Tuesday, August 20, 2013

The true role of a central bank

At the Princeton graduating ceremony in June 2013, Ben Bernanke in his commencement address admitted to the graduating students how economics had failed to read the future:
“Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much. However, careful economic analysis does have one important benefit, which is that it can help kill ideas that are completely logically inconsistent or wildly at variance with the data. This insight covers at least 90 percent of proposed economic policies.”
The prognosis failure is a serious indictment of the economics profession. Yet Bernanke had the gumption to claim that economics was able to correctly explain the past. Had this remark been made of any other knowledge discipline, that discipline would have been ridiculed for its claimed robustness despite failure in predicting the future. As for the past, anyone can rationalise why things unfolded any which way. In fact, economists are no different from lawyers, every one of them believes in the correctness of his own opinion despite wide and deep differences between every one of them. The only valid test for an economist's opinion is how close it is in predicting the future, and in this respect most economists' reasoning would fail scrutiny.

With this kind of shaky grasp of major economic events, economists are ill suited to the task of running a country's central bank. You don't need an economist who is too clever by half to control the monetary policy of a country. Instead the job must be made foolproof enough for a fool to handle it.

But an economist, or anybody for that matter, can run a commercial bank because money is the easiest thing to sell, or rather lend. You really don't need to convince buyers to buy as money sells by itself. The only time you can't sell money is when prices are falling because the collateralised asset will be worth much less than the borrowed amount. That's why banking requires persons with conservative demeanour, not flamboyant salesmen nor smart brains. As banking uses other people's money (OPM), technically there's no limit on how much you can borrow and lend. But more loans lead to more risk. Herein comes the role of the central bank, that is, to ensure that all the lenders in the country do not borrow and lend money beyond what they can absorb in potential losses.

As for a central bank, do we need it in the first place? In my earlier post, I've argued that the objectives of the Fed as set out by Congress are all unattainable. Those objectives however don't include the received wisdom about the role of a central bank, that is, as a lender of last resort. This is equally wrong because first, it distracts the central bankers from their real role and second, it requires colossal financial resources.

As a lender of last resort, a central bank subverts the role of the executive and the legislative assemblies as only these two branches of government have the right to decide whether the government should bear the cost of massive bank bailouts. A central bank is not answerable to the electorate and cannot spend money willy-nilly even though it can print as much money as it wants. Printing money and spending money are two unrelated issues which have confused many economists. If printing can be equated with spending, Obama wouldn't have any problem with sequestration.

What then should be the role of a central bank? The US used to live without a central bank for a long time. In fact, the Federal Reserve was only set up in 1913. Before the existence of the Fed, the only semblance of a central bank that the US ever had was the short-lived First and the Second Bank of the United States (BUS) which were chartered in 1791 and 1816. These were private banks run on a commercial basis but both didn't last beyond their 20-year charters. They didn't get their short lives extended primarily because many people were envious of private organisations enjoying benefits from the federal government. The First BUS wasn't really a central bank in the modern-day sense as its original purposes were to issue notes, pay off the war debts as well as offer commercial loans at a time when there was a dearth of commercial banks. Its notes were in demand as they were accepted for tax payments.

Soon after the demise of the First BUS, the War of 1812 erupted between the US and Britain, stimulating the need for money. Many state banks were established leading to the proliferation of their own unique banknotes, and in its wake, rising inflation. The problem was compounded when the banks of the southern states suspended redeemability in specie (gold or silver coins). Because of this crisis, the US government decided to reestablish the BUS.

As the US government kept its deposits with the BUS, its banknotes had an implicit sovereign backing, enabling them to be accepted at face whereas those of other banks would be discounted. This function of providing a uniform currency however is not the sole preserve of a central bank; the Treasury can perform this role. The easiest way of effecting this is for the government to back the currency. Demand can be created by insisting that taxes be paid using the bank's notes. Had the US government in the early years of the republic settled on a uniform currency, the confusion created by having to fix the discount rate of other banknotes or trying to figure out whether the banknotes were valid would have been unnecessary.

Another central banking role performed by the Second BUS is more relevant. As the Second BUS was the collecting agent for the federal government revenues, it received a large volume of state banks' banknotes. Also, the Second BUS monitored the foreign exchange rate of the US dollar. If the rate went down, it meant that there was too much money (or credit), so it would redeem the banknotes of the respective state banks in specie. As a result, the state banks tended to be cautious in making new loans as it would mean more of its banknotes would be in circulation and a higher need for specie should the banknotes be redeemed.

This role, that is, ensuring that banks don't increase their lending indiscriminately is more important than being a lender of last resort. As mentioned earlier, banks have a morbid tendency to keep increasing their loans since the source of funds is other people's money. Without adequate checks from the central bank, the leverage ratio would quickly multiply, creating a debt mountain that will eventually collapse. Had a central bank carried out its more important role of crimping credit creation in the first place, a lender of last resort role is superfluous.

A good analogy is to picture the central bank as a prison warden and the banks as prisoners. The prisoners are always on the lookout for escape, which in the case of banks means to lend more and more using OPM. The warden's job is to curtail such tendencies through regular checks and audits. For those that manage to break out, the warden has to impose penalties upon capture. The demands imposed on these tasks require the full-time attention of a warden, to wit, a central bank.

A monetary collapse is further facilitated in a specie based monetary system. Actually a specie based system can never be fully backed by specie, typically represented by gold or silver or both, since there is never enough gold or silver to back all the currency notes in circulation. It's an anachronistic system which should have been abandoned long ago. This was demonstrated by the 1819 panic, the first financial crisis in the US.

In this panic the Second BUS was not irreproachable. Along with the state banks, it contributed to the 1819 panic because of excess debt. Napoleon also sowed the seeds of this crisis. Because of Napoleon's need for cash for his European wars (1803-1815), he sold Louisiana — actually all or part of 15 states right from the Canadian border to the Gulf of Mexico — to the US government for $15 million in 1803 (see the orangish bit on the Wikipedia map below). With that, the barrier to the westward expansion of the US was lifted. Also because of the Napoleonic Wars, the US gained from trade surpluses arising from exports to Europe but as the wars ended, Europe made a recovery in its agricultural production in 1817. Cotton also had a new competitor from India, resulting in big drops in cotton prices. The surpluses now turned into a deficit, causing specie to outflow. Furthermore, the US government in 1818 wanted to redeem in specie $2 million worth of bonds that had been raised for the Louisiana purchase. This meant that the credit overextended during the surplus years had to be called in, causing farms and businesses to foreclose.


We can glean two important lessons from the crisis recovery. First, the policymakers suspended specie redemption, thus expanding credit. Any credit contraction crisis can be solved by unshackling credit provided there is enough consumption (people with incomes) to offload capacity. Otherwise the excess credit would go towards funding asset investment which will be written down once deflation takes root. Second, relief was extended to debtors instead of creditors, through the Relief of Public Land Debtors Act of 1821 in which buyers of government land were allowed to keep the proportion of land they had paid and relinquish the balance.

But in the present crisis, the government has gone out of its way to protect the banks. The creditors are the winners, and winners will continue to win as long as we are still in the same Kondratieff Wave. An absence of government help represents only a minor setback to the winners but to the losers, that is, the borrowers, it can be a difference between living on food stamps and living on food kitchens.

The 1819 panic was however a mild foretaste of the more calamitous 1837 panic. Even before the Second BUS's charter lapsed in 1836, the federal government had started transferring its deposits to the state banks from 1833. Flushed with these deposits, the state banks went on a lending binge, especially in financing the westward expansion land sales. These land sales enabled the US government to pay off all its debts — probably the only time it was able to so. However whenever a government has its accounts in surplus, unless it's a small city-state, the surplus spells economic troubles ahead as the private sector would've been deep in debt. By 1836, President Andrew Jackson, troubled by deposits not backed by specie insisted that land sales be made in specie. The specie was withdrawn from many banks and deposited with the land offices or banks of the western border states. As a result the banks suffering from specie withdrawals had to curtail their lending by calling in their outstanding loans, leading to a drastic drop in credit.

Exacerbating this situation was the canal and railway booms — remember that the US had a late start in canal building relative to Britain but its railways, or railroads as the Americans call them, were still in their early stages as reflected in their use of iron instead of steel — in which debt was the driving force. Although no records of credit issued were available, we can safely assume, given the three major investment mania of land, canals and railways running concurrently, that credit outstanding was substantial and had to fall drastically. It was this fall that led to a 7-year deflation, which actually was the first Great Depression.

Economic recovery was only felt in 1844 when trade revived as a result of crop failure in Europe, and debt liquidation no longer took hold. The repeal of Britain's Corn Laws in 1846 fostered the growth of US grain export. Elsewhere on the European continent, bad harvests in 1845 and 1846, followed by restrictive monetary policies to slow the loss of reserves led to the breakout of revolutions which almost toppled many governments across several countries.

In the US, recovery was further boosted by the Mexican-American War (1846-1848), the victory of which allowed the US to seize from Mexico territories ranging from Texas all the way to California. The new territories would lift the economy much later but for now, the immediate boost came from the war spending. In 1847 the federal deficit increased to $31 million, the largest deficit since the founding of the US Republic. Defence alone soaked up $48 million of the $61 million spending in that year. The deficits regressed but continued till 1849, at a time when the norm was federal surpluses arising from land sales. Now, who said that military spending or a budget deficit could suppress the economy? The deficits created credit or money but in the present crisis, that option is no longer available as there is no silver lining, in the form of future income windfall, to offset the massive debts that most governments have piled on.  The Second Kondratieff Wave technologies of railways (steel-based) and telegraph appeared right on cue to link the vast distances from the Atlantic to the Pacific, symbolised by the pounding in of the Golden Spike in Utah in 1869.

In all these events, no central bank was needed to hasten the recovery process. Again important lessons cannot be missed on how the impact of the depression was mitigated. A short-lived Bankrutptcy Act became law in 1841 though it was repealed in 1843 but within its brief existence, it managed to wipe out $450 million worth of debts owed to a million creditors. Though it was the second bankruptcy act, it was the first to provide for both voluntary bankruptcy and individual debtors instead of just merchants and traders. Still, it discouraged investors from making new loans though the lessons from history tell us that their fears will vanish once good investment opportunities appear. In alleviating the sufferings, borrowers deserve more assistance than creditors.

In a future post, we'll continue with how the Fed came to being following a crisis that was resolved by a lender of last resort and how that continued to guide the Fed's actions. The Fed has no memories of how curbing of runaway credit growth would've been the more appropriate role for it.

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