Understanding Central Banking

The New Era of Activism

David Jones

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317453048
• Edition: 1
• Topic: Economía
• Subtopic: Bancos y banca

Employing a light and lively writing style, the book starts with the history of central banking in England and then shifts focus to the United States, explains in detail how the Fed works, and covers the Fed's unprecedented activities to prevent the Great Recession from spiraling into the Greatest Depression. The final chapter presents a detailed scorecard for each of the Fed chairmen over the last 40 years.

1	History and Purpose of Central Banking

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Reduced to its essence, central banking is critical in maintaining an orderly modern economy, but it has proved to be more art than science. No matter how sophisticated the analysis of the impact of monetary policy on the financial markets and how they, in turn, influence spending, output, employment, and inflation, central banking comes down to a process of trial and error, observation and adjustment. To be sure, only central banks have the special power to increase aggregate liquidity in their respective financial systems. Moreover, reasonably independent central banks like our Federal Reserve (the Fed) can react more promptly to financial crises than slow-moving legislatures or other government agencies on the fiscal side. Nevertheless, when fighting financial crises, it has been the Bernanke Fed’s artful innovation, timing, and the unexpectedly large scale of its actions that have saved the day, steering us away from a second Great Depression while rebuilding shattered market confidence. In short, it was Fed chairman Ben Bernanke’s willingness “to do whatever it takes” that kept the U.S. economy afloat, as emphasized by David Wessel in his excellent book, In FED We Trust: Ben Bernanke’s War on The Great Panic (2009).

LENDER OF LAST RESORT

Traditionally, central banks have been viewed as lenders of last resort. The central bank is the institution that your commercial bank turns to in a financial crisis when it is under assault by depositors and short-term bank debt holders demanding immediate cash in return for these bank liabilities.

The Bank of England—founded in 1694 as the nation’s official bank, early debt manager, and clearinghouse—has successfully refined its role as a lender of last resort over the years and thus could be considered the bloodline ancestor of modern central banking. The Bank of England was nationalized in 1946, and subsequently became an independent public organization in 1997. It has the statutory responsibility for setting the UK’s official interest rate, which is the interest rate at which the central bank deals with the banking system. In the modern era, a nine-member monetary policy committee (MPC) decides on the appropriate level of this official interest rate.

As emphasized by Fed chairman Bernanke in his series of lectures to George Washington University students in March 2012 reprinted in book form, The Federal Reserve and the Financial Crisis (Bernanke 2013), the Fed turned first, in fighting the Great Credit Crisis of 2007–2009, to the lender-of-last-resort function to supply emergency liquidity through short-term collateralized discount window loans to banks and eventually other institutions as well. According to Bernanke, this initial reliance on the central bank’s collateralized lending function has a long lineage that stretches back at least to the dictum of the famous nineteenth-century British central banking expert, Walter Bagehot. Bagehot stated in his widely read book Lombard Street: A Description of the Money Market (1873), that central banks—the only institutions with the power to increase aggregate liquidity—should respond to crises or panics by lending freely against sound collateral at a penalty rate.

The Overend Gurney Crisis

Valuable insight into the early days of the central bank as a lender of last resort can be found in a recent paper presented by Mark Flandreau and Stefan Ugolini at a conference on Jekyll Island, South Carolina, on November 5–6, 2010. Titled “Where It All Began” (2011), the paper examines the origins and importance of the Bank of England’s early practice as the lender of last resort at the peak of the Overend, Gurney Crisis of 1866. Overend, Gurney was a London wholesale bank that collapsed in 1866, severely unsettling the London money market. Flandreau and Ugolini explore in detail how the Bank of England (BOE) performed its lending duties in May 1866, the month when the Overend, Gurney Crisis peaked, compared with a “normal” month one year earlier (May 1865). To their surprise, the authors found that the BOE monitored far more closely than known at the time the individual London financial intermediaries either presenting trade acceptances for discount by the central bank or seeking advances. Moreover, Flandreau and Ugolini discovered that the main London financial intermediaries turned to the BOE as the lender of last resort only in the midst of the Overend, Gurney Crisis of 1866, while shunning this source of additional liquidity in normal times.

The authors ultimately credit the Bank of England’s refinement of its role of lender of last resort, especially its excellent supervision of financial intermediaries and exceptional wisdom in supplying liquidity to the London money market, as eventually giving special status to sterling in world trade. Its success as the lender of last resort served as the model for the Federal Reserve’s discount window, established in 1913 in response to the Panic of 1907. Taking its cue from the Bank of England, the Fed closely monitored the financial condition of bank borrowers at its discount window. In the early days of the U.S. central bank, the discount window was the primary means of extending liquidity, predating the discovery of the liquidity-supplying potential of open market operations.

Given the crucial role of the central bank as a lender of last resort, it should be no surprise that our own Fed was created largely in response to the Panic of 1907, as well as perhaps the influence of other earlier periodic crises and panics that had plagued the U.S. financial system in the nineteenth and early twentieth centuries (see Chapter 6).

PRECURSOR OF THE FEDERAL RESERVE

The precursor of our Fed was the First Bank of the United States. Its formation was proposed in the administration of our first president, George Washington, by his highly respected Treasury secretary, Alexander Hamilton, to the first session of the First Congress of the United States, and signed into law on April 25, 1791, with a 20-year renewable charter. The First Bank of the United States was established as a private institution, but one that would be granted monopoly power to print money. This bank would act as a depository for government funds and facilitate the transfer of these funds from one region of the country to another, as well as loan money to the federal government and to other banks.

Opposition to the First Bank of the United States arose from mainly southern and western rural interests. Prominent opponents included plantation owners and several future presidents of the United States, among them Thomas Jefferson and James Madison. These southern gentlemen farmers and western frontiersmen feared that the centralization of power in the First Bank of the United States was done at the behest of urban northern commercial, merchant, and trading interests. By far the most vigorous opponent to the First (and Second) Bank of the United States was Andrew Jackson, the battle-hardened general and future president of our country. An avowed champion of the common man who shunned monied interests, Jackson was above all the sworn enemy of paper currency and anything that resembled a central bank (see Addendum to Chapter 9).

MODERN-DAY CENTRAL BANK FUNCTIONS

The functions of our contemporary Fed, a public institution, are somewhat similar but considerably expanded when compared with those of its predecessor. Specifically, the Fed’s modern-day functions include: (1) conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy; (2) supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial systems; (3) maintaining the stability of the financial system and containing systemic risk that may arise in financial markets; and (4) providing financial services to depository institutions, the U.S. government, and foreign official institutions.

The U.S. monetary policy transmission mechanism consists essentially of three channels: interest rates (levels and spreads), asset (stock) prices, and the U.S. dollar. At its core, U.S. monetary policy means setting the official interest rate (the federal funds rate target) at which the central bank deals with the banking system. (Federal funds are bank reserve balances held at the Fed that are loaned and borrowed among banks, usually overnight). When Fed authorities ease their policy stance, for example, they seek to exert downward pressure on interest rate levels and try to narrow risk spreads while putting upward pressure on prices of stock, houses, and other financial assets. Also in response to Fed easing, one would expect to see downward pressure on the value of the U.S. dollar in the foreign exchange markets. The result is expected to boost aggregate demand, output, employment, and eventually inflation.

REACTION TO FINANCIAL CRISES

To be effective in the modern era of massive global capital flows—those typically triggered by risk-taking portfolio managers in search of maximum returns world-wide—central banks must react to financial crises or panics, as well as to cyclical excesses, promptly and aggressively. The central bank must, first and foremost, do everything possible to maintain its anti-inflation credibility, and especially to keep the public’s longer-term inflation expectations low and well anchored. It must also demonstrate a fervent desire and willingness to act imaginatively, promptly, and on a sufficiently massive scale to deal with the problem at hand, as in the Great Credit Crisis of 2007–2009. This lesson has apparently been heeded not only by Fed chairman Ben Bernanke but also by the new head of the European Central Bank (ECB), Mario Draghi.

The common element in both Bernanke’s fight against the Great Credit Crisis and Draghi’s battle against the eurozone sovereign debt and banking crisis was the crucial need to rebuild the shattered confidence of market participants quickly, while ending blockages to the smooth flow of funds through the credit markets required for healthy capital formation in the economy’s most productive sectors. In the United States, a major source of blockage is extremely strict lending standards among banks, largely reflecting what some observers see as the overregulation that came with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010).

In each case, the central banker found it necessary to supply large amounts of emergency liquidity in order to buy time for more fundamental adjustments related to deleveraging (paying off debt), imposing austerity, reducing credit risk, and minimizing the threat of insolvency. In the U.S. case, the primary need was to deleverage both household balance sheets and the previously overleveraged financial sector. In the eurozone sovereign debt and banking crisis, the main effort of European Union (EU) leaders was to restructure the burdensome sovereign debt of distressed countries, lower prohibitively high sovereign borrowing costs, impose fiscal austerity, and shore up financially weakened eurozone banks—all while seeking to increase the competitiveness of distressed countries by urging the deregulation of labor markets and the lowering of labor costs.

HUMAN FACTOR

In congressional testimony, a lawmaker once asked former Fed chairman Alan Greenspan why, with all his intelligence and power, he didn’t simply do away with the booms and busts, the ups and downs of the business cycle (not to mention the destabilizing impact of asset price bubbles). In short: Why couldn’t the long-serving Fed chair completely eliminate the zigs and zags in the business cycle, avoiding the extremes of accelerating inflation on the upside and mounting unemployment on the downside?

In response, Greenspan astutely observed that the Fed, no matter how enlightened, could never completely conquer the business cycle (not to mention asset price bubbles) because they are, in essence, the product of human nature. Business cycles (as well as asset price bubbles) reflect the extremes of human nature: greed and fear; optimism and pessimism; complacency and panic; euphoria and despair. Unfortunately, human nature tends to take business cycles (as well as asset price bubbles) to extremes, as the public’s collective emotions tend to feed on themselves. About all that the monetary authorities can do in seeking to shave off the rough edges of the business cycle is to “lean against the wind,” in the words of former Fed chairman William McChesney Martin, Jr. (Mayer 2001).

COUNTERCYCLICAL MONETARY POLICY

Two important events set the stage for the Fed’s largely successful post–World War II countercyclical monetary policy. First, there was the legislative passage of the Employment Act of 1946, which made the federal government responsible for economic stability and planted the seeds of the Fed’s dual mandate of maximum employment and price stability. Second, there...