Wednesday, January 8, 2014

A Brief Course in Banking Theory, IIIa: Central Banks


Yesterday we promised to take a look at central banks.  Today we’re keeping that promise.  This is singularly appropriate, because issue banking and central banking (a type of issue banking) run on promises.  If people don’t keep promises, banking, even money and credit, simply don’t and won’t work.

We ended yesterday by asking the question, What happens when all the independent banks of issue go their own way?  The brief answer is, “trouble.”  If nothing else, the dollars (or whatever the currency unit happens to be) issued by one bank will not have the same value as the dollars issued by other banks.  And what if the assets behind the dollars issued by one bank go bust, or were not good in the first place?  Suddenly all the dollars issued by that bank become worth less — or even worthless.

What’s the answer?  In 1694 some bankers in the City of London came up with one.  If one bank is too risky, and all the issues of the different banks have different values, why not establish a central agency to impose uniformity and stand behind all the different issues of the different banks?  That way, all banknotes issued by banks that are members of the central association will have exactly the same value, and if one bank’s assets go bust, the assets of all the other member banks will still stand behind all the banknotes.

Thus, the central agency would be a “bank for banks.”  It would ensure that the paper currency would always be backed by private sector hard assets, and that all banknotes issued by the member banks had exactly the same value.  Further, every member bank would be able to get emergency reserves in case it ran short or there was a “run” on the bank (i.e., every depositor demanding his money right now), and there would always be sufficient credit for business and commerce.

We won’t go into how the founders of this first “central bank,” the Bank of England, had to bribe the government to get a royal charter and began backing banknote issues with government debt instead of private sector hard assets; we’re explaining how central banking is supposed to operate, not how it does.

So a central bank was only ever supposed to ensure that all paper money has the same value, that the value is stable, and there’s always enough credit for business.  The way a central bank is supposed to operate is actually very simple — and that’s what we’ll look at tomorrow.

#30#

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