Issue #15
The Central Bank Conundrum
We are living in very precarious times with large powerful economic undercurrents. In our modern economic history US dollar is again on a spot. Will this all end up with a US dollar that preserve its value? So how did we end up here. Let’s go back to the 19th century and look at the evolution of economic policy in the shadow of central banks.
Central banks have always had an outsized impact on the economy. Monetary stability and banking have been central tenants of any economic policy. But Central Banks were not always there. Do you think that they are at all necessary? Have their monetary control proved helpful at all or their outsized impact done just the opposite.
Let’s start with the largest and most important central bank of all. - The FED. FED was established at the beginning of 20th century, right before World War I. What did the non-central bank system looked like before it? Counter to the narrative that it was a wild wild west. It was an ordered market system governed by constraint of demand and supply for money. Money was left to several commercial banks. It was a competitive business. Essentially paper money backed by deposits and other securities subject to some form of regulations.
Scotland and Canada are two good case studies. They had competitive currency institutions. In that era there were also serious debates. People argued on both sides. Governments however swayed the outcome in favour of centralised institution. Central banks were formed and have been the largest sponsors of government in many ways.
There were good reasons that commercial banks before the central bank worked well for sometime. Competitive rivalry between these banks of issue ensured a system that worked. These banks would very jealously guard the share of currency market. A system of interoperability developed and each accepted rivals notes. But then they would see to it on a daily basis that the notes where actively returned to the source. The other bank would either fork up gold or silver or notes of the rival to offset. Let’s call it a discipline of adverse clearing.
However, a great benefit of this system was that money supply grew when needed i.e. when people had larger balances of money. This also contained tendency for the supply of bank created money to not grow excessively and spark cycles of boom and bust.
Demand for currency back then had a very distinct seasonal pattern - Harvest season and Christmas i.e July and December spike. Hence, supply of currency was a function of demand in the real economy. A perfect pattern which worked for decades.
The Canadian system as an example, automatically adjusted the supply of money. So we did not need a central planner to do it. Market forces drove it.
The US banking system however had all kinds of problems. Among the developed countries it had a terrible banking system. A system of way too many banks. Small and local which were not at all diversified. US had what they called Unit Banks. They worked in one area, sourced deposit from one and had a very concentrated exposure. Diversity is the key to safety. Most banks hence failed in US.
Before the Civil War only state chartered banks were present. Because the banks didn’t branch. The currency lost meaning if it did wander any distance. They would not command its face value. If you wanted to redeem it and covert it a broker may redeem it but at a cost.
Many states passed free banking laws. They all required their banks to back deposits with specific security. Eligible securities were often state debt. Sometime covered to the extent of 100 percent. And most often these banks failed because those securities depreciated in value and most banks went under. And not because of they were fly by night operator.
During Civil war government tampered with monetary supply. Federal government issued their own notes called “Greenbacks”. Created federally chartered banks. What they did was that these banks had to back their currencies with bonds of the Union government.
Greenbacks however where fixed in supply. Seasonality of currency demand was not taken into account. The problem with the new currency system was that it wasn’t flexible at all. That’s because the banks have to buy these bonds to back their currencies. These bonds were scarce. Now to increase money supply they couldn’t find more of these bonds. This resulted in tremendous instability. It came down to banks reserves being run down due to these wild swings in money supply.
These panics led to movements which ended up with FEDs establishment. There however was no panic across the border in Canada. Canada had no problem unlike United States.
All of this required reforming the system. Branch banking was opposed by vested interest. Small banks feared Wall Street where most of the federally chartered banks existed. The US had a more diverse economy and the banking system was quite a contrast. How did the Federal reserve become the system we expected it to become?
FEDs initial mandate was not to manage money. Fed’s mandate was to maintain the gold standard. It was not seen as a problem. People were right. If gold standard was a problem then it would be a problem elsewhere too. Feds mandate was to provide for inevitably an elastic currency especially given that national banks couldn’t do so. Something which the Canadian system automatically generated.
The first decade for Fed were absolute panic. World War I followed and emergency laws were imposed. An embargo was placed on gold. Govt engaged in inflationary finance. Then we had the worst depression in economic history 1929. It was a severe depression. Prices were rising so high but the fed imposed gold standard. In 1937 there was a depression within a depression. These were all banking panics. Before 1914 frequency of banking panics were less very less. Banking failures increased.
Think about though what happens when an institution performs badly. It usually gets its wings clipped. Central Baks however get their power enhanced. As a consequence for sometime Gold convertibility of dollar was domestically restricted.
Here we are again 2020 and we still really on FED to work on and resolve these business cycles.
Other central bank tend to follow in FED’s footstep. FED becomes a dog that wags monetary tail of other banks. In 2008, FED did a number of things. It failed in many ways. In particular FED devoted a lot of effort to bailing out particular institution. While at the same time it was also tightening credit in other markets.
It made more funds available to its emergency lending programs. And soke up as much from emergency lending programs in the market. Some firms it saved were not worth it.
Classically they are lender of all resort. Solvency to good and not the bad firms should be an outcome of FED actions. FED did not learn lessons of the first decade. What sort of similarity are we seeing now? With new crisis we are seeing FED adding more ad-hoc lending facilities. Half a dozen new lending facilities. May be we should re examine more standing facilities and not rely on emergency facilities.
Forget about all the technical issues involved. A very important aspect of todays economic reality is that the creditability of govt commitments to pay back what they owe is wearing down. Govt commitments are eroding fast and soon no one will trust them any more.
Only reasonable thing for the world economy to ask would be a US dollar that preserves its value and is a good medium of exchange. Please do it and I am thinking about it a lot. And I am not certainly not going to say that it has a policy solution.