A central bank is a bank responsible for stabilization of the banking system and the monetary policy of a country. This usually entails the control of commercial banks, a monopoly on the issue of banknotes and other privileges.
"Given that money is one half of every commercial transaction and that whole civilizations literally rise and fall on the quality of their money, we are talking about an awesome power, one that flies under cover of night."
Ron Paul, End the Fed, on the powers of a central bank
Central banks can be nominally owned by private individuals or banks, but are run or influenced by national governments, that create them in the first place. Typically, they have a monopoly on the issue of legal tender, in the form of banknotes and coins.
In the late nineteenth century, the principle became accepted that the central bank must act as the "lender of last resort", freely lending money to banks threatened with failure. Another device is "deposit insurance", where the government guarantees to redeem the banks’ demand liabilities. These and similar devices remove the market brakes on rampant credit expansion.
Monetary policy in the course of history
According to Mueller:
In the early 1920s, the Federal Reserve adopted Irving Fisher's proposal of using the consumer price index as the guide for monetary policy, ushering the economy first into unsustainable economic boom and then into the Great Depression. In Europe, the Deutsche Reichsbank produced a hyperinflation in the early 1920s, and in the United Kingdom, the Bank of England toiled haplessly with a decades-long slump.
After World War II, there was a short period when the so-called Bretton Woods System was firmly in place and it was expected that the philosopher's stone for monetary stability had been found. With the establishment of a link of the US dollar to gold and a fixed-exchange-rate system with adjustable peg for its member countries to the dollar, the Bretton Woods System reflected the political power structure at that time with the United States at the center, surrounded by the satellites.
Yet in the 1960s Keynesianism became the dominant doctrine of central banking. Interest rates had to be low, in order to stimulate investment and economic growth. Consequently, the United States government ignored its obligation to limit the dollar emission to the size of its gold stock, and the US central bank put no breaks on the expansion of the money supply. This policy led right into a decade of inflation first and stagflation later on.
In West Germany, the newly founded "Bank deutscher Länder" (later called "Bundesbank") got its seat in Frankfurt and not in the capital city thereby signaling a certain symbolic detachment from politics. The law that created the new German central bank obliged monetary policy to pursue "price level stability." Yet in the late 1960s and during the 1970s, inflation and then stagflation hit Germany and other European countries also. One reason for that was the existence of the international monetary system itself, which obliged the member countries to stabilize their exchange rates against the US dollar.
While the foundation of this system was cast aside with the expansion of the supply of dollars, the Bundesbank, along with other central banks in Europe and Japan, became the "buyers of last resort" for the weakening greenback. The world experienced a massive increase in liquidity originating from the US dollar that spilled over to the other major currencies. When the central banks in Europe and Japan bought dollars in exchange for their own currencies in order to stabilize the exchange rate, they automatically expanded their domestic monetary base. After a short liquidity-driven boost, the world economy slipped into the stagflation of the 1970s.
The experience of stagflation led to a turnaround of monetary policy in the late 1970s, when the US central bank embarked upon the monetarist experiment. Now, it was the money supply that was the most important guideline for central banking.
With Alan Greenspan (chairman of the Board of Governors of the Federal Reserve System from 1987 to 2006), the US central bank abandoned monetarism and embraced supply-side economics. Greenspan liked to look at productivity growth as the guideline and the money-supply number became less important. His doctrine said that a central bank can generously expand the monetary base and have low policy rates when productivity in the economy is rising. This laid the groundwork for the great financial-asset boom of the 1990s.
In Asia, meanwhile, the Japanese central bank produced first an unsustainable economic boom in the 1980s, then instigated the bust of 1989–90, and has tried desperately to re-inflate the economy ever since. In the 1980s, the Japanese central bank saw no need to curb the booming stock and real-estate markets because the price index remained relatively stable, and Japan was seemingly on its way to becoming "number one." The Bank of Japan boosted its monetary base in the 1980s, and after the bust, it lowered its policy rate to almost zero. While the expected recovery did not happen, the Bank of Japan inadvertently provided a bonanza for financial speculators who practice the yen-carry-trade by borrowing at low interest rates in Japan and lending at higher interest rates abroad.
In Europe, a common currency was introduced in 1999 and the statutes for the establishment of the European Central Bank (ECB) called for a clear priority of "price stability" as the guideline for monetary policy. The seat of the European Central Bank is in Frankfurt, almost equidistant to Brussels, where the executive branch of the European Union is hosted, and Strasbourg, where the European Parliament resides, thus symbolizing the idea that the ECB should be completely autonomous and free of political influence.
In the United States, Ben Bernanke has been the chairman of the Board of Governors of the US Federal Reserve System since early 2006. He, too, is an adherent of inflation targeting, yet the US central bank is not explicit about what definite desired rate of inflation (as it is measured by the consumer price index) should be its goal.
The monetary policy concept of inflation targeting suffers from the fundamental problem that a valid price index does not exist. There is no such a thing as a representative basket of goods and services. Irving Fisher's idea was already problematic in the more simple economy of the 1920s; nowadays it is outright obsolete to establish an index that would be representative of the highly complex and diverse economy as it exists today. Actually, each individual person has his specific basket of goods and services, and its composition will change for the same individual over time. Although a uniformly valid price index cannot be constructed, central bankers use this indicator as a guideline in order to formulate a monetary policy that affects the whole economy.
Forms of central banks
Most countries have a central bank in one form or another (for example, Panama does not).
Notable central banks
- Murray N. Rothbard "E. The Government as Promoter of Credit Expansion", Chapter 12—The Economics of Violent Intervention in the Market, Man, Economy and State, online edition, referenced 2009-05-10.
- Antony P. Mueller. "Nightmares of a Central Banker", Mises Daily, February 2007, referenced 2010-05-17.
- David Saied. "Panama Has No Central Bank", Mises Institute, posted 2007-04-26, referenced 2009-07-26.