central_banking

Central Banking

(Topics: The Economy | Back to Home)

There's an old joke about a couple of people living in a oppressive regime:

Farmer: So you have your money in the town bank. What would happen if that bank were to fail?

Friend: Ah, well if that happens, the deposits in the town bank are insured by the regional bank in our provincial capital.

Farmer: But yes, what if the regional bank were to fail?

Friend: Well, the deposits in the regional bank are are insured by the national bank in our capital city.

Farmer: But what if the national bank were to fail? What then, friend?

Friend: If the national bank were to fail? My dear neighbor, could we ever be so lucky?!

Central banking is an simple but powerful idea. It says the economy is unpredictable, so let's have one authority with special powers to try and influence it—rather than countless firms that are not really coordinating.

As much as we like to hate on government, this has been good. Since the rise of central banking, we've generally had more stable economies. Now, almost every country in the world has a central bank. For the U.S., it's the Federal Reserve. And the Fed has more power than just about anybody in government.

Which is why I told that joke. If you're living in an oppressive regime, the collapse of the bank would be a good thing. If you're living in a modern democratic country, we must have a well-managed, innovative, effective, but carefully controlled central bank.

What the Fed Does Today

The Federal Reserve does a lot of things but it has three main goals:

  • Keep inflation low
  • Keep prices stable
  • Keep employment high

To do this, the Fed has lots of power. In fact the Fed has so much power, they don't have to use it very often. Usually the Federal Reserve Chair can raise their eyebrows or use a particular set of words to try and spook the market into acting. This isn't an exaggeration. It's called Fedspeak.

But the Fed can do a lot directly, if needed. Basically, they can what any bank can do: accept deposits, pay interest, give out loans, and allow withdrawals. The Fed can also buy and sell assets (but they wouldn't know what to do with a bunch of office supplies) so they tend to only buy and sell non-tangible financial products.

The difference is that the Fed doesn't have to worry about running out of money. They can change their account balances to say any amount they want.

Which is a scary amount of power, and we should all understand it.


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