BIS publishes screed about trust in fiat

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The short answer (to be developed further below) is that a strong capital position is neither necessary nor sufficient for preserving trust in money. A strong capital position of the central bank in the conventional accounting sense is not an absolute prerequisite for preserving trust in money. This is evidenced by central banks that have operated effectively with negative equity. Still, these central banks have all benefited from support by fiscal authorities with sustainable debt levels. Conversely, there have been instances where trust in money eroded due to concerns about fiscal sustainability, despite central banks having positive capital. This suggests that the sustainability of public finances plays a critical role.

Instead of the central bank’s capital position, our paper highlights the importance of a related set of issues as key for the preservation of trust in money. The pivotal economic mechanism that we highlight is the portfolio decision of private holders of central bank money. When private holders have access to alternative forms of money and other financial claims, fiat money needs to command unquestioned trust on the part of the private holders. While network effects will preserve support from private financial entities, erosion of trust could shift the economy closer to potential “tipping points” when holders abandon domestic money in favor of alternatives, whether they are metal coins in the 1700s or other reserve fiat currencies or crypto stablecoins in the modern era. It is in this context of the portfolio choice of private holders of central bank money that the capital position of the central bank enters into the analysis. This is because a weak or negative equity position of the central bank will have a bearing on how the tipping point of the switch to an alternative currency is determined. The outward symptom of such a tipping point would be the sudden collapse of the exchange rate during a currency crisis. The collapse of the currency can be seen as the point where there is a sudden loss of trust in money.
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