Even Mighty Central Banks Can Go Broke If Imprudent Policies Are Adopted

By W.A Wijewardena -December 2, 2013

Dr. W.A. Wijewardena

Central banks are not that mighty

A central bank in theory cannot be bankrupt because it can always print money and pay out the external creditors, namely, the holders of its currency and banks and other institutions that maintain accounts with it. An institution is unable to make pay-outs to its external creditors when it does not have enough assets to do so – a situation known as having a negative net-worth.

By printing money at its own discretion, a central bank, unlike any other institution in the economy, can convert a negative net-worth – the sign of the bankruptcy of a central bank – into a positive one. Yet, in practice some central banks have become bankrupt and many have got into trouble due to imprudent policies they have followed. Thus, even a mighty central bank can go broke if it has adopted imprudent policies.

There are two reasons which may contribute to the bankruptcy of a central bank.

Loss of credibility is the worst enemy of a central bank

One is that it may have issued too much of money causing a rapid increase in the inflation rate. When inflation rises to a very high level within a short span of time, it is called ‘hyperinflation’ and when it rises without showing any sign of abatement, it is called ‘high inflation’. During either episode, people refuse to accept the currency issued by a central bank because they stand to lose if they do so.

Every currency note issued by a central bank carries a promise to its holder that he could continue to acquire a desirable basket of goods and services by using it. For instance, a dollar note acquired by an exporter is a promise by the US authorities that the holder could acquire a dollar’s worth of goods and services from that country or from any other country which is willing to accept that dollar in exchange.

But if prices go up as moderately as it is happening in many countries including Sri Lanka or rapidly in the case of high inflation that is taking place in Venezuela today, the basket starts shrinking making the holder of the currency note poorer day by day. Knowing this, a smart person will very quickly transfer all his currencies into other currencies or other assets that do not have that particular problem.

During the hyperinflation in Bolivia in mid 1980s, the Bolivians refused to accept the Bolivian Peso and instead chose to accept the US dollar as the currency for transactions, keeping wealth and recovering debt from borrowers. Similarly, during the recent hyperinflation in Zimbabwe, it was the South African Rand that was accepted by Zimbabweans and not the dollars issued by their Reserve Bank. Thus, when people refuse to accept the currencies supplied by a central bank, it also loses the ability to issue new currency and convert a negative net-worth into a positive one. The result is the bankruptcy of the central bank raising an issue concerning its credibility.                                          Read More