4: Central Bank and Monetary Policy

When money consisted of commodities (gold and silver), no central regulation was needed. The acceptor of metal was responsible for assessing the weight and purity to ensure he was getting the agreed-upon value. While coins were created by independent mints, it was still a matter of faith to believe that the weight and purity were what was represented on the coin.

Paper money, which was based on the existence of commodities in the vaults of a bank, was as good as the reputation of the bank itself. Aside of a few swindles, most banks maintained their reputation and issued notes for only as much specie as they actually had - and even when one bank engaged in fraud, only that bank's notes were rendered worthless, so only a portion of the money supply was rendered worthless when a bank collapsed.

And then, government got involved in the money business, issuing coins and notes and demanding monopolist control of the money of their citizens. Invariably, governments began to debase their currency, demanding that their coins be treated as an ounce of silver even though they were half copper, and demanding that their notes and bills be honored even though there was not sufficient specie in the vaults to redeem them.

The citizens of these nations generally agreed to cooperate, under threat of violence from the government, for as long as they could. Citizens of other nations did not - and the debasement of currency led to fluctuations and shutdowns of foreign trade and eventually a shutdown of domestic trade as well.

Eventually, and after a multitude of financial disasters, it became necessary for governments to refrain from interfering in the money supply and to do business with an (ostensibly) independent banking entity: the central bank, whose role it was to create a stable money supply.

The Role of the Central Bank

The central bank's primary task is to take responsibility for money: to ensure that there is sufficient money to support economic activity and that the money of a country remains stable in its value. It does so by virtue of the fact that it manages the single largest account in the country - that of the national government - and by managing the supply of money to the market by buying and selling debt to the national treasury.

The central bank can manage the money supply by making loans to the nation's largest banks. If there is too much money in circulation (and money is losing value), it can raise its rates so that banks borrow less money from it to extend to their own borrowers. IF there is not enough money in circulation (and money is gaining value), the central bank can lower its rate, encouraging banks to borrow more money and lend it at lower rates to borrowers. There are various other mechanisms by which the central bank can put money into circulation or call it back from circulation - but lending is the primary means.

Management of the money supply has a number of ancillary effects, and at times national governments put pressure on the central bank to achieve some other outcome by the manner in which the money supply is managed. Some examples are:

All of these are indirect consequences of money supply: the central bank cannot lower unemployment, but can cheapen money, which facilitates economic growth, which causes the demand for labor to increase. There are also necessarily correlations: one cannot lower unemployment while increasing prosperity because the weaker money that helps employment is capable of buying fewer goods and services.

Also, the change in the money supply can only encourage behavior, not force it to occur. Loosening the money supply makes it cheaper to get loans to start new businesses, but this depends on an unlimited supply of entrepreneurs who want to borrow money to start new businesses. Tightening the money supply makes it cheaper to purchase foreign goods, but if foreign manufacturers do not ramp up production, then imports will not increase.

The central bank also depends on the cooperation of the entire banking system. A commercial bank may choose not to participate in the central bank - not to maintain a reserve of funds with the bank, not to accept or extend loans to the central bank, etc. Though in most countries, commercial banks are required to participate to some degree in order to gain certain protections (such as federal deposit insurance or the availability of emergency funds) that make it worthwhile for them to play ball.

The Principle of Independence

The principle of independence means that government must refrain from interfering in the operation of the central bank: it should be left to make its own decisions and act in the interest of the financial system and the national economy. This depends on government to keep its hands off the central bank entirely, which is a tall order. Ostensibly, government does, but there are often clear signs that government attempts to exert influence over the central bank.

In most instances, the members of the central bank committee are appointed or confirmed by government, but government has no control over them once they have been appointed to the committee. It is also common for decisions to be made by committee rather than a single individual - so whereas the Chairman of the Federal Reserve has a great deal of personal influence, he has no formal authority to make a unilateral decision pertaining to the policies and practices of the bank.

It is also common for central banks to involve outsiders in its committees: banking industry executives and economic scholars. The proceedings of these committees are often made public, and any decisions they make are announced publicly within minutes of concluding the vote.

Central Banks in Europe and America

The Bank of England is the central bank of the UK. It had been a corporate bank, owned by shareholders, until it was nationalized in 1946. Even before nationalization, it functioned as the central bank. The bank did not have operational independence until 1997.

The European Central Bank was created in 1998 to operate as the guarantor of the Euro, a currency common to all nations participating in the European Economic Union. Its executive board is appointed by committee of the heads of government of all participating states, meaning that the ECB has never been beholden to a single government.

The Federal Reserve System is the central bank of the United States. Created in 1913, the Fed is composed of twelve regional banks, federally chartered and managed by a committee of representatives of participating banks, though the national director is Presidentially appointed.

A Central Bank's Operations

The balance sheet of a central bank is similar to that of a typical bank. While it does not have individual or corporate clients, it maintains the reserves of member banks in a similar way to deposits (cash balanced against accounts payable) and securities it issues (cash balanced against bonds), loans of capital to and from member banks, deposits from and loans to the federal government.

The central bank does have some control over its depositors by maintaining a required reserve rate, such that member banks must have deposit with the reserve at least a fixed percentage of their own depositors' funds. Banks may refuse to meet the reserve, but this renders them ineligible to receive any of the services of the central bank.

As with any other bank, the central bank can grant loans and make investments to generate income, and tends to do so only in pursuit of its monetary policy. As "the lender of last resort" the central bank is compelled to maintain stability by providing money when it is necessary - loaning or borrowing without limits to maintain the stability of the financial system. Traditionally, the central bank borrows and lends only to its member banks - but in the financial crisis the central bank acted to prop up companies in the shadow banking system,.

The central bank may take specific action to mitigate the impact of crises that are not systemic, such as managing the exchange rate of domestic currency against a specific foreign currency or making a large-scale investment in a risky security (such as muni bonds of a distressed region of the country or the commercial paper of a failing financial giant).

The International Monetary Fund

The IMF was established in 1945 as an attempt to create a central bank for the world - a central bank that would support the central banks of all participating nations (188 of them at the time the book was written). The fund generally attempts to stabilize exchange rates among different currencies by buying and selling them against one another, though it may sometimes focus on stabilizing one currency that gets out of line - buying to increase their relative value, selling to decrease relative value.

Like most central banks, the IMF has no real authority over sovereign central banks, but it does have the ability to refuse to lend to them if they do not adhere to its policies. There are instances in which the IMF has been accused of posing harsh conditions on nations that need emergency funding, though these conditions are intended to help restore economic stability to a troubled economy.

The Conduct of Monetary Policy

A central bank may engage in open-market operations to manage the money supply - buying securities to release cash to the market, selling them to recall cash from the market. These exchanges depend on the ability to present an offer that is appealing to another party who will voluntarily buy or sell. This is the most frequently used method to manage the money supply.

Borrowing and lending to member banks also affects the money supply, but is generally an activity that is initiated by the member banks themselves. The central bank can offer to borrow/loan at an attractive rate to encourage participation - but ultimately the supply and demand of money for a given bank will determine whether it is interested.

Many central banks also engage in foreign exchange transactions to manage the supply of their currency versus foreign currencies: purchasing a foreign currency will weaken the domestic currency against it. It generally requires very large transactions to sway exchange rates, so large economies have a significant advantage over small ones.

The Deposit Expansion Multiplier

There's a brief bit on the money supply - how a tight definition considers only the coins and bills in circulation, looser definition include ready-to-spend bank deposits, and even looser ones include anything that can be converted to cash in less than thirty days.

The reserve rate is the first way that a central bank can influence the money supply. By increasing the reserve rate, banks are required to keep more money on deposit with the central bank (which takes it out of circulation) and by decreasing the rate, banks can withdraw their deposits and lend them out, increasing cash in circulation. Granted, the amount of their capital banks lend is at their discretion, but they are motivated to lend because dead money earns no profit.

It's also noted that money "in circulation" is not entirely accurate: it's money that is available to spend. People may prefer to keep money in their checking and savings accounts than to spend it, and companies seek t maintain a certain amount of cash in their treasuries. But for the most part, people seek to benefit from spending their money - and certainly no sane person borrows at interest to sit on the money they have borrowed.

(EN: This is subject to some debate. Since 2008, the checking/savings balances of individuals and organizations have roughly tripled, meaning people are choosing to hoard money rather than spend it. This is part of the reason that the central bank's "quantitative easing" has not led to much economic growth: people aren't buying things, so companies don't need to make things, so there's no investment in growing their operations.)

While the reserve requirement was meant to function as a safety net that limited lending, a mathematical loophole enables banks to increase their lending operations exponentially. That is, a 10% reserve rate was intended to cause a bank with $10m to lend to lend only $9m and keep $1m in reserve - so in effect, the requirement allows a bank to lend up to nine times as much as it has in deposits. So the bank with $10m in deposits can float $90m in loans, backed by the security of those deposits.

As a result of this, small changes at the central bank have the potential to make major changes in the economy - which is why the financial press goes bananas over a seemingly minor adjustment to the federal reserve rate.

Interest Rate Targeting

Instead of focusing on the amount of money in circulation, many banks make the interest rate their highest concern - as regardless of the amount, the interest rate is an indicator of whether the value of money is stable.

The central bank controls interest rates by the amount it charges to its member banks. IF a bank can borrow from the central bank at 2%, the cheapest loan it can afford make is a little more than 2% (to repay the vig to the central bank and cover their operating expenses). Hence by raising or lowering the rate to banks, the central bank influences the rate that banks charge consumers for borrowing money.

There is also the influence of inflation on interest rates. Inflation is caused by the balance of supply and demand of money. When there is more money than is needed, prices are bid up; and when there is less, prices are bid down. For those people who save/invest rather than spend, they seek to earn interest that outpaces inflation. When inflation is high, they move to riskier investments to preserve the value of their wealth - and this, too, influences the overall rate of interest in an economy.

There's some talk of the Taylor Rule, a principle that states that low inflation is a sign that an economy is not living up to its potential - that not enough goods and services are being provided to require all of the money available to purchase them to be spend. Hence to keep an economy growing, the inflation rate must be maintained at a low level, but not a negative one. While this rule has not been formally embraced, calculations suggest that the basic principle is embraced implicitly based on the actions of the federal reserve.

(EN: And again, the behavior of consumers in the present economy does not meet these expectations. Consider that the amount of money in savings accounts has tripled, in spite of the fact that savings accounts pay far less than the inflation rate. In theory, people would move from saving to investing to preserve their wealth. In practice, that clearly is not happening.)

Quantitative Easing

Quantitative Easing is a technique that was implemented in the wake of the 2007-2009 economic crisis to maintain the stability of the national economy. The bursting of the real estate bubble essentially caused a great deal of money to disappear - when DMOs were recognized as worthless, their investors' money was wiped out. Where banks (including central banks) held these DMOs on their books, their collateral was wiped out, and where lenders held junk mortgages on their books, those assets were wiped out.

The sudden disappearance of such a large amount of cash was a shock to the system that could have sent inflation and interest rates skyward. To prevent this, the central bank immediately purchased essentially worthless debt contracts from organizations that held them, restoring the losses that would have occurred. Alternately, the central bank left these instruments in the hands of the unlucky holders, but guaranteed it would buy them in future at their face value. This prevented an immediate economic collapse, but left the bank holding a lot of assets that are essentially worthless - and which will have to be retired slowly, over a long period of time, to allow the economy to absorb the loss gradually rather than all at once.

The net effect of quantitative easing has been to flatten the economy, and there has been low inflation and low interest rates since. In theory, this stability should not only restore the economy, but spur economic growth. This has not happened due to the skittishness of investors, who withdraw their money from financial markets (where they would fund productive activity) and horde them in safe harbors (where they do not stimulate production).

It's noted that these are "unconventional" monetary policies that are justified, even made necessary, by the crisis and that they are not expected to continue after the loss has been fully absorbed and economic activity returns to normal. (EN: But the, consider many of the "emergency measures" put in place after the Great Depression are still active today, nearly a century later, and are considered sacred cows that politicians won't touch. So Qualitative Easing may remain a wet blanket on the economy for decades and generations to come.)