Monday, 21 January 2013

Why do we have central banks?

Why do we have central banks?

Why do nations have central banks? And if they do not, why are they pressurised to have one? The answer lies in their function to stabilise prices and maintain full employment by monetary policy. This post will expound of the function of the central banks in inflation targeting, being a ‘lender of last resort’ and ensuring financial stability. These are the three crucial reasons why countries have central banks. Before concluding, a brief look at the Radcliffe Report will be made in order for us to really get down to whether the existence of a central bank is in fact as necessary as we make it out to be.

Inflation Targeting
It is accepted that it is the role of central banks to target inflation and achieve full employment synonymously through one unified monetary policy. However, in this post I want to focus mainly on inflation targeting, as the specificity with which the goal is carried out implies that it a goal of higher priority than full employment. 
According to mainstream economic theory, money is endogenous and thus has the ability to be controlled by an external agent such as the central bank. By controlling the money supply, inflation can be easily targeted. This is simply explained through Fisher’s Quantity Theory of Money which states that the velocity of money is constant in the long-run and national income is fairly predictable therefore according to the formula MV = PY, money supply is equal to the price level. 
By manipulating interest rates, you determine how much money is spent in the economy and how much is saved. Open Market Operation, too alter the amount of money held by the central bank, instead of the amount held by the public. So it fairly obvious then  that central banks can do this. This was very much believed to be the cure to inflation in the 1970s and influenced important economic events such as the Thatcher experiment. 
Then, why does the central bank need to be involved, surely the government could carry this task out? What happened in reality is that governments manipulated interest rates in political cycles, loosening monetary policy when election time drew close. Thus, by having an independent central bank with the sole goal of inflation targeting, short-political cycles would not form and inflation would be under control.
Central banks, that inflation target as a priority have a very specific criteria that they follow. For instance, they have an established numerical target like the Bank of England has of 2% and our transparent about the mechanism they use to achieve this goal. It is clear then that the Fed for instance could not be said to be inflation targeting in the strict sense, so what are some of the other reasons for having a central bank?

“Lender of Last Resort”
Central banks are deemed to be lenders of last resort, but what does this mean? This means that when liquidity dries and there is no credit being lent as seen in the Financial Crisis of 2008, it is the responsibility of the central bank to lend money and stimulate the credit market. This was based on the economic theory that banks should act as if no central bank existed in boom times and in bust the central bank would aid the economy. Thus we need central banks. In the Financial Crisis of 2008, the accumulation of ‘bad debt’sucked the credit out of the money market, had it not been of the central banks and their manipulation of quantitative easing, we would be in a worse position than we are today, so the theory goes. 
However, as mentioned before it was ‘bad debt’ which dried the credit market, debt which essentially cannot be paid so how will central banks lend non-existent money? They sell government bonds, however, this lends to an increase in money supply and pushes up inflation. Already we can see clash in the functions of the bank. The point to note for this post is that without a central bank, these problems could not be solved, so the theory states. 

Financial Stability
After the wake of the Financial crisis there has been a lot of talk on the role of the central bank as the banking supervisor, without whom we will not be able to avoid another financial crisis. This is because the central bank supervises commercial banks and ensures that all banking practises is sustainable. 
Financial stability links very closely to the need of central banks in inflation targeting. Political monetary cycles as discussed before cause instability and that is what gave birth to idea of an external institution, a central bank in stability. Conventional wisdom is that leaving the money market to the invisible hand of supply and demand is ineffective and too dangerous and thus the need for central banks. 
In the banking sector particularly, information asymmetry is a problem, as Goodhart points out consumers just don’t know the difference between banks. Therefore, some kind of security and buffer cushion like a central bank - a lender of last resort- becomes even more crucial in creating stability and given consumers and investors confidence. 
Central banks usually help create financial stability by setting reserve requirements too which are minimum requirements of deposits that banks have to keep as reserves. Commercial banks are profit-maximising enterprises and reserves make no return what so ever. Returns come from lending money in various forms so banks will want to keep reserves as low as possible so having a central bank which sets reserve requirement particularly helps in taming commercial bank drive for profit. 
Moreover, central banks also ask commercial banks for bank balance details etc and create ratios which they can pass to the Financial Services Authority for checking and monitoring.

Radcliffe Report
Before concluding, it is important to look into the Radcliffe Report. All the purposes and need for central banks highlight above rest on the assumption that money is exogenous and thus can be controlled. However, in 1957, a report chaired by Lord Radcliffe argued something else. The report essentially said  there are two reasons why central banks have a limited role/need when it comes to stability and that is that (i) central banks can never completely control money supply as there are many near-money substitutes such as savings deposits and (ii) velocity of money cannot be controlled and has the power to alter inflation significantly. The report was completely forgot about with the creation of the Quantity Theory of Money and the rise of the monetarist.
The interesting thing is that now, after the Financial Crisis, questions regarding the exogenous of money supply and therefore the role of central banks have appeared again. Moore for instance says that central banks can maybe control the supply price of money via interest rates but cannot control the quantity of credit and by implication the need for central banks extinguishes into something quite menial. 

In sum, the need for a central banks relates to stability in the economy, whether it is price stability, financial stability or liquidity stability in downturns. However, the Financial Crisis 2008, has drawn some light into whether this is really a need and whether central banks are actually effective at what they do. The key problems with them can be drawn back to the Radcliffe Report of 1957.

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