Let’s discuss what is arguably the most powerful institution in the world, the central
bank.
Nearly every country in the world has a central bank, or institution that manages the currency
and monetary policy of an entire country.
Unlike a commercial bank, a central bank has a monopoly on how much money can be created
and put in circulation.
That’s quite a power, as historically, countries have risen and fallen due to the value of
their currency.
Because of the powerful nature of central banks, most countries have made theirs institutionally
independent from political interference, meaning that governments can’t use them to control
society.
So why do we let these central banks have so much power?
The simple answer is to prevent economic crashes and keep markets stable, based on all the
devastating recessions throughout history that occurred when we didn’t have central
banks.
Let’s look at an example.
In 1837, a financial panic led to a major depression in the United States.
What caused the panic?
A dramatic drop in cotton and land prices, along with a dramatic drop in lending, which
led investors to attempt to withdraw all their funds from banks.
Due to these panicked withdrawals which caused banks to fail, the crisis became known as
the Panic of 1837, and most economists today argue it could have been avoided had there
been a central bank in place to regulate banking transactions and aid failing banks.
While the role of central banks is constantly debated by politicians, central banks have
many extremely important functions.
First, as we mentioned, they control monetary policy by setting the official interest rate
for lending, and determining how much currency can be created and in circulation.
Second, central banks manage how a country exchanges currency with other countries, as
well as a country’s gold reserves and government bonds.
They use what is known as “open market operations” to buy and sell securities from banks in order
to also influence the money supply.
Third, central banks often regulate the banking industry.
Fourth, and perhaps most importantly, central banks act as a government’s banker, and
as the “bankers’ bank,” or “lender of last resort.”
In other words, the central bank is the provider of liquidity when no other institution is
able to be.
Other functions of central banks that aren’t as common include economic research, statistical
collection, and advising governments regarding financial policy.
The most influential central bank system in the world is likely The Federal Reserve System
of the United States.
You may have heard a lot about the Federal Reserve, including some conspiracy theories,
but you likely know little about it.
While the Fed also has a reputation for being secretive, much of what it does is publicly
available, and frankly, kind of boring.
So why was it created?
Well, after the Panic of 1837, the United States had many more panics and recessions
and depressions for the next 80 years, until Congress finally passed the Federal Reserve
Act, primarily in order to prevent future panics.
Much of the conspiracy theories about the Fed today are related to the secret nature
of its creation.
In 1910, six wealthy and powerful men secretly met on a secluded island off the coast of
Georgia to lay its foundations, although at the time most economists supported their proposal.
Today, the Fed’s three objectives for monetary policy are: one, maximizing employment.
Two: keeping prices stable.
And three: managing interest rates to influence lending.
Often, these three are related.
For example, in order to keep prices stable, the Fed may have to adjust interest rates.
If inflation is sharply increasing, it likely will increase interest rates to lower borrowing
and spending.
If unemployment is high, it will likely lower interest rates to encourage borrowing to pay
for more workers.
Part of the appeal of the Federal Reserve System is that it is decentralized.
It’s made up of 12 different banks that control 12 districts.
Each reserve bank has a board of nine directors.
While the President of the United States appoints and the U.S. Senate approves a Federal Reserve
Board of Governors that oversees all of the Federal Reserve banks, the Fed itself is largely
independent.
The Federal Reserve System doesn’t have to be approved by the President or any other
part of government.
It also doesn’t get appropriated funding by Congress, and the terms of the members
of the board of governors span multiple presidential and congressional terms.
Because of that, the Fed is often immune from politics.
Still, due to its secretive nature and vast amount of power, the Fed remains controversial.
After all, like most central banks, it is set up like a corporation.
Therefore, it is both private and public.
Additionally, central banks are inherently political institutions due to their power,
whether they want to be or not.
Regardless, most economists maintain that we need central banks to help stabilize economies,
and history has shown that economies are generally much
more volatile without them.