Central Banks

Central bank today is the most important feature of the financial systems of the majority of countries. The main function of a modern central bank is the monitoring and regulation of interest rates in the economy. The central bank does this by changing the interest rates that it charges on money that it lends to the banking system through its "discount windows". Interest rates are supposed to influence the level of economic activity in the economy. (Vaknin,2009) However, during a financial crisis, central banks often take on additional roles.

Most importantly, in a credit crisis, the central bank often becomes the lender of last resort to guard against systemic risk in the banking sector and to support interbank lending. Interbank lending consists of banks loaning money to each other, typically for a short-term period, to meet reserve requirements. The rate at which these loans are made is called the interbank rate. During the global financial crisis, banks were wary of lending to one another, resulting in a rise in the interbank lending rate and the “freezing up” of credit.

The credit freeze forced banks to seek liquidity from the central bank the lender of last resort. In fact, some suggest that lack of confidence in private money markets during the crisis resulted in central banks becoming, at least temporarily, the lender of only resort. This phenomenon resulted in central banks worldwide taking unprecedented actions to respond effectively to the crisis. ( Dozark-Frideres,2010) During the global financial crisis, three central banks played an important role in attempting to prevent and control the crisis.

As the crisis became a global financial and economic crisis, other central banks also became involved, but the actions of the Federal Reserve, the European Central Bank, and the Bank of England remained the focus of attention. General background information about each central bank will be helpful in understanding the banks’ respective responses to the crisis. ( Dozark-Frideres2010) According to Posner(2011), the case for central bank independence from the political branches of the government is simple. Central banks control the amount of money in the economy.

For example, by selling short-term government securities for cash, they reduce the amount of money in the economy and this drives up short-term interest rates, while by buying such securities for cash they increase the amount of money in the economy and that drives down short-term interest rates. Politicians like the money supply to increase before elections, because a reduction in interest rates stimulates economic activity; consumers borrow more to consume, and businesses borrow more to invest in production.

In principle, consumers and businesses should anticipate inflation, resulting in higher long-term interest rates and various distortions in economic activity, and take preventive measures that will reduce the simulative effect of the central’s bank low-interest-rate policy. But we know from the reaction of consumers and producers to the very low interest rates of the early 2000s that the effect of very low rates on consumption and production are not fully and immediately offset by anticipation of future consequences.

In a sense, central banks have returned to their roots. The first central banks were created to handle the sovereign's financial affairs and issue a national currency. That endowed them with competitive advantages that led naturally to becoming lenders of last resort to commercial banks. Because such lending created moral hazard and the risk of loss, they also became those banks' supervisors. Only later did monetary policy managing economic growth and inflation become a primary duty.

( WASHINGTON,2011) According to Posner(2011), if a nation’s central bank is controlled by politicians, it can be expected to reduce short-term interest rates at particular phases in the electoral cycle, and this tendency, because unrelated to any economic reasons for low interest rates, can be expected to have an inflationary effect. Moreover, inflation can easily get out of hand. When inflation is anticipated, the amount of money in circulation increases; people hold smaller cash balances because inflation erodes the value of cash.

The more rapidly money circulates, the higher the ratio of money to output and therefore the higher the rate of inflation. In fact the Federal Reserve is not completely independent from politics. Unlike the Supreme Court, its independence is not dictated by the Constitution. The United States did not have a central bank when the Constitution was promulgated, and the Constitution didn’t require the creation of one. The Federal Reserve dates only from 1911, and before then experiments with central banking in the United States had been sporadic.

The Federal Reserve’s independence which is a function of the long terms of the members of the Federal Reserve Board ,the fact that they cannot be removed before the expiration of their terms, the fact that the Federal Reserve is self-financed rather than financed by annual congressional appropriations, and the fact that the members of the Open Market Committee include presidents of the local federal reserve banks, who are chosen by private banks rather than by the President is a gift of Congress; and what Congress has given, Congress can take back. Hence Federal Reserve chairmen and members can’t just thumb their nose at Congress.

(Posner,2011) The appendix 1 shows us European Central Bank as the most independent central bank because of its unique structure. It is not formed by any one government but has been formed by a special treaty with capital coming from erstwhile central banks of European Monetary Union countries. In order to keep the bank independent, ECB decided not to buy any government bonds apart from accepting bonds as collateral for liquidity purposes. As the crisis shaped, ECB finally could not resist the market pressures and started buying government bonds following Greece bailout in May-10.

The appendix 2 is about Bank of England. Bank of England also started an asset purchase program like Federal Reserve and other central banks. But unlike the case of US, there was more clear segregation of responsibilities between Government and central bank. in this case Bank of England was merely conducting operations on behalf of the UK government. This is unlike the case of Federal Reserve where the asset buying activity was seen as an independent activity. As a conclusion, the central bank should not be too independent. It is better semi-independent and closely with the federal government.