Wednesday, December 29, 2010

Central Banking for Dumbos, Part IV: What the Heck is a "Central Bank"?

(Welcome to our 700th blog posting. Now that the cheers have subsided, read on.) Concluding our short series of postings on Central Banking for Dumbos, the basic idea behind a commercial bank (the most common type of bank of issue) is that, by substituting its good name and creditworthiness of the bank for that of the drawer of a bill of exchange, risk is spread out and people have more confidence in the currency. The banknotes and demand deposits of a bank that discounts and rediscounts bills of exchange issued by many different drawers are more likely to be "good" than the issues of a single company or individual that acts as its own banker. The bank's name and reputation is also more likely to be known and trusted than that of an individual or company.

If a bank of issue can do that for individuals and companies, then why not an institution that can do the same for the banks themselves? Why not a bank of issue for banks of issue?

That is the basic idea behind a central bank. A commercial bank that discounts bills of individual drawers of bills in an area served by a single bank of issue ensures that all the currency in that area has the same value. Similarly, a single, central bank that serves all the banks of issue in a country or economy ensures that all the currency in that country or economy has the same value.

A commercial bank ensures that all of its currency has the same value by being equally liable for every promissory note it issues and every demand deposit it creates. It doesn't matter how honest or shady the individual who uses the banknote or writes a check, as long as the instrument itself is good and a reputable bank stands behind it. By discounting bills of exchange from individuals, the commercial bank substitutes its own obligations for those of the original drawer of the bill. In effect, the good name of the bank, presumably known everywhere in the district it serves, is substituted for that of the good name of the original drawer, who may or may not be known — and who may or may not be honest. The bank assumes the risk and the obligation instead of the holders in due course of the banknotes that replaced the bill of exchange.

Similarly, there are varying degrees of public confidence in different commercial banks. Bank A's notes might pass at a discount, where Bank B's might pass at a premium. Bank C's notes might pass at par. How do you make certain that all the banknotes in an entire economy or country pass at par?

By doing the same thing for commercial banks that a commercial bank does for individual drawers of bills of exchange. Just as individual drawers of bills discount their bills at a commercial bank with many borrowers, a commercial bank rediscounts the bills it receives in the course of trade at the central bank that has many member banks.

Rediscounting bills of exchange at a central bank that serves an entire economy not only ensures a uniform currency for that economy, it also minimizes risk by increasing the size of the "pool" of assets backing the currency and the number of individuals and institutions participating in the process of money creation. By this means, the percentage of "bad" debts/bills of exchange approaches the statistical average for that economy under existing conditions, spreading out the risk. The failure or dishonesty of a single individual or company — even region — is thus less likely to have as far-reaching or as long-lasting an effect than would otherwise be the case.

This is the risk-spreading principle on which insurance works. By pooling interests through the issuance of a common currency, a central bank ensures that everyone is equally affected by someone's failure — and that the effect is minimized. Of course, unlike insurance, the individual or company that fails still bears the full brunt of its failure. The effect, however, is not passed through to individuals and companies holding the bills of exchange issued by the failed company. Instead, only the commercial bank that discounted the bills suffers — and then only if the bills were not rediscounted at the central bank or adequately collateralized. This minimizes the effects throughout the economy, for just as the failure of a single borrower has a small effect on a commercial bank with many customers, it has even less of an effect on a central bank that serves many commercial banks.

Thus, just as a central bank ensures that the currency in an economy or country will have a uniform value, it also optimizes the possibility of that same currency having a stable value. That is, by spreading out the effects of any failures to an entire population (the larger, the better — you want to avoid any individual, business, or bank getting "too big to fail"), there is a greater chance that the value of a dollar today will maintain the same value as a dollar tomorrow, or next week, or next year.

We are not, of course, bringing in the time value of money here. The issue at hand is whether a dollar that buys X loaves of bread today will buy X loaves of bread next year. That is, whether the currency retains its value, not whether being able to buy X loaves of bread now is more valuable than buying X loans of bread next year. A properly run central bank optimizes the possibility that, everything else being equal, a dollar that buys ten one-pound loaves of Grade A bread today will buy ten one-pound loaves of Grade A bread next year. (And, yes, Virginia, within living memory good bread once sold for between five and ten cents for a standard 16-ounce loaf.)

Finally, a central bank ensures that there will always be sufficient credit in the system to provide liquidity for financially feasible private sector economic growth and development. A commercial bank, of course, can do this for the area it serves by discounting bills of exchange, but (as we've seen) not in the most secure or stable way. The main reason central banks were invented was, in fact, to ensure that its member commercial banks would always be able to rediscount the bills of exchange that they had discounted, thereby always having sufficient liquidity to supply the needs of commerce.

In this way an entire economy would optimize the possibility that there would always be enough money and credit to meet the needs of commerce, and that the currency would have a uniform and stable value.

What about all those other things that central banks do today? What about funding government debt, ensuring full employment, and providing jobs for Nobel Laureates?

Those are all very well in their way — except that all of them represent more or less egregious misuse of a very specialized and extremely powerful financial and monetary tool. Our concern in this short series has been to show what central banks were intended to do, not what they've been manipulated into doing. That's a story for another day.

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