Central Banking
4 years ago, as the financial crisis was just gaining momentum, George F Will, a leading conservative political columnist in the US, wrote
this article.
Folly and the Fed
By George F. Will
Thursday, August 16, 2007
Exactly a century ago, panic seized financial markets. The collateral for perhaps half of the bank loans in New York consisted of securities whose values had been inflated by speculation. Then on Sunday night, Nov. 3, 1907, a 70-year-old man gathered some fellow financiers at his home at 36th and Madison in Manhattan. The next morning, a New York Times headline proclaimed:
"BANKERS CONFER WITH MR. MORGAN
Long Discussion in His Library
Not Ended Until 4 o'Clock This Morning."
Both the Times and The Post ["BANKERS IN CONFERENCE. Money Stringency and Remedial Measures Discussed in Morgan's Library."] noted that bankers shuttled between meetings at Morgan's mansion and the Waldorf-Astoria (then at Fifth Avenue and 33rd Street) in a newfangled conveyance -- an automobile. Working 19 hours a day, and restricting himself on doctor's orders to 20 cigars a day, J.P. Morgan seemed so heroic that the president of Princeton University, Woodrow Wilson, said the financier should chair a panel of intellectuals who would advise the nation on its future.
Six years later, however, under Wilson as the nation's president, the Federal Reserve System was created, ending the era when a few titans of finance could be what central banks now are -- the economy's "lenders of last resort." Central banks have been performing that role during today's turmoil in the market for subprime mortgages -- those granted to the least creditworthy borrowers.
....
The Federal Reserve's proper mission is not to produce a particular rate of economic growth or unemployment, or to cure injuries -- least of all, self-inflicted ones -- to certain sectors of the economy. It is to preserve the currency as a store of value -- to contain inflation. The fact that inflation remains a worry is testimony to the fundamental soundness of the economy, in spite of turbulence in a small slice of one sector.
...
Now note the dichotomy. On the one hand Will describes how the Federal Reserve was created as the "lender of last resort", and on the other hand says that the mission of the Fed is to "control inflation", but not to worry about economic growth.
It is particularly this type of disinformation that informs a lot of the criticism of the Fed.
What is a central bank, and why have one?
Central banks started off as the government's bank. It is where governments deposited their tax revenue until they spent it. And it assisted the government in borrowing money. America's first 2 central banks, named creatively the First and Second Banks of the United States, did more than that, and loaned money commercially to businesses and for internal improvements. However, there were controversies about them, and Andrew Jackson managed to kill the Second Bank of the United States. The US didn't have a central bank again until 1913.
Not having a central bank didn't cure the cronyism that was one of the common criticisms against the Banks of the US. The government still had to deposit its money someplace. And so they chose a collection of politically well connected private banks. This gave those banks a huge windfall and advantage over other banks.
This period from 1837 to 1913 was a chaotic one in the US. There was just so much going on that you can find some of anything you happen to look for. Economically there was both great growth and frequent severe crashes wiping out much of that growth. There was money printed by private banks backed by gold, and sometimes money backed by nothing. And sometimes outright counterfeiting, but the counterfeit money was accepted none the less because people simply needed the money so badly they didn't much care where it came from.
By 1907 the system had gone as far as it could. JP Morgan, in the events Mr Will described above, was able to get all the major bankers to act as a lender of last resort, and help the economy as a whole. But also realized that it wouldn't be enough to do that again. And so the creation of the Federal Reserve was organized.
Now, to be clear, the Fed was created to be the "lender of last resort" to stabilize the economy when no one else, and no organizations, could. Everything else is secondary to that.
That is mainly what a central bank is for. But it is not all of what they do. The design of the Fed gives it control of the currency. And therefor the money supply. And that inherently ties the Fed into the role of controlling, or not, the rate of growth of the economy and inflation.
And so the roles of the Fed became:
- Lender of last resort
- Promote economic growth and purchasing power
- Regulate the banks
- Stabilize the economy
- Maintain price stability
- Act as a clearing house for checks between banks
Sometimes some of these goals are in conflict with others.
The US Federal Reserve has an extremely strange structure. This is a result of the political compromises needed to get the legislation passed at all. There has been from the time of the proposal of the creation of the First Bank of the US a belief among some that the US Constitution does not allow the authority for Congress to create a central bank. Most have disagreed with that belief. But it has had enough power at times to result in some odd political choices. For example, not all of it is part of the US government. The 12 regional Federal Reserve Banks are owned by the member private commercial banks in those regions. So the presidents of the regional Fed banks are not government employees.
The committee that decides on the monetary policy of the Fed, called the Federal Open Market Committee, includes 12 members. The chairman, currently Ben Bernanke, who you should have heard of, is appointed by the president and confirmed by the Senate for 4 year terms. The vice chairman and the other 5 appointed members, IIRC, are appointed to 12 year terms. This means that no one president can "stack the board" because he won't be in office long enough to do so. The other 5 members are the president of the New York Fed (by far the most important of the regional Fed banks) and 4 presidents by rotation from the other Fed regional banks.
The president of the United States can fire none of these people. Removing them requires either out-waiting their term or impeachment, which would be like impeaching a judge by Congress.
The reason for such an odd structure is to give the Fed's governing board both a great deal of isolation from the politics of the moment and broad input from around the country. That is the model of what is called an "independent central bank". Why independence? Because otherwise you get a bank that makes short term decisions for political gains without regard to the long term consequences.
Seriously, would you want Congress making monetary policy?
Money has such a huge effect on the economy that the incentive to manipulate it for political gains is overwhelming. Even with the independence designed into the Fed, efforts to influence the Fed's decisions are commonplace. A central bank that was too much subject to political interference, or directly politically controlled, would have much too strong of incentives to do what the current political leaders wanted, regardless of consequences down the road. That would mean both periods of much higher inflation than we have now, as well as periods of stagnation due to political majorities that wanted to crush inflation at all costs. And overall greater instability. Just keep in mind the current debate, where the majority in the House of Representatives wants government policy to help throw the current president out of office, regardless of the affect on the country. And this is why we have a central bank that in insulated, in the short run anyways, from the politics of the moment. And why Congressional proposals to hamper the Fed, audit it, restrict its freedom of action, prioritize inflation targeting above all other considerations, is such a disastrous idea.
Now meeting these competing demands is very difficult. In fact, it would probably be fair to say that the central bank essentially never "gets it right" in any one time period. Instead they manage a scattershot around right, and try to get the average right in the long run. Why aren't they getting it "right" all the time? Imperfect information. Remember MV=PQ? How many of those variables do they have next month's number for?
None of them.
Based on past experience and careful analysis of all available information they think they've got a pretty good guess at it. But it is a constantly moving target. And there are constantly external factors that throw the variables off projections, if even by only a tiny margin. And that is why the Austrian Economics criticism that "If only money was right, we wouldn't be having these problems" is essentially useless. Worse than useless really, extremely dangerous. Perfect is unattainable. So given that you know you are going to be wrong, you try to shoot for wrong in the direction that has the less harmful consequences.
TL; DR version
Why do we have a central bank?
The markets and the government both recognized that the economy was too unstable and wasn't working well enough without one.
What does a central bank do?
It acts as a lender of last resort to protect and stabilize the economy.