Tuesday, March 17, 2015

What Is a Central Bank Supposed to Do?


Happy Saint Patrick’s Day.  We won’t be wearing green on the blog today, but we will be talking about it.  Long green, that is: money.  Admittedly, that’s a pretty clumsy way of segueing into our subject, but they can’t all be smooth . . . which doesn’t detract from the importance of what we’re talking about.

"Ich bin der Stat...I mean..."
Ask most people today what a central bank is supposed to do, and they’ll answer “to fund government,” or words to that effect.  Oddly enough, however, that’s not why central banks were invented, nor is it what they’re supposed to do.  In the preface to the original Federal Reserve Act of 1913, it states that the system is being established to (and we quote),

. . . provide for the establishment of federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes. (Ch. 6, 38 Stat. 251, December 23, 1913, 12 U.S.C. ch. 3, § 1.)

One Dollar Treasury Note of 1890
Read that again and see if you can find where it says that the primary purpose is to fund government.  Then dig out a copy of the original Act (it’s on the internet), and give it a read through.  The Act specifically prohibits dealing in primary issuances of government securities, i.e., securities issued to monetize deficits.  Dealing in secondary issuances was allowed to retire that portion of the national debt backing the National Bank Notes of 1863-1913, the Treasury Notes of 1890, and the United States Notes of 1861-1963.  In other words, part of the reason for establishing the Federal Reserve in the first place was to get rid of the national debt, not to make it grow to astronomical proportions.

Federal Reserve (Bank) Note Series 1914
You’d never know that from the way the Federal Reserve operates today.  Contrary to the original intent, new money is created these days by the central bank to purchase Treasury paper, and destroyed when the central bank sells its accumulation of government debt (bills of credit). Thus, rather than a having a reserve currency backed by productive assets (or any assets at all), America today has a reserve currency backed by government debt — the very thing they were trying to get rid of in 1913. The reserve currency is still uniform and elastic, but it is far from stable or asset-backed.

How was it supposed to work?  By rediscounting qualified private sector commercial paper representing the present value of actual future assets, not unqualified government debt representing the present value of future possible taxes . . . that might never be collected. . . .

That’s a nice bit of jargon, but what does it mean?  It’s actually pretty simple.

Tellers at the First National Bank of Columbia, PA, cir. 1890.
Let’s talk “discount window.”  Although no actual teller’s window exists where commercial banks stand in line to sell loan paper to the Federal Reserve (although commercial banks used to have such things — the photo to the left is of the First National Bank of Columbia, Pennsylvania, now a museum, well worth a visit, which has a — pardon the expression — mint condition discount teller's window), the transaction is described as taking place at “the discount window.” When the discount window is “open,” commercial banks can sell their “qualified industrial, commercial and agricultural paper” to the central bank, which creates money by issuing promissory notes backed by the paper to purchase it.

When the discount window is “closed,” commercial banks must go elsewhere to obtain reserves to support their loans, or cease making loans. Important point: reserves do not back bank-created money, but provide uniformity and confidence in the system by supplying cash to satisfy daily transactions demand and allowing the bank-issued money (promissory notes and demand deposits) to be converted on demand into the reserve currency.

Thus (if operated correctly) a central bank ensures that there is always enough money in the economy, and that all the different types of money can be converted into a reserve currency that is stable in value and asset-backed.

Of course, we know that’s not what’s going on — but we’ll look at that tomorrow.

#30#

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