Relevance of central bank

Question

Why do we need central bank ? surely the government can print currency (say at a regular 5% a year to create some inflation) and regulate banks by conducting audits through finance ministry and so on. Why do we need central bank setting interest rates? Surely private banks could set their own interest rates just like any other business sets their own prices.

Answer 1

On a day-to-day basis in ordinary times, a government-owned central bank is not necessary. The United States did not have a central bank before 1913. There are two questions, I believe, hidden in your query. The first question is, do banking systems of any size need a central bank? The second would be about whether or not it needs to be government owned?

I will make my answer somewhat generic, so do not assume that governments print money or that the national government can create banks. Do not assume fiat money or commodity-backed money. The United States did not print money until the Civil War. From 1806 to 1857, foreign specie was lawful tender for all debts, public and private. Foreign specie continued to be accepted until around 1870 except for the payment of federal taxes. Private banknotes didn’t vanish until Congress taxed them. In addition, banks in Scotland print their own money to this day.

So we should ask what functions do central banks perform? That depends on the nation. Could another entity perform them?

The answer to the first question, do banking systems of any size need a central bank. The historical answer seems to be “yes.” They need an agreed-upon bank to serve as a clearing bank, what used to be called in the United States city banks and country banks. One of those banks needs to act as a lender of last resort to the other banks in a crisis. For most of U.S. history, the banks had a banker’s bank. That bank had to be willing to lend reserves to banks that may fail and not repay the loan.

From a game-theoretic perspective as well as a historical one, the difficulty is that the designated bank may decide to turn into a turtle, protect itself, and not make the loans allowing the system to collapse. Without a bank with a statutory obligation to lend, the system was riskier than necessary than would exist with a bank backed by the sovereign. That does not imply that the central bank could not fail. On a specie basis, it could fail by having no remaining reserves and national outflows. On a fiat currency basis, the central bank could fail by having such a high inflation rate that it ceased having relevance and stopped being the marginal actor in a crisis. It would legally exist but not matter in any practical sense.

All large banking systems maintain private clearing systems in parallel with the government one. Some of these exist for statutory reasons, such as the fact that credit unions cannot be members of the Federal Reserve system, so somebody has to clear their check. Others exist because it costs less for a private system; or, the system performs other functions such as the Visa or Mastercard system like guaranteeing payments to merchants.

Should the government own the system? Until the shock of the 1907 banking crisis, which was set off by a single loan at the Knickerbocker Trust, I think the consensus answer in the United States would have been to say no. The 1907 crisis was enormous, and the government lacked a way to act quickly. It needed a bailout without a mechanism to pull it off. Through a series of coordinated rescues, J.P. Morgan became the coordinator of lenders of last resort. The government deposited money in weak banks, large businesses, and wealthy individuals made large cash deposits and so forth, all coordinated by Morgan.

At first, he was a hero, but then resentments grew. He could have demanded any price from the government, including being made king. Had he had a different character, he could have let the place collapse and bought tangible assets up for pennies on the dollar. The Federal Reserve grew out of the realization that the de facto central banks in the United States were outside democratic control. Shareholders and not voters determined, indirectly, which businesses would fail and which jobs would be lost.

The intent of the framers of the Federal Reserve Act, from Congressional testimony, was that it would work like the Bank of England and nearly exclusively buy what is now called commercial paper in the United States. It would provide liquidity to large merchants, particularly in international trade. In the end, that never happened. Instead, the Fed bought bills, notes, and bonds from the Treasury and, until the 2008 financial crisis, avoided direct interaction with the economy.

So, as a lender of last resort, there should be some government backstop if the concern is that democratic control should trump the power of the wealthy in a national crisis.

Now, as to other functions, most of them do not need to be performed strictly by a central bank. The FDIC, for example, examines all but the handful of banks that are federally insured. A few decades ago, about two dozen uninsured banks still existed, but I wouldn’t be surprised if they vanished in mergers. The Federal Reserve audits member banks, but there is no reason they have to. They are just convenient for the role.

There is an open question as to whether or not a central bank should control the money supply or whether the government should have the power to print money. Certainly, Scotland is an example of a case where private banks can print their own banknotes. Before the Civil War, that was common in the U.S. Still, Scottish banks do not control Scotland’s money supply.

The other question, should a central bank control the money supply, is a political question that is answered by what consequences do you not want to have. The two alternatives would be to let supply and demand create and destroy money at will or have a private or governmental ministry perform the function.

Do you want a government ministry to be able to outbid its citizens on unnecessary projects in order to get re-elected? Without a central bank, there is no check on the executive’s ability to fund projects by simply printing money and getting appropriate language in the law. You could end up with one governing coalition forever. Do you want a private coterie of wealthy individuals with the monopoly power to determine what gets funded and what does not? The independent central bank is the compromise in use in most nations.

As for a supply and demand based solution, do you want deeper recessions and larger booms? That was the result in most of American history before 1913. The money supply was unregulated, and the booms were bigger, and the collapses were larger. They were also more frequent than in the 20th century. We will have to see about the 21st. The answer to that question is really a question about the risk tolerance of the voter. Allowing supply and demand to rule also works, but it can be a wild ride. One need but look at the overnight cost of funds in New York for principal merchants during Andrew Jackson’s crisis to watch how much your perpetual reserves might have to be in order to run a business that can survive.

The job of a central bank is not to control supply or demand but to transition markets from one level to another. However, in a crisis, it can create a supply that changes the factor costs of doing business enough to alter the real supply of services and goods, ignoring the case of a liquidity trap.

Answer 2

First of all, Central Banks like the FED cannot even print money in the conventional sense.

Secondly, Banks do set their own interest rates, just look up deposit rates, or mortgage rates. They will be influenced by monetary policy decisions, but that is about it.

Thirdly, a bank however doesn't care about the overall economic conditions when deciding about their actions. So no Bank will engage in the act of trying to fine tune the economy.

Most central banks have supervisory and regulatory powers to ensure the stability of member institutions, to prevent bank runs, and to discourage reckless or fraudulent behaviour by member banks. All of which is a constant problem in banking.

Giving money supply to the government is like letting your child decide how much pocket money to get. Historically (and there will certainly also be new examples in the future), this frequently resulted in hyper inflation. Assuming any government would stick to a constant monetary growth rate is illusionist at best. Assuming a constant growth rate will be beneficial is in itself questionable.

Answer 3

So why did we need a central bank? Well, lets look at what the co-author of what has gone down in history as the Aldrich Plan, named after Senator Nelson Aldrich. His co-author on the bill was Edward Vreeland who wrote in August 25th, 1910, in the Independent, a newspaper owned by Nelson Aldrich that, "Under the proposed monetary plan of Senator Aldrich, monopolies will disappear, because monopolies cannot continue at such a low rate. Also, this will mark the disappearance of the Government from the banking business."

An interesting piece of trivia is that when our modern day "Federal Reserve System" was being planned, Paul Warburg who was a European from Germany that worked for the banking house Kuhn, Loeb and Company informed his other colleagues that were also planning for this new system that we have today, to avoid using "central bank" in the name. That's how we got this name of "Federal Reserve System", but it's basically a central bank with a new label, new to the early Twentieth Century.

Another piece of trivia is that the argument for a central bank in 1812 was presented as being that financial distress brought about by the war (War of 1812) required financial relief in the form of a new national bank.

This was at least the argument made for the second central bank that was charted in the history of the United States, the House and Senate passed a bill creating the Second Bank of the United States. I am speeding through history here.

One last piece of trivia that speaks to your statement of, "surely the government can print currency and regulate banks by conducting audits through finance ministry and so on".

At the outset the opinion of Thomas Jefferson made the powerful argument regarding the proposal for the first central bank of the United States:

I consider the foundation of the Constitution as laid on this ground; That "all powers not delegated to the United States by the Constitution nor prohibited by it to the states, are reserved to the states, or to the people." To take a single step beyond the boundaries thus specifically drawn around the powers of Congress is to take possession of a boundless field of power no longer susceptible of any definition. The Bill delivers us up bound to the National Bank, who are free to refuse all arrangements, but on their own terms, and the public not free, on such refusal, to employ any other bank.

The bill that Thomas Jefferson referred to was one put before him by proponents of central banks, namely Alexander Hamilton.

Citation:

1. Charles A. Lindbergh, Sr., Banking Currency and the Money Trust
2. The Writings of Jefferson, vol. 7 (Autobiography, Correspondence Reports, Messages, Addresses and other Writings)(Committee of Congress: Washington, D.C., 1861) page 685.