The Bank of Amsterdam and the limits of fiat money

BISWorkingPapers No1065 TheBankofAmsterdamandthelimitsoffiatmoney byWilkoBolt,JonFrost,HyunSongShinandPeterWierts MonetaryandEconomicDepartment January2023(revisedNovember2023) JELclassification:E42,E58,N13.Keywords:centralbanks,negativeequity,fiatmoney,trust. BISWorkingPapersarewrittenbymembersoftheMonetaryandEconomicDepartmentoftheBankforInternationalSettlements,andfromtimetotimebyothereconomists,andarepublishedbytheBank.Thepapersareonsubjectsoftopicalinterestandaretechnicalincharacter.TheviewsexpressedinthemarethoseoftheirauthorsandnotnecessarilytheviewsoftheBIS. ThispublicationisavailableontheBISwebsite(www.bis.org). ©BankforInternationalSettlements2023.Allrightsreserved.Briefexcerptsmaybereproducedortranslatedprovidedthesourceisstated. ISSN1020-0959(print) ISSN1682-7678(online) TheBankofAmsterdamandthelimitsoffiatmoney WilkoBolt,JonFrost,HyunSongShinandPeterWierts∗November13,2023 Abstract Centralbankscanoperatewithnegativeequity,andmanyhavedonesoinhistorywithoutunderminingtrustinfiatmoney.However,therearelimits.Hownega-tivecancentralbankequitybebeforefiatmoneylosescredibility?WeaddressthisquestionusingaglobalgameapproachmotivatedbythefalloftheBankofAmsterdam(1609–1820).Wesolvefortheuniquebreakpointwherenegativeequityandassetilliquidityrenderfiatmoneyworthless.Wedrawlessonsontheroleoffiscalsupportandcentralbankcapitalinsustainingtrustinfiatmoney. Keywords:centralbanks,negativeequity,fiatmoney,trust JELCodes:E42,E58,N13 ∗WilkoBolt,DeNederlandscheBank(DNB),Westeinde1,1017ZNAmsterdam,TheNetherlands; VrijeUniversiteitAmsterdam.E-mail:w.bolt@dnb.nl JonFrost,BankforInternationalSettlements(BIS),Rub´enDar´ıo281,Polanco,MiguelHidalgo,MexicoCity,Mexico;CambridgeCentreforAlternativeFinance.Tel:+525591385288.E-mail:jon.frost@bis.org Correspondingauthor:HyunSongShin,BankforInternationalSettlements(BIS),PostfachCH-4002Basel,Switzerland.Tel:+41612808621.E-mail:hyunsong.shin@bis.org PeterWierts,BankforInternationalSettlements(BIS),PostfachCH-4002Basel,Switzerland.Tel: +41763508250.E-mail:peter.wierts@bis.org TheviewsarethoseoftheauthorsandnotnecessarilythoseoftheBankforInternationalSettlements(BIS)orDeNederlandscheBank(DNB).Forvaluablecomments,wethankHaraldUhligandthreeanonymousreferees,aswellasWeiCui,FreddyPinzonandToniAhnert.Anearlierversionofthepaperwasreleasedas“Anearlystablecoin?TheBankofAmsterdamandthegovernanceofmoney”.WethankPeterSpreijforhelpfulinput,GiulioCornelliandCeciliaFrancoforexcellentresearchassistance,andClareBattsandEmmaClaggettforeditorialsupport.WethankStephenQuinnandWillRoberdsforsharingtheirdataset. I.Introduction Moneyisasocialconvention.Onepartyacceptsitaspaymentintheexpectationthatotherswillalsodosointhefuture.Butatwhatpointdotheseexpectationsbreakdown,causingmoneytoloseitsvalue?Inthispaper,weidentifythelimitsbeyondwhichtrustinfiatmoneyfallsaway.OuranalysisismotivatedbythefalloftheBankofAmsterdam(1609-1820),perhapsthebestknownofthepublicdepositbanksinEurope.TheBankofAmsterdamwasarguablyanearlyprecursortoamoderncentralbankinthatitissuedfiatmoneyandconductedmonetarypolicytostabiliseitsvalue.Byexaminingwhatittakesforanissueroffiatmoneytofail,wedrawlessonsonthecentralbankunderpinningsoftheinstitutionofmoney.Theselessonshaveresonanceandrelevanceeventoday. Howthendoesacentralbankfail?Indeed,howcouldacentralbankfailwhenitcanalways“print”moremoney?Itiswell-knownthatcentralbankscanoperatewithnegativeequity,andmanyhavedonesothroughouthistorywithoutunderminingtrustinfiatmoney(egStella1997;ArcherandMoser-Boehm2013).However,thisisnottosaythattherearenolimits.Wecanposethequestioninthefollowing,morepreciseway:hownegativecancentralbankequitybebeforefiatmoneylosescredibility? Inourmodel,failurereferstothecentralbank’sinabilitytoachieveitspublicpolicyobjective.Oursisnotabankrunmodel;wearenotlookingatthedefaultofaprivateinstitutionfacedwithaliquidityshock(DiamondandDybvig1983).Neitherisitacurrencycrisismodelinwhichspeculatorsdecidewhethertheyshouldattackacurrency(Krugman1979;MorrisandShin1998).Norisitaboutalackofcentralbankindependenceandcommitmenttoitspolicyobjective(Obstfeld,1995).Instead,ourmodeliscruciallyaboutmoneydemand,andthecentralbank’sabilitytoadjustthemoneysupplyinresponsetochangesinmoneydemand.Ifitlackstheroomformanoeuvretodoso,itspolicyobjectivecouldbeatrisk.Thefailuretoachieveits policyobjectivemayimplythatitwillultimatelybereplacedbyanotherinstitution,ashappenedin1820,whentheBankofAmsterdamwasshutdownandsucceededbytoday’scentralbankoftheNetherlands,DeNederlandscheBank. WeaddressthelimitsoffiatmoneyusingaglobalgameapproachmotivatedbythefeaturesthateventuallyledtothefailureoftheBankofAmsterdam.1Inourmodel,thevaluetousersofbankmoney(iethedepositsissuedbytheBankofAmsterdam)dependsonitsvalueinsettlementofwholesaletradetransactions,andthereforeonthevolumeoftradeandthegeneralbuoyancyoftheeconomy.Inthefaceofanegativeshocktotheeconomythatreducesthevaluetousers,thereisreduceddemandforbankmoney.Thenetworkeffectsintheuseofbankmoneyfurtheramplifythedeclineinthevaluetousersofholdingbankmoney.Otherthingseq