system emerges, they break even.

Irrelevance of open-market operations

In light of the old debate, and given the unconventional policies undertaken by many central banks, it is natural to wonder who is backing the currency under such new style. A popular result comes to rescue, namely Wallace’s irrelevance of open-market operations (Wallace 1981). Let monetary policy fix its stance by setting the nominal interest with the aim of controlling inflation and growth. Consider the implied equilibrium; it is surprising to discover that inflation and growth remain unchanged, regardless of what the central bank holds in its portfolio of assets.

On the one hand, this neutrality result challenges those who argue in favour of unconventional policies but, on the other hand, it reassures them of the absence of collateral damages that could impair the value of money. Digging deeply in the mechanism behind this result, one discovers who is really backing the currency. Consider a central bank that grasps some risky securities from the hands of the private sector and have risk materialised in losses. For the irrelevance result to hold, the treasury must be ready to promptly cover those losses by transferring resources to the central bank. Key is, however, that at the end these resources come from higher taxes levied on the private sector. It is therefore not gold, nor reserves, nor ‘real bills’ that back money – taxpayers do. In light of this, it should not be a surprise to hear in the European debate the public opinion questioning what the ECB buys. And even more will come if the ESM is asked to acquire the Greek debt held by the ECB.

In practice, the mechanism supporting the irrelevance of unconventional monetary policies can break down along either one – or both – of two directions. One is going from the taxpayer to the treasury, and the other going from the treasury to the central bank. If the treasury is unable or unwilling to tax citizens for the losses made by the central bank, and keeps them in its own balance sheet, then whoever unloaded the risky securities experiences a positive blip in financial wealth. Demand will surge and so will inflation. The value of money will fall.

Losses on central bank’s balance sheets

On the other side, looking at the relationship between treasury and central bank, automatic transfers in the case of losses are often excluded.3 An exception is the recent experience of unconventional operations of the Bank of England.4 Different is the case of the Federal Reserve and the ECB, in which full fiscal backing cannot be taken for granted. However, even in these cases, the central bank has still a way to keep the value of money unchanged. It can eventually shift the entire burden of the loss to the treasury by lowering future remittances to it, when profits turn positive again. For this way to be viable, however, losses should be limited in time and size. The time requirement points toward the use of unconventional operations only as extraordinary ones. The size requirement is particularly interesting. Large losses, indeed, can irrevocably impair the central bank’s profitability, unless the value of money is appropriately reduced – i.e. inflation rises – up to the point in which private agents are forced to hold more currency, so that the seigniorage earnings of the central bank can increase and its profitability can be restored.

It could be argued that the above circumstances are very abstract and never apply in practice since we won’t see significant losses on central bank’s balance sheets. But this could be observationally equivalent to a central bank that navigates these unchartered waters by changing its ordinary monetary policy stance to avoid negative profits, perhaps because it feels the pressure of the public or the treasury for the unconventional purchases undertaken. The way to avoid losses altogether is again to reduce the value of money, push inflation, and even delay exit strategies from zero interest-rate policies. Indeed, something we are starting to see.

Too bad for the proponents of this new style of central banking, if currency is unbacked, the value of money might fall. On the other hand, this might be good news for central banks trapped in dangerous disinflationary spirals, as they can signal a change towards a more inflationary policy stance.

However, it is always worth keeping in mind that unbacked currency can disappear. A rare event that, however, has already occurred in the past to the florin – the international reserve currency of the late 18th century – as a consequence of the losses made by the Bank of Amsterdam in lending to the East India Company.5


Bassetto, M and T Messer (2013), “Fiscal Consequences of Paying Interest on Reserves”, Federal Reserve of Chicago Working Paper No. 2013-04.

Benigno, P and S Nisticò (2015), “Non-Neutrality of Open-Market Operations”, CEPR Discussion Paper 10594.

Del Negro, M and C Sims (2014), “When Does a Central Bank’s Balance Sheet Require Fiscal Support?”, Unpublished manuscript, Princeton University.

Hall, R and R Reis (2015), “Maintaining Central-Bank Solvency Under New-Style Central Banking”, NBER Working Paper No. 21173.

Quinn, S and W Roberds (2014), “Death of a Reserve Currency”, Atlanta Fed Working Paper 2014-17.

Reis, R (2015), “The Mystique Surrounding the Central Bank’s Balance Sheet, Applied to the European Crisis”, The American Economic Review, 103 (3): 135-140.

Sims, C (2005). “Limits to Inflation Targeting”, In B Bernanke and M Woodford (Eds.) National Bureau of Economic Research Studies in Business Cycles, Vol 32, Ch 7, Chicago: University of Chicago Press, pp 283-310.

Smith, A (1806), An Inquiry into the Nature and Causes of the Wealth of Nations, in three volumes, Vol.II. Edinburgh: William Greech.

Wallace, N (1981). “A Modigliani-Miller Theorem for Open-Market Operations”, The American Economic Review, 71(3): 267-274.


1 See Hall and Reis (2015).

2 See for the original incipit Adam Smith (1806).

3 See Sims (2005) for a seminal contribution and later works by Bassetto and Messer (2013), Reis (2013) and Del Negro and Sims (2014).

4 The Bank of England and the Treasury established the Bank of England Asset Purchase Facility Fund Limited in January 2009 with the responsibility of buying private and public long-term securities through funds that the same Bank of England raised by increasing reserves. The created company is fully indemnified by the Treasury since any financial losses resulting from the asset purchases are borne by the Treasury and any gains are owed to the Treasury.

5 See Quinn and Roberds (2014).



Topics:  Financial markets Monetary policy

Tags:  QE, unconventional monetary policy, Central Banks, central bank’s balance sheet

Professor of Economics, LUISS Guido Carli; Research Fellow, EIEF and CEPR

Associate Professor of Economics at the Department of Social and Economic Sciences, Sapienza University