Despite all the conspiracy theories floating around, central banking is essential in a modern technologically and economically advanced economy. Allowing government to fill the role of a central bank is a serious mistake on so many levels that we won’t get into it. We’ll focus instead on the mechanics. So, what is a central bank all about?
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| Founding of the Bank of England |
The Bank of England, established in 1694, is usually considered the first true example of a central bank. The idea was primarily to provide “accommodation” for the mercantile (commercial) banks of London; “The business which this new corporation principally intended to do by virtue of its charter, was the purchase and sale of bills of exchange.” (Richard Hildreth, The History of Banks. Boston, Massachusetts: Hilliard, Gray & Company, 1837, 11.)
Thus, the purpose of a central bank, as expressed in the preface to the original Federal Reserve Act of 1913 (Ch. 6, 38 Stat. 251, December 23, 1913, 12 U.S.C. ch. 3), is to
. . . 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. (Ibid., § 1. This section has been removed from the amended Act.)
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| Dr. Harold G. Moulton |
We will use the United States Federal Reserve System as the chief example in this discussion of central banking. Overall, the aims of establishing a central banking system as a backup for the commercial banking system in the United States and replacement of the National Bank system in place since the Civil War, were, “Oversee and regulate clearinghouse operations,” i.e., transactions between private financial institutions. (Moulton, Principles of Money and Banking, op. cit., II.322-328.)
A central bank is also supposed to provide additional reserves as needed to commercial banks by rediscounting eligible paper directly from member banks (ibid., II.309-314) and engaging in limited open market operations to rediscount eligible paper from non-member banks and individual businesses. (Ibid., II.316-318.)
Another important function of a central bank is to supply the country with an “elastic currency” that expands and contracts with the level of business and so avoid both inflation and deflation by rediscounting eligible paper. (Ibid., II.295-298, 300-302.)
Finally, specifically for the Federal Reserve, it was important to phase out the debt-backed United States Notes, National Bank Notes under the National Bank Act of 1863, and Treasury Notes of 1890 and replace them with asset-backed Federal Reserve Notes. (Ibid., II.283-300.)
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| The Panic of 1907 |
The first two purposes of central banks as they applied to the Federal Reserve were an effort to prevent a recurrence of the manipulation of the clearinghouse system and the refusal of J. P. Morgan to make an emergency loan to the Knickerbocker Bank and Trust that had gotten into trouble due to its president speculating in copper shares. This caused the “Bankers Panic,” the Panic of 1907 (ibid., II.172-173), and led to agitation for reform that led in turn to the establishment of the Federal Reserve — See U.S. Congressional House Committee on Banking and Currency, Report of the Committee Appointed Pursuant to House Resolutions 429 and 504 to Investigate the Concentration of Control of Money and Credit, February 28, 1913. Washington, DC: U.S. Government Printing Office, 1913, “The Pujo Report.”
The latter two purposes of the Federal Reserve were intended to address the problem of the “inelastic,” government debt-backed currency of the United States Notes, and the National Bank system, by replacing the United States Notes, the National Bank Notes and the Treasury Notes of 1890 with an “elastic” (yes, it does get a little tiring saying that) private sector asset-backed currency. (Moulton, Principles of Money and Banking, op. cit., II.259-260.)
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| The Panic of 1893 |
The idea of an elastic currency is that, with a currency that increases and decreases as the present value of existing and future marketable goods and services increases and decreases, the economy will avoid the twin evils of deflation and inflation. (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 343.)
This would avoid the problem that occurred, e.g., in the United States in the Great Depression which followed the Panic of 1893 in which there was a dearth of currency with which to carry out daily transactions. (Gerald T. White, The United States and the Problem of Recovery after 1893. University, Alabama: University of Alabama Press, 1982, 3-7; Moulton, Principles of Money and Banking, op. cit., II.173-174.) This exacerbated the underlying problem of insufficient liquidity for business by causing a significant downturn in effective demand on the part of consumers.
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| Jean-Baptiste Say |
The goal was that the vast bulk of the money supply would continue to be bills of exchange drawn by private sector businesses and discounted and rediscounted either at other businesses or, to a lesser degree, commercial banks. Consistent with Say’s Law and the real bills doctrine, this would be money, but not currency, per se.
Next in importance would be commercial bank demand deposits at the Federal Reserve and Federal Reserve Notes backed by commercial paper of member banks rediscounted at the Federal Reserve as the “lender of last resort,” supplemented with limited open market operations in commercial paper issued by non-member banks, enterprises, and individuals. This was to be the elastic component of the currency.
The demand deposits and Federal Reserve Notes were thus to be backed by liens on qualified industrial, commercial, and agricultural assets, and would expand and contract with the short-term needs of business. Finally, there would be gold coin and gold certificates, supplemented by the subsidiary silver coinage and silver certificates for daily transactions.
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| Sir Norman Angell |
The U.S. Federal Reserve Act was the first time in history a government acknowledged the reality of Say’s Law of Markets and the real bills doctrine by implementing the system required to provide the country with an elastic “asset currency.” (Moulton, Principles of Money and Banking, op. cit., II.260.) Of course, we must acknowledge that John Law’s proposal was adopted by the French government early in the eighteenth century, but the legislators as well as the majority of the French people did not grasp the essential concepts behind Law’s system, and this virtually guaranteed its failure. It was also before Jean-Baptiste Say articulated his version of the relationship . . .
In any event, by the terms of the Federal Reserve Act, the United States federal government recognized that “money” consists of anything that can be used to settle a debt and is a derivative of the present value of existing and future marketable goods and services. As one authority remarked, “As Professor Beard suggests in ‘The Rise of American Civilization’ the Federal Reserve Act of 1913 represents the union of ‘Jacksonian hopes’ with ‘financial propriety’.” (Norman Angell, The Story of Money. New York: Frederick A. Stokes Company, 1929, 305-306.)
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