My project is to write a draft which should become a chapter in my bank book. The inflation manuscript is in good condition (but very late), but I cannot publish anything from it (other than republishing the edited version of the articles published earlier). This article is somewhat light – it could turn into an introductory section, which I normally keep as a summary of the chapter’s content. The good thing about posting this summary is that it sort of explains why I might digress a few times in the first few posts.
Central banks, as their name suggests, are actually banks. This rather simple perspective was lost in the decades after World War II, when central bankers bought into mainstream thinking and saw themselves as “benevolent central planners.” Instead of worrying about mundane distractions like credit risks within the system, researchers took to pretending to be 1960s control systems engineers optimally determining the trade-off between growth and inflation . Of course, this neglect of the banking sector led to the rather tricky financial crisis of 2008, where central bankers suddenly had to rein in banking risks again. Since then, central bankers have been very vigilant about banking risks – at least those similar to those of the last crisis.
I see two major sources of confusion about the relationship between banks and the central bank, which fall into two generic schools of thought.
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As discussed previously, central bank operating procedures changed after World War II. Anglo-Allied central banks were stuffed with government paper (bonds and notes) as part of their role in financing the war. (Everyone who did not default on their debt during the war was stuffed with government papers – debt-to-GDP ratios were generally over 150%.) Pre-war debates over the role of banks central principles – for example, the “doctrine of real invoices” – were now archaic. Additionally, the rise of neoclassical Old Keynesians meant that central banks conceived their policy space as consisting of setting a policy rate and the number of bonds/government notes they buy – the banking system was literally scratched from the models. Instead, the focus was on “monetary growth,” which could supposedly be controlled through control of the monetary base.
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People who draw their experience from pegged currencies – either to gold or to a hard currency. Although gold and cryptocurrency enthusiasts remain the largest source of economic misinformation on the planet, reliance on pegged money thinking is widespread. This is not a heterodox/orthodox divide, as some post-Keynesians advocate fixed monetary orthodoxy.
So what?
Although my analysis on central banking and banking is primarily the result of thinking about Modern Monetary Theory (MMT), it is not particularly unorthodox. My point is that many people with different viewpoints think that a central bank overhaul could provide some magical special economic sauce. My view is that we have a much better chance of understanding what is going on by not falling into the misleading views listed earlier, but the open economic policy space in the real world is not that big. Banking is the art of determining where the money is, but economics is driven by money flows, primarily income. Central bankers don’t have much influence over revenue flows, aside from the controversial interest rate channel. At the same time, fiscal policy is entirely focused on revenue flows, hence the emphasis on fiscal policy in most MMT textbooks.
Central banks and banking
The topics of interest I see arise from these points.
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The central bank is a bank through which the fiscal branch of the government (Treasury, Ministry of Finance), private banks and foreign central banks carry out their banking operations. Although the Bank of England once had accounts for non-banks, modern central banks do not compete for retail or business customers. The problem in understanding these operations is the generic problem of understanding the general functioning of banks: the popular debate seems to oscillate between the point of view of a bank’s customers and that of the bank itself. For example, balance sheet entries often end up on the wrong side of the balance sheet in discussions because people are thinking about their balance sheet and not the bank’s.
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The payment system allows cash flow between banks. There are a number of issues surrounding the payment system discussion. They vary according to the currency blocks and are complex, with only the banks involved having an interest in them. Thus, discussions are dominated by experts who wish to emphasize the importance of their expertise. This complexity is offset by the observation that the payment system sucks if it works properly. The only reason to worry about the payment system is if it’s about to explode. However, payment systems experts don’t like to be ignored, which is why they disproportionately exaggerate every potential problem.
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It is extremely unusual for banks to issue their own currency (“banknotes”) in the modern era. Instead, they exchange their deposits for government bank notes. This creates an asymmetry between the central bank and private banks. That said, banknotes do not represent a significant part of modern economies (apart from the underground economy) and their importance is overstated in online discussions.
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The main topic of debate revolves around whether the currency is pegged or not. If the currency is pegged, the central bank finds itself in a position that is not radically different from that of a private bank. However, if the currency is not pegged, the central bank is freed from real obligations, and he is able to do everything he can. This means that any “constraints” it faces can usually be circumvented via some form of regulatory/financial engineering – which makes everyone attached to the currency peg go crazy.
The last topic should make up the bulk of the chapter, but I think I need to cover the previous ones before I get to that.
Concluding Remarks
Leaving aside the questionable effect of interest rate policy, the central bank’s function is primarily to guarantee cash flows where they are supposed to occur. Until central bankers completely abandon regulation of the banking system – which they did until 2008 – the system should work as intended, and the economic forces that matter are elsewhere. In a country without a fixed currency, the financial constraints imposed on the central bank – such as its level of capital – have only symbolic importance and can be circumvented. If the country has an anchor, the question of whether there is a risk that this anchor will be broken is important. These fragmentary remarks should be explained in more detail in subsequent articles.
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