Central Banks: the Captains of the Economy

Published: 31 August 2009

A central Banks is the authority responsible for determining and implementing the monetary policy of a nation. As the originator of all currency in the economy, it possesses a degree of control over the amount, and cost of credit available to borrowers. In most nations central banks are also responsible, at least in part, for regulating the banking sector, and maintaining the value of the national currency against its competitors.

History

The first central bank in history is the Riksbank in Sweden, established in 1668. It was followed by the Bank of England in 1696. The Riksbank was created to stabilize the Swedish economy following the collapse of a private bank which issued too many banknotes without the backing of collateral. The Bank of England was established to subsidize government operations. At first central banks had a very different role than what we are accustomed to today. In time, their duties and areas of responsibility expanded to encompass a wide range of areas, from maintaining the stability of the financial system, to extending to credit to illiquid banks. Before our present-day era of fiat money, central banks had to tie their issuance of credit to some kind of hard asset, such as gold, in order to maintain credibility. In today’s world the asset backing the central bank’s issuance of currency is its own credibility, and in a wider sense, all the goods and services created in the borders of the nation.

Monetary Policy

The central bank is responsible for declaring and implementing the monetary policy of a nation. Central banks can implement monetary policy towards different purposes, such as mirroring another central bank, controlling currency prices, or inflation. Among nations that target currency prices, those that run a current account deficit seek to appreciate the national currency in a bid to maintain purchasing power, while those with a surplus prefer to keep the currency cheap so as to maintain competitive power in the international markets, although at times this paradigm may be reversed. The structure and mission of the central bank reflects this purpose as well. Economies that are largely dependent on exports with a comparatively small domestic sector, such as Singapore or Hong Kong, generally tie monetary policy to the value of the local currency and conduct regular interventions. Others maintain a currency board for political purposes, such As Bulgaria or Esthonia. Economies with a large domestic sector, such as the U.S., Europe, or Japan, seek to maintain a balance between the needs of the various sectors of the economy.

Monetary policy in advanced, large economies generally aims to keep inflation low. By adjusting the amount of lending going on in the economy through the main interest rate, the central bank attempts to prevent the national economy from overheating, in order to keep a ceiling over inflation.

Finally, the central banks of nations maintaining pegged currencies possess no independent policy direction, but merely mirror the policies of the controlling central bank in order to prevent arbitrageurs from exploiting any policy differences for profit. The relationship between the Danish Central Bank and the ECB is a good example of such a relationship. Although there is a diversity of goals and policy directions among the various central banks of the world, but the tendency is increasingly towards interest rate targeting as the main guideline of policymaking.

Currency Issuance

A unique power of a central bank is seigniorage, or the right to issue currency. By exercising the right of seigniorage, the central bank has the power to create unlimited credit to be distributed among market participants. Clearly, the combination of fiat-money and seigniorage can be very destructive if utilized for political purposes at the hands of a government. Hyperinflation, as exampled in present-day Zimbabwe, and chronic inflation in the 80s and 90s has led to many nations granting the privilege of issuing money exclusively to independent central banks, in order to prevent populist governments from abusing the power for electoral gains or short term advantage.

Banking Supervision and Regulation

Apart from its responsibilities at the macro level, a central bank is often tasked with banking sector regulation in cooperation with other public authorities which are specialized in oversight and regulation. In the U.S., for example, banking sector oversight is the duty of the FDIC (Federal Deposit Insurance Corporation), the OTC( Office of the Comptroller), and the Federal Reserve. In the U.K. this role is exclusively assumed by the FSA.

In addition to its role in banking sector supervision, a central bank is also the “lender of last resort”. When a fundamentally solvent firm faces a liquidity shortage and finds it difficult to meet its obligations in the wholesale market, the central bank is expected to intervene and provide the liquidity to ensure the smooth functioning of the financial system. In modern times it is also customary to see central banks intervene to protect an insolvent firm from becoming bankrupt if it poses systemic risk, in other words, if its failure will lead to a chain of bankruptcies, eroding the credibility of the system, leading to bank runs and other unforeseen consequences.

Impossible Trinity

One of the more important constraints faced by central banks while formulating policy is the impossible trinity of controlling currency prices, interest rates, and maintaining an open economy at the same time. First examined in a model developed by Mundell and Fleming, the impossible trinity simply states the incompatibility of an open economy with state control on a large scale. If for example, a central bank desires to reduce interest rates, investors will sell that curency in order to seek higher yield in other currencies, which will lead to a cheaper national currency. The only way to prevent this from happening while keeping interest rates low is closing the capital account, and preventing citizens and investors from acquiring assets in other nations. In that case, the currency price will not fall, because the currency is only available in limited quantities determined by the central bank outside the borders of the nation. Conversely, it is not possible to maintain an open economy, and raise interest rates, while also keeping the price of the currency low. If the economy is open, foreigners will flock in to profit from the high rates available, creating the impossible trinity.

Central Banks and Forex

Central Banks are the most important actors in the forex market, although in terms of market volume, and amount of money controlled, they are not the most powerful players. Theoretically they possess infinite powers over the supply of the national currency. They can sell as much of it as they want, and withdraw it from the international market by intervening with required amounts of foreign currency, in other words, the foreign exchange reserve. As such, forex traders carefully monitor central bank reserves, and the policies of the institution in order to make sense of price movements and trends.

Apart from determining trends in the carry trade by adjusting the main lending rate, central banks have an important role in steering the growth path of national economies. Not just in terms of immediate forex flows, but also with respect to long term investment, and trends in consumption, and industrial activity, as well as lending and the availability of credit, the central bank plays a very important role in creating currency trends.

However, central banks are not all powerful. The great powers enjoyed by them can easily lead to ruin and financial chaos if used recklessly. Numerous past examples in developing as well as developed nations demonstrate the great dangers involved in using the seiniorage privilege recklessly. The wretched situation of modern-day Zimbabwe, where the economic norm is recession, and the painful memories of Germany following the First World War provide sufficient samples on how severe the consequences of excessive money printing can be. In the modern world central banks extend credit often without having to expand the actual supply of coins and banknotes, but the results are the same.

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