Chapter 13: Central Banks
A "central bank" is an organization that controls the money supply: it is essentially the state bank, maintaining the deposits and borrowings of the government itself and selling or redeeming its debt with other banks as a means to maintain their capital reserves. By managing the money supply, the central bank regulates interest and inflation (which balance the demand for money against the demand for goods and borrowing). It also has the ability to regulated commercial banks (by refusing to do business with them unless they comply with its requirement) and to serve as the lender of last resort during financial crises (as it can loan unlimited amounts to the government, to be repaid from future tax revenues).
Central banks can and do fail, and the Federal Reserve Bank is the third central bank in US history. The original Bank of the United States was chartered in 1791 and failed shortly after the war of 1812, then a second Bank of the US was established and persisted until 1837, when the financial meltdown in Europe spread.
From 1837 to 1914, there was no central bank in the United States. The US Treasury kept its funds in a number of different commercial banks rather than keeping all its eggs in a single basket. During this time, the nation's money was commodity-backed, and the value of the currency floated with the value of the gold or silver for which it was redeemable. While credit currency (greenbacks) did exist, it was eventually redeemable, so the government remained on a fixed diet with no ability to print money without the ability to back or repay it.
Here, the author mentions currency boards and pegged values, as many other nations at the time did not have reserves of precious metals, but instead retained reserves of other currencies, often US dollars because they were stable (to the degree that precious metals supply and demand were relatively balanced), and the exchange rate of the currency was determined by the amount in circulation compared to the amount of foreign currency in their national treasuries (hence the term "dollarization" of foreign currencies).
The drawback to a fixed or pegged currency is the inability to arbitrarily increase or decrease the money supply to mitigate inflation and interest rate changes - which means that the central bank could not bail out commercial banks or protect the depositors' assets. This, in turn, meant that banks who extended credit too liberally would be caught without the funds to pay out its deposits, which caused a number of bank crises and financial panics (the author lists 1837, 1839. 1857, 1873, 1893, and 1907 as very bad years for banking). In each of these cases, there was an economic setback that required time to heal.
The last of those incidents in 1907 was so severe that the government was pressured to re-establish a central bank. At that time, the American people were wary of giving government too much power, so it took another seven years to get sufficient support to establish a new central bank: The Federal Reserve.
The Federal Reserve System's Structure
While the Fed is often spoken of as if it is a single entity, it is actually composed of twelve district banks that operate one or more branches. There is a headquarters in Washington DC, but it does not have complete authority over the branches: it is headed by a chairman and each regional branch is represented on the Federal Reserve's board of directors.
The branches of the Fed are also not independent corporations, but are owned by the various commercial banks in its district: they are voting members of the board of the branches, which any bank chartered nationally or on the state level are able to join - but at the same time the requirements to join and remain affliaited with the Fed are subject to requirements set forth by the board. Each of the branches has stock that does not trade in public markets and pays an annual dividend.
The twelve district banks function like any independent commercial bank (buying and selling debt, lending and borrowing from banks, etc.) except that they have the ability to issue reserve notes (the letter seal on all paper money indicates the issuing FRB) and performing some basic data gathering and ambassadorial duties (conducting research on regional economic conditions, acting as a liaison to the business community, etc.) The NY branch also has a few unique duties such as buying and selling bonds on behalf of the system and safeguarding assets (including over $100B iun gold) for central banks in other countries.
While the FRB is technically an independent organization, it is beholden to the US Government, who is its major client. The members of the board are appointed by the President and confirmed by the Senate to serve a single 14-year term; the chair is likewise appointed/confirmed to serve a renewable 4-year term. While there is no "de jure" power, the chairman holds a great deal of de facto power by virtue of his influence over the board's agenda and decisions.
In the present day, the chairman of the federal reserve is looked upon as a figure of tremendous power and an "infallible demigod" but this has not always been the case. Many of the chairmen have been reclusive figureheads who were not very proactive - nor is it necessary for a chairman to take an active role in the economy during periods of stability.
Other Important Central Banks
The US Federal Reserve is considered the world's most important central bank because the US has been the world's economic center since the second world war and the US dollar is the de facto world currency due to its long-term stability. Most countries of any significant size have their own central banks to manage their currency. Smaller countries have currency boards that maintain their currency by managing reserves of foreign currencies to back it. And the smallest countries simply do not have their own currency but use that of other nations.
Another important central bank is the European Central Bank, which governs the Euro. Most of the countries that are part of the European Economic Union have adopted this currency and their national banks serve as branches of the ECB, and some countries that have not formally joined the EU are using the Euro as their national currency. In all, the countries that do participate in the European System of Central Banks have enough financial clout in aggregate to make the ECB a major player in the world economy.
Two other important central banks are the Bank of England and the Bank of Japan, which represent the regional financial superpowers of Europe and Asia. Not all central banks are organized and operated like the Federal Reserve, nor do they have the same level of independence and autonomy.
Central Bank Autonomy
Money was not always in the province of government: as trade evolved, people chose what commodity to trade with (seashells, tobacco leaves, wheat, or whatnot) and eventually settled on precious metals. Money was made by creating small ingots and rounds by anyone who could work with metal, and its value was assessed by its weight and purity. Stamped coins became a matter of convenience - people came to trust that the coins made by a given maker (or mint) were the weight and purity they represented, and they would sometimes not bother to assess and weigh the metal. And in the same way, banks were vaults that issued notes that gave the bearer the right to withdraw the metal, and the notes were used in trade in lieu of metal.
Governments seized control of the money under the premise that government could serve as a neutral authority and use the power of the state to guarantee the quality of the money and punish forgers and counterfeiters. But as in all cases, power corrupts and many governments debased their currency: making coins of lesser weight and purity and insisting they be accepted at face value, issuing notes that could never be redeemed, and otherwise allowing themselves to engage in the very fraud and deception they initially promised to prevent.
The problem is that money is a token of trade, and it must be accepted in exchange. Where state currency became debased and worthless, merchants simply stopped accepting it. The state has limited and short-term ability to force someone to accept currency, or to continue to bring goods to the market after they have been swindled. Hence great importance is placed on the idea of having an independent source of money that is beholden to the law, rather than able to ignore it or change it to its own advantage.
Central banks are ostensibly independent of the government, and ostensibly serve the interests of all players in the market fairly. But of course, no central bank is entirely free from the law, and governments simply cannot resist interfering in economic affairs to gain an unfair advantage (for the government or favored groups). So the autonomy of central banks is seen as a relative thing: government will always interfere, but ideally should keep their interference to a minimum.
The value of independence is supported by various statistical studies, which demonstrate a strong correlation between independence and market stability. The more a government meddles, the less stable the currency tends to be, as is evidenced by the inflation in the cost of consumer goods (rising prices mean that merchants want more money for goods because the money is worth less). But it's counter-argued that inflation also occurs if the management of a central bank makes bad decisions. The argument is merely whether the source of bad decisions is the internal management of the bank or government's meddling, and it can be difficult to prove the source.
The author mentions various measures of independence: whether the bank has its own budget, whether its decisions are made internally, whether its officers are appointed or elected, etc. But it's also noted that government's power to meddle in the operations is unlimited and there is no structure or procedure that it cannot immediately undermine or overrule. We can only say that a central bank appears to have been independent because we can only assess what is known (rather than hidden) about the past (rather than the present).
There's a brief bit about the political interest in inflation. One of the main causes of inflation is debasement, when the government gives itself spending power by merely creating more money for itself, taking goods and demanding services indirectly rather than seizing goods by force and compelling service. There is also the argument that inflation stimulates economic growth: if money decreases in value, then it is reasoned that people will be more apt to spend than save their money (because it will be worth less in future), which drives consumption, demand of goods, and productivity to satisfy that demand. (EN: this is a sketchy argument at best, because inflation means that both goods and wages increase: there is more money being spent on the same amount of goods created by the same amount of labor, but no-one's life is improved by it.)