Central banks are not just interest rate setters

Central banks are not just interest rate setters: an introduction to modern central bank roles

This is the online presentation I made at the 2020 Freedom Week (by the Adam Smith Institute and the Institute of Economic Affairs) on August 21st. It is an overview of the major roles undertaken by modern central banks in our economies, which involves much more than setting the policy rate. Actually, since the outbreak of the Global Financial Crisis what leading central banks have been doing is to act as ‘bank of banks’, ‘bank of the government’ and, as regards monetary policy, to engage in asset purchase operations (i.e. Quantitative Easing). Once policy rates were brought down to the effective lower (nominal) bound, central banks have used outright asset purchases to be able to affect macroeconomic outcomes. Contrary to a very popular misperception, in purely fiat monetary systems, central banks cannot run out of ammunition, even when nominal policy rates are zero or close to zero. In this presentation, I briefly discuss (1) what central banks do as providers of services to the banking sector and to the government, as well as (2) the importance of monetary analysis to understand the effects of changes in the amount of money on inflation and output over the medium to the long term. This is at the core of what we do at the Institute of International Monetary Research.

I hope you find it a good introduction to central bank roles in modern economies. As ever, comments welcome.

Juan Castaneda

PS. If only for enjoying James Gillray‘s caricatures as a means to explain money and central banking, it may well be worth watching.

 

Advertisement

Read Full Post »

MONEY TALKS, by IIMR

‘Money talks’ is a series of mini-videos the Institute of International Monetary Research (IIMR) will start to release every week on the 18th of June, Monday.

The name of the series says it all: experts in money and central banking will be covering key concepts to understand better monetary economics in less than two minutes long videos. Tim Congdon (Chairman of the IIMR) and Geoffrey Wood (IIMR Academic Advisory Council) along with myself and many others to come will be addressing the fundamentals in money and banking to be able to understand how our monetary systems work and which are the roles and functions of modern central banks.

The topics address include the following:

Episode 1: What is Money?

Episode 2: What is the Central Bank?

Episode 3: What is the Monetary Base?

Episode 4: What is the Money Multiplier?

Episode 5: What does Monetary Policy consist of?

Episode 6: What is Central Bank Independence?

Episode 7: The Central Bank as the Lender of Last Resort

Episode 8: Bail outs and Bank Failures

Episode 9: Basel Rules

Episode 10: What os ‘Narrow Banking’?

Episode 11: Fiat Money

Episode 12: What is a monetary policy rule?

Episode 13: What is Monetarism?

Episode 14: Monetary Policy Tasks

But of course, these are just the ones we are starting with. The list will be expanded in the next few weeks and the aim is to produce a library of mini-videos that could be a good reference to search for short definitions on money, banking and central banking.

If you are interested in this project, please subscribe to the IIMR YouTube channel (https://www.youtube.com/playlist?list=PLudZPVEs3S82iu2zb-QZfcK7pqnrHfPgO) to stay tuned.

As ever, comments and feedback most welcome!

 

Juan Castañeda

 

 

 

 

Read Full Post »

LIBOR 2008 scandal: the Lender of Last Resort function revisited again …

Should the allegations published by the BBC (on Panorama programme) last week be confirmed, this news brings very serious concerns for the credibility of the Bank of England (BoE) and also the trust of the general public in the banking sector. Ours is a fractional reserve monetary system with no ‘metallic anchor’, but purely based on trust and the record and effectiveness of the BoE and the rest of the banking sector. The alleged pressure of the government and the Bank of England to keep LIBOR (London Interbank Overnight Rate) artificially low back in the Autumn of 2008 (in an effort to send the message that banks and money markets were not that disrupted) erodes the sound functioning or markets and the formation of interest rates, which are key signals for households and companies in planning their decisions.

 

But why messing with LIBOR?! Central banks have plenty of monetary weaponry to tackle a liquidity crisis

Instead of interfering in the functioning of the interbank market (as alleged), should the Bank of England had wanted to prevent the contagion of a panic in the banking sector after the fall of Lehman Brothers in the Autumn of 2008, it could have done it much more promptly and effectively by being a more active (last resort) lender of the banking sector: i. e. by extending the maturity of the loans and increasing the amount of the loans given to the banks. Following Walter Bagehot´s seminal narrative of the way the Bank of England should step in if a liquidity crisis occurs, it should do so by (1) lending promptly as much as money as needed, (2) against collateral and (3) at a penalty rate (usually at a higher rate than the main policy rate). Before 2007, the Bank of England had been acting as the lender of last resort of the British banks very successfully for more than two hundred years, and there had not been major bank collapses in the UK; at least when compared with the record of other central banks. The application of this more active and timely lending of last resort policy at the time would have been a much more efficient, effective and indeed transparent way to prevent the banking crisis from escalating further; and also a more effective way to send the message to the public the Bank of England was actively responding to the crisis.

I was quoted in an article published by S&P Global Market Intelligence (Sohia Furber) about the allegations of the rigging of the LIBOR in 2008 (see more at http://www.mv-pt.org/latest-news).

 

Juan Castañeda

PS. You can read the piece published by S&P on the 12th of April at: http://www.snl.com/web/client?auth=inherit#news/article?id=40298030&cdid=A-40298030-11831

 

 

Read Full Post »

A discussion on money and central banking with Tim Congdon and Geoffrey Wood

On the 13th of March (IEA, London) I had the pleasure to participate in the launch of the new MSc in Money, Banking and Central Banking (University of Buckingham, with the collaboration of the Institute of International Monetary Research), starting in September 2017; and I did it with two of the professors who will be teaching in the MSc, indeed two excellent and very well-known experts in the field: Professors Geoffrey Wood and Tim Congdon. I have known them both for long and shared research projects and co-authored works in money and central banking; and it was a privilege for me to have the chance to  introduce the new MSc, as well as to engage in a fascinating dialogue with them on very topical and key questions in monetary economics in our days: amongst others, ‘How is money determined? And how does this affect the economy?’; ‘Is a fractional reserve banking system inherently fragile?’; ‘Does the size of central banks’ balance sheet matter?’; ‘If we opt for inflation targeting as a policy strategy, which should be the variable to measure and target inflation?’; ‘Why the obsession amongst economists and academics with interest rates, and the disregard of money?”; ‘Who is to blame for the Global Financial Crisis, banks or regulators?’; ‘Does tougher bank regulation result in saver banks?’; ‘Is the US Fed conducting Quantitative Tightening in the last few months?’.

You can find the video with the full event here; with the presentation of the MSc in Money, Banking and Central Banking up to minute 9:20 and the discussion on the topics mentioned above onwards.  Several lessons can be learned from our discussion, and however evident they may sound, academics and policy-makers should be reminded of them again and again:

• Inflation and deflation are monetary phenomena over the medium and long term.
• Central banks‘ main missions are to preserve the purchasing power of the currency and maintain financial stability; and thus they should have never disregarded the analysis of money growth and its impact on prices and nominal income in the years running up to the Global Financial Crisis.
• A central bank acting as the lender of last resort of the banking sector does not mean rescuing every bank in trouble. Broke banks need to fail to preserve the stability of the banking system over the long term.
• The analysis of both the composition and the changes in central banks’ balance sheets is key to assess monetary conditions in the economy and ultimately make policy prescriptions.
• The analysis of the central banks’ decisions and operations cannot be done properly without the study of the relevant historical precedents: to learn monetary and central banking history is vital to understand current policies monetary questions.
• Tighter bank regulation, such as Basel III new liquidity ratios and the much higher capital ratios announced in the midst of the Global Financial Crisis, resulted in a greater contraction in the amount of money, and so it had even greater deflationary effects and worsened the crisis.

These are indeed key lessons and principles to apply should we want to achieve both monetary and financial stability over the medium and long term.

I hope you enjoy the discussion as much as I did. As ever, comments and feedback will be most welcome.

Apply for the MSc here!

Juan Castaneda

Read Full Post »

The communication of a banking crisis: it’s all about confidence!

During a visit to the National Portrait Gallery in Washington DC (‘The Reynolds Center for American Art and Portraiture’) I visited the Presidents’ gallery and found Franklin Delano Roosevelt‘s portrait accompanied by an interactive panel with some of his very popular at the time ‘fireside (radio) chats’ with the nation. One of them caught my attention; it was his address to the nation on the 13th of March of 1933 on the occasion of a major financial panic which led to the suspension of all banking activities for a week (the proclamation of 5 days of bank holiday). Of course the explanation of it would take us to the Great Depression and the massive fall in banks’ deposits in the country (as calculated by M. Friedman and A. Schwartz in their seminal Monetary History of the US, more than a third of the money supply since 1929). But what this brief post is about today is on just the communication of the suspension of the banking activities by the President himself to the nation: as you will hear in this audio recording, it is a very good explanation, and very easy to follow, of how the financial system in a modern economy operates and how fragile it becomes when confidence is lost and people run suddenly on their banks for liquidity. Even at that time, when the US was still on the gold standard and thus paper notes were ultimately backed by gold, the system relied on the confidence of the depositors on the soundness of the banks. Being very well aware of it, all the President tries to do with in this ‘fireside chat’ on the banking crisis was to restore the confidence lost by reassuring the american  people the monetary authorities were willing (and had already) to lend to sound banks to meet the liquidity needs of their customers. It is a good example of how to educate the people on these complex issues and to communicate how the crisis was being tackled.

Do not miss the opportunity to listen to it; in just a two-minute recording you will easily recognise all the elements involved in a banking panic and in the solutions needed: run on liquidity, fractional reserve, fiat versus backed money, lender of last resort, confidence, … . It is an excellent teaching material for a lecture in macroeconomics or money and banking.

However, involved in a massive fiscal expansionary program, only three months later the President suspended the convertibility of the US$ notes in gold, which left more room for the government and the baking sector as a whole to expand the amount of (fiat) money in circulation.

Juan Castañeda

PS. This audio and others of FDR and other Presidents can be found at ‘The American Presidency Project‘ website (http://www.presidency.ucsb.edu/medialist.php?presid=32).

(Franklin Delano Roosevelt, picture taken at the National Portrait Gallery, Washington DC)

Read Full Post »

The Greek question once more: back to ‘Central Banking 101’ …

Very, very basic hints on how a fractional reserve and fully centralised monetary reserve monetary system works

It seems to be unnecessary but, given all it’s being said by all and sundry in the last two weeks, may I remind the kind readers of this blog that the current monetary crisis in Greece is just a textbook example of how a fully centralised monetary system works. I would have thought that the members of the recently appointed new government in Greece were well aware of the institutional and economic constraints of the euro, as well as the very much restricted range of manoeuvre a monetary union allows to its members. Let’s start with the very basics:

Under a fractional reserve and fully centralised monetary system such as ours, the ultimate source of liquidity is under the control of a central bank, the single issuer of the currency with legal tender power. The Greek economy (along with quite some other countries in the euro area) has been running persistent and quite significant current account deficits and, particularly since the outbreak of the 2007-08 financial crisis, has required the extraordinary assistance of the ECB. When no one was willing to lend out money to Greece, the ECB has not only taken part on the bail-out successive plan(s) granted to Greece but also, and most importantly, has been accepting Greek government bonds as collateral in its main refinancing operation with Greek commercial banks. The latter has been key to maintain a regular source of liquidity to the Greek economy and thus to avoid the collapse of its national monetary system and a run on Greek banks.

Along with the loans, the ECB (actually the so-called Troika with the other two institutional lenders, the EU Commission and the IMF) has imposed conditionality on the provision of the loans granted to Greece. And of course, this is the (natural) expected behaviour of any lender: those willing to lend out their money would like to be sure the borrower will be able to honour his debts. Needles to say that successive Greek governments have accepted the deal because no other international creditor was willing to make a loan to the country or to accept Greek bonds as collateral. Who else but your central bank could take such a high risk and keep on hoarding in its portfolio assets nobody wants? (By the way, all the shareholders of the ECB are contributing to these loans and supporting this continuous financial assistance in accordance to their percentage in the capital of the bank).

Now a new government in Greece is playing a quite risky game, with potentially disastrous consequences for the country. All along the campaign, Syriza has been denouncing the ‘imposition’ of the bail-out programmes and the loss of sovereignty of the Greek government in favour of the interests of the international creditors (let us leave aside the meaningless and populist rhetoric used by its dealers to refer to the bankers, capitalists and free marketeers as those wickedly pulling the strings in the shadow … ). They claim that the debt is unfair and needs to be restructured, if not partially or totally written off (may I remind one more time that a more than 50% ‘voluntary’ haircut was already accepted by private bondholders in 2012). Actually the new finance minister has been very busy in his recent road trip throughout   Europe to demand a change in the rules of the game; as if he was in a position to do so. Let me remind again few very basic facts in this regard:

– The more radical the demands of the Greek governments the more difficult it will become to find any other source of liquidity in international markets and thus the more dependent the Greeks will be on the single source of money available, the ECB. Actually the risk premium of Greek bonds has already exploded in the last two weeks and thus this situation has already materialised.

– The message that the Greek government couldn’t be willing to fulfil the conditions of the bail out programme has already increased capital flights out of the country and this shouldn’t be surprising at all (as it already happened back in 2012). And again, in this financially stressed scenario Greek banks are even more fragile and exposed to high liquidity constraints, which can only be sorted out by the assistance of the ECB (if willing to accept Greek bonds as collateral).

In this context we may well understand last week’s Mr Draghi’s reaction to the demands of the Greek government; in particular, his announcement that since next Wednesday Greek banks will no longer have access to the regular financing operations of the ECB via the ordinary discount of Greek bonds as collateral. This can only mean two things: either (hopefully) the precipitation of a new mutually beneficial deal between the new Greek government and the Troika or, if not feasible, the most likely sudden collapse of Greek banks as soon as the ECB stops providing liquidity to them on a regular basis. Well, perhaps another alternative might happen, which is the return to the national (devalued) currency (see an alternative in line with the introduction of more monetary competition in Europe here).

I do not know who advices the new Greek government on these matters but it would help to familiarise first with the very basics on money and central banking. All my best wishes to the Greeks of course!

Juan Castaneda

Read Full Post »

Quantitative Easing or the reinvention of the wheel

Much has been said about the QE operations conducted in the US and elsewhere in the recent financial crisis. Some have claimed they constitute a true revolution in central banking; some have even gone further to suggest that it is the beginning of a new monetary policy. And, also quite many still claim that these extraordinary monetary policy measures should not be applied as they are supposed to be highly inflationary by their own nature.

Just a very quick look at the modern monetary history in Europe and in the US will reveal how wrong those views can be. On the one hand, as tested quite many times in our economic history, yes, too loose monetary policies (via QE operations or other else) will result in inflation, but only if (broad) money grows much faster than real income. So, how inflationary QE will be in the coming years cannot be assessed without making a proper monetarist analysis. Monetary expansion will have other effects, true (in part, already addressed here). On the other hand, even though under a different name, with the current QE operations we are just “inventing the wheel” or, following the Spanish saying, “discovering the Mediterranean sea”.

As quoted from Geoffrey Wood’s “The lender of last resort reconsidered” (A paper prepared for a conference in honour of Anna J Schwartz. Washington, 14-15 April 2000), in relation to the 1825 panic affecting the british banks:

“There had been a substantial external drain of gold, and there was a shortage of currency.  A panic developed, and there were runs on banks.  The type of bills the Bank would normally discount soon ran out and the panic continued.  If a wave of bank failures were to be prevented, the banks would have had to borrow on the security of other types of assets. Of that change of policy Jeremiah Harman, a Director of the Bank, spoke as follows when giving evidence before a Parliamentary Committee in 1832.  The Bank had lent money “… by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances in Exchequer bills, we not only discounted outright but we made advances on the deposit of bills of exchange to an immense amount, in short by every means consistent with the safety of the Bank, and we were not on some occasions over nice”. Published in the Journal of Financial Services Research, 2000, vol. 18, issue 2, pages 203-227. See:  http://link.springer.com/article/10.1023/A%3A1026542821454.

So the Bank of England, already in the early 19th c., did conduct a truly active monetary policy to prevent the collapse of the banking system in Britain “by every possible means”; which included the purchase of stocks, public bonds, the discount of paper, … . And even most interesting,  Professor Wood (Cass Business School and University of Buckingham) provided in his work (written in 2000!) an excellent description of several successful application of the lender of last resort role of central banks that did prevent the collapse of the banking system without provoking (the supposed) hyperinflation. His work could have been taken as an excellent guide to make policy decisions from 2008 on.

The study of monetary history will do no harm to all of us at all, either academics or policy-makers. Quite the contrary!!!

Juan Castañeda

Read Full Post »

A chat on fractional reserve and monetary competition

This video was originally recorded in Spanish and released on the 15th of March 2012 at Vimeo (Spanish version). Then it was very kindly supported by the GoldMoney Foundation, so we could release an English version of the video on July this year, entitled: “The Spanish economic crisis”. I would like to thank GoldMoney very much for their support.

You can also find below a summary of the content of the video, as quoted from the GoldMoney website (research section).

Enjoy it! Comments very much welcome.

Juan Castañeda

——————————————–

The Spanish economic crisis: ‘Yo Invito – ¿Dónde está mi dinero?’

What caused the Spanish economic crisis, and how safe is your money in banks? Maria Blanco, economist and member of the Instituto Juan de Mariana; Doctor in Economics Juan Castaneda; Marion Mueller, founder of OroyFinanzas.com; and Expansion.com journalist Miquel Roig discuss this and more over coffee at Madrid’s Café Gijón.

Fractional reserve banking, sound money, and the prospects for monetary reform in Spain and the wider world are the broader topics of conversation. Though the quartet are heartened that more and more people in Spain are taking an interest in economics since the country’s debt problems became apparent, they doubt that the kind of radical monetary reforms they favour would win support among many Spaniards. They are heartened though that elsewhere in the world – notably an increasing number of US states – the sound money cause is gaining support, albeit slowly, among citizens and politicians.

This video was recorded on 10 March 2012 in Madrid.

————————————————————————–

Read Full Post »

A debate on how banks create money

Article originally published in GoldMoney Research (15th May 2012)

Improving the banking system

Governments grant central banks a monopoly on the creation of hard currency. At the same time, we ordinarily make transactions with other means of payment supplied by commercial banks. This is possible because in our monetary system commercial banks are able to create so-called bank money. These means of payment consist of different banks’ deposits that can be used with cheques, bank transfers, credit or debit cards and direct billings, which make our lives much easier as we do not have to hold or carry bank notes or coins to make ordinary transactions.

However, commercial banks are not free to issue their own currency. Bank money has to be denominated in the currency issued by the national central bank and the banks are legally required to redeem their sight deposits in the currency of the central bank at any time. However, the need to back any single deposit of their clients does not necessarily mean that the bank is keeping all our money in their vaults at all times. According to current regulations, they just have to keep a tiny fraction of it. This is the legal reserve ratio. In the eurozone this is 2% of banks’ total deposits; and for this reason we call it a fractional reserve monetary system. This system allows for easy expansion of the money supply, but it also involves a significant risk: that of bank runs caused when depositors all try to take their money out of banks at once.

Banks started to operate under a fractional reserve system in the early modern era, when it started dawning on them that in ordinary times, few clients actually asked for the money kept on deposit. So they started to lend part of it out. By doing so, new deposits were created and hence new means of payments. Consequently, banks increased their balance sheets as well as their profits quite substantially, as the costs of backing their new deposits were much lower than the earnings coming form the new loans. Since the mid to late 19th century, with the expansion and development of modern banking, banks were able to offer these new means of payment more efficiently – which did not require the use of paper notes or coins. As a result, banks realised that their clients needed less and less physical currency, which resulted again in a reduction in reserve ratios.

But during the 19th century the gold standard regime – championed by the British Empire – was an effective means to limit monetary expansion, both from central banks and commercial banks, as they still had to keep gold in reserve to back their issuance of money and credit. However, with the abandonment of the classical gold standard during the First World War, banks no longer needed to keep valuable assets in their vaults as the new reserve money of the economy was the notes of the central bank; which, in theory, could be expanded overnight with no tangible costs. This new system, in combination with the running of purely discretional monetary rules, resulted in excessive money creation and, finally, in more inflation and output instability in the late 1960s and 1970s.

Consequently, fractional reserve systems based on fiat currency tend to over-issue money unless strictly controlled by the central bank, or by the emergence of free competition in money. With the former, the central bank commits to a sound monetary rule focused on maintaining the purchasing power of money. Under this rule, both the central bank and the commercial banks are able to create means of payments but are subject to restrictions.

As sight deposits are redeemable at very short notice, banks could be required to fully back all their sight deposits with an equivalent amount of notes. Hence, the reserve ratio would amount to 100% of all sight deposits. Under this regulation, banks could only create new means of payment by lending the money kept in their time or savings deposits. It would result in a more stable monetary system but at the cost of having a less developed banking system, and thus a much smaller money supply.

In my view we do not have to go all the way towards a 100% reserve ratio to preserve the stability of the monetary system, while allowing for the development of the banking system. The gold standard seen in Britain and other countries during the 19th century is a good example of a self-correcting monetary system that nonetheless operated on a fractional reserve basis.

However it is achieved though, greater recourse to preserving the purchasing power of money would go a long way to improving our current monetary system.

Juan Castañeda

Read Full Post »

Modern central banks and the state: a coalition of interests

Published in “GoldMoney Analysis” , 3rd June 2011

Money creation has long been synonymous with state power. In the dim-and-distant past, governments minted gold and silver coins, before eventually becoming the monopoly issuer of notes. In both cases they get a non-negligible profit – seignoriage – which is the difference between the face or exchange value of money and its intrinsic value. In the case of coins, the earning of a seignoriage is explained by the costs of minting and by the fact that the state (the seignior or lord) guaranteed the face value of the currency. As for paper money, seignoriage boomed with the increasing use of banks notes as substitutes for coins during the 19th century, as the face value of notes always massively exceeds the notes’ intrinsic value, thus boosting the earnings of the issuer. Unsurprisingly, governments – ever eager to find new sources of revenues – soon cottoned on to this fact.

As the law of basic economics dictates, an excessive supply of a good or service will push down its price. Regarding money, it means a deterioration of the purchasing power of the currency. Thus the massive inflow of precious metals into Spanish ports in the 16th and 17th centuries, as a result of the discovery of large gold and silver deposits in the Americas, was followed by rising prices across Europe (albeit at the modest rate – by modern standards – of around 2 per cent, according to the historian Niall Ferguson). Inflation is a monetary phenomenon that results from the growth of the money supply exceeding the growth in goods and services in an economy. If our income and wealth remain steady, but our money supply increases, then we will not be richer – we will simply pay more for existing goods.

The risk of inflation increases in purely fiat monetary systems in which there are no means of payment that retain any intrinsic value, and where only bank notes and other “bank money” media – such as various types of account deposits – are available for market transactions. In the absence of any limit on money creation in such a fiat system, the money supply grows at the whim of the monopoly issuer. This is why monetary rules are essential to protect the purchasing value of money. Such rules entail quantitative limits on the legal ability of monetary authorities (as well as the associated banking system) to create money.

The origins of central banks

Modern central banks are the result of the shared mutual interests of private banks and the state. In essence, the state granted the exclusive privilege to issue bank notes – for a certain amount of money – to a single bank, and received in exchange a credit by the bank of the same amount to cover its budget deficit.

This constituted true deficit monetisation as the deficit was paid for with newly printed money. As Vera Smith comments in her master work The Rationale of Central Banking and the Free Banking Alternative(1936), this exclusive privilege to issue notes was renewed and extended, both in relation to the area of influence of the bank notes and to the total amount of notes issued, every time the state needed further credit to finance increasing deficits. This monopoly of paper money was furthered by the imposition of legal tender clauses, while in many countries after the Second World War, the state took direct control of the central bank. This created an unstable monetary system that was heavily biased towards inflation.

Nevertheless, the monetary system – at least during the operation of the gold standard from the mid-19th century until 1914 – imposed effective limits on central banks’ proclivity towards money creation, as every single bank note had to be redeemable in gold on demand. As a result, money supply expansion was restricted, leading to a remarkable period of monetary and price stability.

These days, under fully fiat monetary systems, bank notes are no longer redeemable into gold and the acceptance of notes (as well as the stability of whole national economies) relies on central banks maintaining a disciplined approach to money issuance. But as the second half of the 20th century showed, central banks rarely stick to exacting standards. However, in our increasingly globalised world, people can often elude the effects of reckless monetary policies by buying sound currencies and gold and silver. In the face of this reaction, at the end of 20th century, states had no choice but to resume the independent status of the central banks and to let them conduct a monetary rule committed to maintaining low inflation. This, however, was not enough as central banks continued to issue excessive amounts of money – a key cause of the last financial crisis of 2007-08.

Maybe one day governments will again recognise the benefits of sound money.

Author: Juan Castañeda

Read Full Post »