Is the central bank a bank at all? The case for a privately-owned central bank

Last month I had the pleasure to contribute to the IIMR/IEA annual monetary conference (8 November 2017) in London, ‘Has Financial Regulation Gone Too Far? And do banks really need all the extra capital?‘. I gave a short talk in session 3, ‘The role of the central bank in financial regulation‘, chaired by Charles Goodhart (LSE), on the essential nature of central banks as banking institutions. It may sound silly to state the obvious but, as my good friend, mentor and excellent colleague – Pedro Schwartz – always reminds me, we should not take for granted the fundamentals in economics, even less in money and central banking. Let me then start by saying that modern central banks were established to cope with two major tasks: (1) to be the bankers of the State (the Bank of England and other continental European central banks are good examples of this, see here) but also (2) to become the bankers of the banks in monetary systems operated under a fractional reserve (again, the Bank of England is the first modern central bank in this regard); the latter is what we call the lender of last resort function of central banks.

In the early years of the establishment of central banks, with the running of the gold standard, strictly speaking, there was no monetary policy nor the pursue of a macroeconomic target as we understand it now; but a bank of issue with a privilege position in the monetary market, and mainly focused on maintaining the convertibility of its currency at the pre-announced rate. It was only quite recently (historically speaking), after the abandonment of the gold standard in the interwar years, that central banks have explicitly adopted or given other tasks, and indeed macroeconomic tasks, such as keeping price stability or achieving economic growth.

But we should not forget that central banks are at the core of the monetary system and the banking sector, providing financial services to a ‘club’ of commercial banks which create money in the currency issued by the central banks. Which money? ‘Bank money’, that is, bank deposits under a fractional reserve system. This money constitutes the bulk of the money supply in modern economies, and it is vital for the central bank to keep a steady growth of the amount of money in circulation to preserve stable and long term economic growth; thus avoiding too much money during the expansion of the economy or too little in a banking crisis. What I state in my talk is that privately-owned central banks are genuinely interested in maintaining financial stability, and thus will be willing to intervene in a liquidity crisis much more promptly and efficiently than a central bank under the shadow – if not the control – of the State. This is something I have supported in other articles (recently in this article), and my colleague at the IIMR, Tim Congdon, has written on (see chapter 7 in ‘Central Banking in a Free Society‘).

This is the video of the talk:

Comments are very welcome as ever!

 

Juan Castañeda

PS. To the best of my knowledge the characterisation of central banks as the bankers of a ‘club’ was first coined by Charles Goodhart in his seminal 1988 book, ‘The Evolution of Central Banks‘, a book anyone interested in the history and functions of central banks must read. However, unlike Goodhart’s position in his book, I do not see a conflict of interest for a self-interested central bank to become a lender of last resort in times of crisis. Actually, central banks did make a profit when lending in times of crisis, such as the Bank of England in several banking crises in the 19th century.

 

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Invite: Professors Geoffrey Wood and Tim Congdon on monetary policy and central banking

Within the launch event of the new MSc in Money, Banking and Central Banking (hosted by the Institute of Economic Affairs in London, 13th March, 12:00-14:00), I will be delighted to introduce two of the teaching staff of the programme, Professors Tim Congdon and Geoffrey Wood, who will be discussing the major topics covered in the programme: such as policies aimed at achieving price stability and financial stability, as well as the current debates on alternative central banks’ strategies and the effects of tighter bank regulation in a post-crisis era. A key question is to assess whether central banks should shrink their balance sheets and, if so, the strategy to do it so economic recovery is not harmed by a shortage in the amount of money. Ins this regard, the US Fed’s Quantitative Tightening policy in recent months will be discussed (see a more detailed analysis here: http://www.mv-pt.org/monthly-monetary-update) along with other alternatives.

This is a new MSc focused on how money is created in modern economies and on how changes in the amount of money affect prices (all prices, consumer and asset prices!) as well as income along the cycle. In addition emphasis is given to the functions, operations and monetary policy strategies of major central banks, so we can understand better the way monetary policy makers actually make a decision. Surprisingly enough, this very classical approach to money and central banking has become quite distinct and unique,  since monetary analysis has been labelled as ‘out-fashioned’ and has somehow been disregarded in the last two decades. The MSc is offered by the University of Buckingham and you can find more on the programme and how to apply here: https://www.buckingham.ac.uk/humanities/msc/money-banking .

Places for the launch event are still available. Should you want to attend RSVP to enquiries@mv-pt.org or call Gail Grimston on 01280 827524. For those who will not be able to make it we will be recording the presentation and the debate and upload it on the Institute of International Monetary Research‘s website (http://www.mv-pt.org/index).

All welcome!

Juan Castaneda

 

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Selgin on deflation(s)

Professor G. Selgin (University of Georgia and Cato) has masterly studied the question of deflations and distinguished those benign deflations, associated with increasing productivity and economic growth, from those recessive deflations associated with stagnation in the economy, increasing unemployment and financial instability, which seems to be the only one mostly considered by all and sundry. As Hayek did it in the 20s and 30s last century, Selgin has studied in detailed this question and has emphasised the notable implications of distinguishing amongst these different types of deflations in the running of a sound monetary policy rule (see his excellent Less than zero. The case for a falling price level in a growing economy, fully available at the IEA website).

One of the main implications of his analysis of deflations for policy making is that price stabilisation (either the price level or the inflation rate) is not a desirable policy criterion if we are committed to achieving monetary stability in the long term: it can lead to excessive money growth in the expansions of the economy (thus, monetary disequilibrium), being a major pro-cyclical policy that will destabilise financial markets in the medium to the long term. Other, both theoretical and operational, critiques to price stability as a policy criterion can be found here. This is by far the main lesson that can be drawn for the recent financial crisis and its precedent years, and it will a be very useful one if we do not want to resume the same policy rules that have contributed to the recent crisis and the monetary and financial chaos in which we are still in.

Enjoy George Selgin’s video, which is a recent CNBC interview; it is an excellent and brief explanation on the nature and consequences of different  deflations: http://video.cnbc.com/gallery/?video=3000171632

Juan Castañeda

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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

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How money is created?

A conversation on money, central banks (and much more)

GoldMoney has just published a very interesting video on money and the current Eurozone crisis. In the video, James Turk interviews Professor Pedro Schwartz (San Pablo University, Madrid) on how central banks create money in our days and on the risks of the current expansionary monetary measures announced and developed by two major central banks, the ECB and the Federal Reserve of the US. As you will see, Professor Schwartz masterly explains how money is created “out of the blue” and why he thinks the ECB is actually disregarding its own Statutes, that clearly establish the prohibition of lending to any national government. How is the ECB doing so? Very easy; by purchasing public bonds of the States in crisis indirectly, in the secondary markets, and by accepting those bonds as valid and unlimited collateral in the conduction of the standard open market operations. Doing so the ECB is actually loosing its independence from political bodies and governments, and it is expanding its own remit; which was just to preserve price stability in the Eurozone, and not injecting money to foster GDP growth in the short run or to finance the State(s). Professor Schwartz also talks about the risks of inflation in the medium to the long term coming from the current (massive) injections of liquidity of central banks in the money markets.

In sum it is a very clear and interesting video that I do strongly recommend not only to any student of Economics, but also to anyone interested in how money is created in our days.

You will find below the summary of the conversation as extracted by GoldMoney.

Juan Castañeda

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“GoldMoney’s James Turk interviews Prof. Pedro Schwartz who is the president of the Economic and Social Council of Madrid. They talk about bank regulation, the creation of money out of thin air and the beauty of the free market system.

They discuss how banks have expanded despite of government regulation which Schwartz in large attributes to the granted privilege of fractional reserve lending. Using this procedure a bank can create loans above the actual amount of deposits at hand and therefore create new money. This also leads to fragility in the banking system and to boom and bust cycles. Schwartz argues for a leaner and more effective regulation of financial markets as the current regulation has not worked in regards to the financial crisis.

They talk about the “tennis” between the Federal Reserve and the European Central Bank when it comes to the creating money out of thin air. Schwartz states that the ECB is disregarding the rules that were aimed to guard it from being influenced by political pressure. Despite the opposition of the German Bundesbank they are buying government bonds. This is equal to digital money printing and Schwartz scents that it is not being done for monetary policy, but for the stimulation of the economy which goes beyond the original remit of the bank.

However despite the injections of new liquidity by the ECB Europe is still in recession, because interbank lending has dried up. That means that banks are parking much of the liquidity back at the ECB. The big question will be what will happen to inflation once the economy starts to pick up again and those funds find their way into the real economy. Schwartz also questions whether it is a productive business when banks can make a profit by borrowing money from the ECB at 1% interest and then turning around to buy government bond which yield 5% or 6%.

A serious inflationary disaster will only be prevented if governments will succeed in reducing their deficits and stop selling bonds. Schwartz states that cutting government spending is the only viable solution to the problem. To accomplish this there has to be a change in social mentality so that people recognise that nothing is free and that the government sector has to shrink. In the end the market is the most efficient mechanism of allocating resources according to the wants and needs of people.

This video was recorded on 14 September 2012 in Madrid.“

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(Summary from: http://www.goldmoney.com/video/pedro-schwartz-on-the-creation-of-money-out-of-thin-air.html)

 

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