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Up until last week, the Swiss central bank used Francs to buy Euros, in an effort to lower the value of the Franc; today the European central bank announced that it would use Euros to buy bonds in order to fight deflation.

I assume that the central banks "create" the money used for these programs electronically. I would like to understand how this works. Can a central bank simply by fiat change its holdings of its own currency, and then use this new money in any way they please? Do they later have to "pay back" this money to balance the books, or can they simply forget about it?

Or more concretely: if the ECB buys bonds with newly created electronic money, and these bonds later default, would that be a problem for the ECB or could they laugh it off?

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Can a central bank simply by fiat change its holdings of its own currency, and then use this new money in any way they please?

Yes, but with oversight and in line with all sorts of principles of best practice. They answer to the legislature in some instances and the judiciary if they are shown to break any of those principals that are enshrined in law.

This oversight means that large bond buys typically require political impetus, as in the case of holding the Eurozone together (serving as a paltry stand-in for fiscal integration, also dependent on political impetus) being the primary political consideration here.

Do they later have to "pay back" this money to balance the books, or can they simply forget about it?

They certainly don't "have to" pay anything back, though if the value of a currency were to crash in bearish circumstances for investment in the economies using the currency, the responsible central bank might be expected to stave off the worst of the inflation by reducing the amount of money in circulation, perhaps by literally accepting tax revenues and writing them off without spending in the cases of inflation well above target levels (though perhaps the logic doesn't stretch to extremes).

An interesting factor here is that international investors are spooked because the Euro is still going down, but the HICP inflation within the currency zone is well below target rates, so arbitrarily expanding the money and leverage pools makes a degree of sense, just acknowledging that it implies that you are bullish regarding long run growth of tax receipts or your balance of trade will start encouraging you to take on debt. This is where the differences in dynamic between different forms of debt and money seem to become a difficult barrier to my progress on this topic. Suffice it to say for my purposes, that the simultaneous devaluation of a currency against others and the extant risk of consumer deflation within the currency zone means that there is going to be price pressure to buy European for both exporters and internally.

If that isn't manifesting in inflation, then either output is growing or expected to grow or there have been significant improvements in economic efficiency (like, tending to pay lower wages so that the poor can't import things or breaking up trusts and cartels so that the rich can't export things). Which of these kinds of measures we should prefer to use when presented an option is a whole thorny political debate all of it's own. The ECB, though perhaps through political pressure, have chosen to imply that they expect output to grow to a degree (certainly aggregate demand - whatever that even means if we treat it like a single coherent number comparing all forms of economic activity - is not going to decrease) warranting the risk of any undesirable effects that their diminished balance of trade might cause the currency union.

Either more will have to be produced or people will have to do without some things they currently consume, but which is likely?

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Short Answer

Can a central bank simply by fiat change its holdings of its own currency, and then use this new money in any way they please?

Theoretically it can, if you don't mind destroying credibility and the economy in the process. In modern economies there are regulations in place that make this impossible. So no.

Do they later have to "pay back" this money to balance the books, or can they simply forget about it?

If they keep "printing" new money and keep paying back old money in perpetual, the net effect is not having to pay back. So the US government can afford US\$19T of debt. But technically they have to pay back. See long answer below.

Or more concretely: if the ECB buys bonds with newly created electronic money, and these bonds later default, would that be a problem for the ECB or could they laugh it off?

ECB can laugh it off, but Draghi can't, and certainly Eurozone can't either.


Long Answer

First you have to look into the process of money creation. Let's say you provide an ounce of gold bar (asset) to the Fed, in exchange the Fed will pay you an equivalent sum for your gold, say US\$35. The gold is now in the Fed's reserve (it is called Federal Reserve for a reason). Archaically, you can redeem your gold bar with US\$35 (or whatever the current market price is).

However, note that debt instruments (i.e. bonds) are also assets. Therefore the government can issue short-term bonds to the Fed, which the Fed will put them in its reserve, and hand the cash to the government. The book is still balanced because the bonds in reserve are now "disabled", just like you cannot use your gold bar anymore when it's in reserve. But there will be more liquid cash in the market, cash that can be used to do other things, such as investment. When the bonds mature, the process is reversed. Furthermore, the interest (profit) earned from the government bonds will also be remitted back to the government, so the book is still balanced even when interest is taken into consideration.

Quantitative easing isn't all too different. In addition to government bonds, the central bank is now allowed to buy a set quantity of financial instruments that it normally wouldn't have access to, in the same exchange mechanism as stated above. QE allows central banks to (directly) influence interest yield of other instruments, in addition to the usual interbank interest rate which is already close to zero. A lower interest rate makes investment more attractive, which drives the economy. As a side effect from supply demand, now that there is more cash in circulation, exchange rate falls, which makes foreign direct investment attractive because US assets cost less in foreign currencies's perspective.

Now, what if the bonds default? Let's suppose there are US\$100 out in circulation, backed by US\$100-equivalent of reserves. If US\$20 of the bonds default, the value of the US currency in circulation will drop in value accordingly in terms of exchange rate. i.e. nominally the dollar notes still say US\$100, but the actual purchasing power will drop to only US\$80.

(Consider that initially US\$20 of reserve is in bond and US\$80 is in gold. When you reason further, had it been a fixed exchange rate system, once the bonds default, if the owners of the US\$40 of gold rush to redeem their gold at a fixed rate, the reserve will now be worth US\$40. The remaining US\$60 in circulation will now have only 2/3 of it's initial purchasing power (compare with 80% purchasing power right after the default). If all US\$80 of gold reserves is redeemed, the remaining US\$20 in the market will worth US\$0. This is one of the reasons why fixed exchange rate won't work: Once there has been a default and people rush to redeem the reserves, hyperinflation follows.)

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They have a procedure to make it look like it isn't what it actualy is - dictat.

The problem is that if we accept the reality we may all clammer for more money creation and eventually destroy the value of it, as happened many times in the past.

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