Disclaimer: Albeit I have been spending a considerable amount of time researching & thinking about these topics, I am still just scratching the surface of understanding of these topics. I am writing and publishing this to deepen my understanding, share my ideas and perspectives & connect with peers. If this topic is as fascinating to you as to me, feel free to reach out on Twitter. DMs are Open.

Assumptions:

The core assumptions driving this exploration are the following:

Hyperinflation != Printing too much money (per se)

Hyperinflation = Insolvency of Central Bank

Strength of Currency = Solvency of Central Bank Balance Sheet

I take this perspective from I. B. Sauer.

False Problem:

Quantitative Theory (“Printing Money”)

Real Problem:

A well managed central bank only buys AAA debt (=lowest risk debt). They assume homogeneity across the assets they get as collateral and therefore assign the same fixed prime-rate for all these transactions.

In times of crisis the central bank might stimulate the economy by issuing more loans against lower quality debt but at the same fixed prime-rate. In the short term this stimulates the economy, because essentially the CB is taking a loss as interest rate mismatches risk.

Solutions + Extensions:

• Only buy homogenous AAA debt at the fixed prime rate

• Have a variable interest rate depending on the risk of the counterparties collateral (debt agnosticism)

• Extension: Use non-debt assets to back the issuance of cash (asset agnosticism)

The first solution is what a good central bank should be doing anyway if it doesn’t want to go insolvent. The second & third solution opens up a plethora of new possibilities of how to structure a central bank’s balance sheet:

Source: Capital Structure

You see, classical central banks should only run on highest quality AAA debt. Provided that risk is properly assessed, it seems plausible that it could also run with riskier debt instruments and even equities. For example the SBA loan program in the US is kind of an example of this as they give out long-term loans to already running businesses at roughly double the prime rate.

Moreover, it should even be possible to accept equity instead of debt instruments for the issuance of cash. In this case, rather than setting an interest rate to be repaid in addition to the principal, a price would be set at which cash would be exchanged for equity. While with debt, the mechanism by which the issued cash returns to the CB is the moment the debt is paid back, with an equity the cash returns either in the form of dividends, revenue splits or liquidation of the equity.

Looking at the difference between debt and equity, we see quite different attributes in kind.

In the case of debt, both risk and return is the lowest, especially if the interest rate is, by definition, equal to the prime rate. The return is temporary, i.e. once the debt is repaid, no further income is generated and the transaction is complete.

Although equity is much riskier, it can also generate considerable returns. Moreover, the return is permanent, i.e. as long as the company exists, the shareholders share in its results. Once the central bank’s investments bear fruit, it can generate a substantial positive return.

A real world example of this is the sovereign wealth fund of Singapore which manages surplus reserves of Singapore’s monetary authority and is arguably one of the cornerstones of Singapore’s success.

What could be done with these returns?

1. Remove currency from circulation (deflation, increase value of currency)

2. Pay out as dividend to … a. Shareholders b. Stakeholders/Citizens

3. Use surplus to fund government budgets

4. Build up the reserve to buffer the additional risk

5. Keep reinvesting (e.g. real estate worked well for Singapore)

Both 1 & 2a are fairly similar, as both distribute profits on an ownership basis while 2b resembles something like a UBI. 3 & 4 are contributing to the economic-systems wealth by supporting government programs & reducing systemic risk respectively.

Overall it seems that issuing cash in exchange for more diverse capital, all levels of debt, equity, revenue-splits, etc. will open up the possibility for more growth in the CBs economy.

The biggest reasons against putting higher risk debt & especially equity on a CBs balance sheet is the structural risk involved. When the total CBs economy gets hit on a macro level, and the CBs balance sheet holds a lot of exposed equities, that could degrade the currency quicker than it would have otherwise. So using this mechanism should be done only to a certain percentage!

In the end, like with all things in life, it’s about finding the right balance. The mechanisms of having a dynamic interest rate to allow for more diverse debt & even equity acceptance is promising and an interesting frame to think in, opening up an exciting design space.

Disclaimer: Albeit I have been spending a considerable amount of time researching & thinking about these topics, I am still just scratching the surface of understanding of these topics. I am writing and publishing this to deepen my understanding, share my ideas and perspectives & connect with peers. If this topic is as fascinating to you as to me, feel free to reach out on Twitter. DMs are Open.

Assumptions:

The core assumptions driving this exploration are the following:

Hyperinflation != Printing too much money (per se)

Hyperinflation = Insolvency of Central Bank

Strength of Currency = Solvency of Central Bank Balance Sheet

I take this perspective from I. B. Sauer.

False Problem:

Quantitative Theory (“Printing Money”)

Real Problem:

A well managed central bank only buys AAA debt (=lowest risk debt). They assume homogeneity across the assets they get as collateral and therefore assign the same fixed prime-rate for all these transactions.

In times of crisis the central bank might stimulate the economy by issuing more loans against lower quality debt but at the same fixed prime-rate. In the short term this stimulates the economy, because essentially the CB is taking a loss as interest rate mismatches risk.

Solutions + Extensions:

• Only buy homogenous AAA debt at the fixed prime rate

• Have a variable interest rate depending on the risk of the counterparties collateral (debt agnosticism)

• Extension: Use non-debt assets to back the issuance of cash (asset agnosticism)

The first solution is what a good central bank should be doing anyway if it doesn’t want to go insolvent. The second & third solution opens up a plethora of new possibilities of how to structure a central bank’s balance sheet:

Source: Capital Structure

You see, classical central banks should only run on highest quality AAA debt. Provided that risk is properly assessed, it seems plausible that it could also run with riskier debt instruments and even equities. For example the SBA loan program in the US is kind of an example of this as they give out long-term loans to already running businesses at roughly double the prime rate.

Moreover, it should even be possible to accept equity instead of debt instruments for the issuance of cash. In this case, rather than setting an interest rate to be repaid in addition to the principal, a price would be set at which cash would be exchanged for equity. While with debt, the mechanism by which the issued cash returns to the CB is the moment the debt is paid back, with an equity the cash returns either in the form of dividends, revenue splits or liquidation of the equity.

Looking at the difference between debt and equity, we see quite different attributes in kind.

In the case of debt, both risk and return is the lowest, especially if the interest rate is, by definition, equal to the prime rate. The return is temporary, i.e. once the debt is repaid, no further income is generated and the transaction is complete.

Although equity is much riskier, it can also generate considerable returns. Moreover, the return is permanent, i.e. as long as the company exists, the shareholders share in its results. Once the central bank’s investments bear fruit, it can generate a substantial positive return.

A real world example of this is the sovereign wealth fund of Singapore which manages surplus reserves of Singapore’s monetary authority and is arguably one of the cornerstones of Singapore’s success.

What could be done with these returns?

1. Remove currency from circulation (deflation, increase value of currency)

2. Pay out as dividend to … a. Shareholders b. Stakeholders/Citizens

3. Use surplus to fund government budgets

4. Build up the reserve to buffer the additional risk

5. Keep reinvesting (e.g. real estate worked well for Singapore)

Both 1 & 2a are fairly similar, as both distribute profits on an ownership basis while 2b resembles something like a UBI. 3 & 4 are contributing to the economic-systems wealth by supporting government programs & reducing systemic risk respectively.

Overall it seems that issuing cash in exchange for more diverse capital, all levels of debt, equity, revenue-splits, etc. will open up the possibility for more growth in the CBs economy.

The biggest reasons against putting higher risk debt & especially equity on a CBs balance sheet is the structural risk involved. When the total CBs economy gets hit on a macro level, and the CBs balance sheet holds a lot of exposed equities, that could degrade the currency quicker than it would have otherwise. So using this mechanism should be done only to a certain percentage!

In the end, like with all things in life, it’s about finding the right balance. The mechanisms of having a dynamic interest rate to allow for more diverse debt & even equity acceptance is promising and an interesting frame to think in, opening up an exciting design space.