Because it's made out of paper, and is more valuable than the paper it's written on, it certainly looks like debt. But that doesn't mean it is debt.

That's what we teach them. We draw a balance sheet for the Bank of Canada. We put the government bonds it owns on the asset side, and the currency it has issued on the liability side. That's what the textbooks say. But is it right?

I waved a $20 note in front of my macro class this morning. I said: "Is this a liability of the Bank of Canada?". They all answered "Yes".

Let me tell you a counterfactual alternate history of money.

Once upon a time, in the olden days, people used gold as money. Gold was valuable because it was costly to produce, which limited supply, and because there was a demand for gold to use in fixing teeth and making airbag switches. The demand for gold to use as money merely added to that industrial demand and made it even more valuable.

The government used gold as money too. People had to pay taxes in gold, and the government used that gold to buy things. Sometimes, if the government wanted to buy more stuff than it had collected in taxes, it would borrow gold.

Then someone invented better things to use for fixing teeth and making airbag switches, so the industrial demand for gold disappeared. But the demand for gold to use as money meant it was still valuable, though not quite as valuable as before.

Then the government nationalised all the gold mines, so it had a monopoly. The government set the price of gold equal to the Marginal Cost of producing gold, so the value of gold was unaffected by the government monopoly (the government was neither more nor less efficient at mining gold than the private firms it replaced).

Then the government decided to abandon marginal cost pricing. The government would increase or decrease gold production, relative to the P=MC quantity, for various public policy purposes. The government would sometimes even make gold sales negative if it wanted to, by buying back gold it had previously sold.

Then an alchemist discovered how to make gold from paper, very cheaply. "Phew!" said the government, "It's just as well we nationalised gold production and made it a government monopoly!" The only difference the alchemist's discovery made was to reduce the government's cost of producing money. And it meant the government had to be even more vigilant to protect its monopoly, because the profits from producing "counterfeit" gold were now higher.

Do we list the houses sold by a builder as a liability on the balance sheet of that builder? No. Do we list the gold sold by a gold-miner as a liability on the balance sheet of that gold-miner? No. So where in my alternate history did gold become a liability of the central bank? Just because currency is usually made of paper, and liabilities are usually made of paper too, doesn't mean that currency is a liability.

The only difference between the endpoint of my alternate history, and where we are now, is that we use paper (and electrons) for government issued money, not gold. But the physical form of central bank issued money is irrelevant (unless it's very heavy or otherwise inconvenient etc.). Modern money is stuff that is very cheap to produce relative to its value, and isn't useful for anything else.

The fact that some paper currency was historically redeemable on demand into gold, and so was historically a liability in that sense, doesn't mean that paper currency is still a liability today. Sometimes, history really is bunk. Now that we are here, it doesn't always matter how we got here.

Now some central bank money is redeemable on demand into something else. If the Bank of Canada pegged the Loonie to the US Dollar, and promised to redeem Loonies at par in US Dollars, and promised never to break that exchange rate, and if that promise were written into the constitution, then you could perhaps argue that it is useful to think of the $20 note in my pocket as a liability of the Bank of Canada.

And you could also argue that the current 2% inflation target has some similarities to the pegged exchange rate example. It is as if the Bank of Canada had made the Loonie indirectly convertible into the CPI basket of goods, at a crawling peg that depreciates on average at 2% per year, with a 1% to 3% tunnel, plus some base drift.

If you think of that commitment to 2% inflation target as written in stone, you could argue that that makes the $20 note a liability of the Bank of Canada. If we wanted to hold fewer Bank of Canada notes, the Bank of Canada would need to buy them back in order to keep its commitment of 2% inflation. But it's still not a liability in quite the normal sense. Here's why:

If you list all the assets of a firm, and subtract all its liabilities, the difference should equal its net worth. That just doesn't work for the Bank of Canada. Bank of Canada currency pays 0% nominal interest, (and minus 2% real interest). Its assets earn positive interest. The Bank of Canada earns a profit on the spread. The net worth of the Bank of Canada is the expected present value of those (seigniorage) profits. A $20 note would only be a $20 subtraction from its net worth if the demand to hold that note disappeared tomorrow, and the Bank needed to redeem it to keep inflation on target. If the demand for Bank of Canada notes will never fall, then the present value of a $20 liability at 0% interest that need never be paid off is $0.

If I borrowed $20 at 0% interest, and I knew that the lender would never ask me for the $20 back, would it really be a liability? The demand for currency typically rises over time, in part precisely because it depreciates at 2% per year, so people would need to buy 2% more notes every year from the Bank of Canada just to keep up with inflation and hold their real stock of currency constant.

What about government bonds? If a Canadian government bond is a promise to pay Bank of Canada money, and that money isn't really a liability, and the government owns the Bank of Canada anyway, is the bond really a liability? Is government debt really debt?

Well, not in the same sense that private debt is a debt. The government of Canada could print off a very large number of $100 bills, equal in value to the national debt, plus interest, and pay off (most of) the national debt at a stroke, if it wanted to. (This wouldn't work for foreign currency bonds, or indexed bonds). But it wouldn't want to, under any normal circumstances, because people wouldn't want to hold that much 0% interest currency, so this policy would be incompatible with the 2% inflation target. Plus, the government's reputation and ability to borrow in future would probably be severely harmed.

But could the government just rollover the debt forever, issuing more debt to pay the interest on the existing debt? That depends. If the demand for debt is always growing faster than the rate of interest, then it can. This is definitely true for currency, which typically pays negative real interest, as long as the government keeps a de facto monopoly on currency, and doesn't try to persuade people to hold "too much" currency (in real terms). It may be true for government bonds too, as long as the government doesn't try to persuade people to hold "too much" in bonds.

What about privately issued money, like my chequing account at the Bank of Montreal? That's different. The Bank of Montreal is obliged to redeem my BMO money in BoC money, at par, on demand. BMO dollars are a liability of BMO in the same way that BoC dollars would be a liability of BoC, if the BoC were obliged, by law, to redeem my BoC dollars for US dollars at par (or at any pegged exchange rate).

(It's that asymmetric redeemability which gives the BoC, rather than BMO, the power to set Canadian monetary policy. And if the BoC pegged the Loonie to the US dollar, then it would be giving the Fed the power to set Canadian monetary policy. And if the Fed pegged the US dollar to the Loonie, then it would be giving the BoC the power to set US monetary policy.)

But suppose the Bank of Montreal had a de facto monopoly over chequing accounts in Canada, and could pay 0% interest on deposits, while earning monopoly profits from interest on its assets minus the administrative costs of running our chequing accounts? If BMO can borrow at 0%, and if it never needs to redeem demand deposits because the demand for demand deposits keeps on growing, would those demand deposits really be a liability? BMO's net worth would be the present value of the interest on its assets minus the transactions costs of servicing its demand deposits.

It is only competition between commercial banks that makes their demand deposits a liability in the normal sense of the word.

Just because something looks like debt doesn't mean it is debt.

(This post was inspired by, and is partly a response to, JW Mason's interesting post, which is well worth reading, even if I disagree with some of it.)