Imagine a modern economy without a central bank. What would the people and the companies do to conduct the business of every day? Try to imagine this while bearing in mind that bartering will not be feasible in an economy where a commercial transaction may involve as much as a shipload of commodities and manufactured goods.
In this kind of economy, even a precious metal such as gold, silver or platinum would be too cumbersome to carry around and pay for a shipment of that size or even a fraction thereof. This leaves paper money as the only practical means to conduct modern business. But what if there was no central bank to print the money, write the cheques or electronically move around the large sums of money?
Fear not, dear friend, because this was the situation in the United States of America before the financial panic of 1907 and for six more years after that. Yes, the world came close to experiencing a disaster as a result but it did not end. Mirroring the set-up that existed in mainland Europe since the Eighteenth Century where the goldsmiths acted as the bankers of the day, there were in America a multitude of private banks. But then came the state banks, followed by the federally chartered banks, all of which operated without the authority or supervision of a central bank. And they held out fairly well until they did no more.
Clearly, the American system could not maintain a financial operation that was as smooth and dependable as it was hoped for but the panic of 1907 to which the system was headed had a bright side. It resulted in the creation of an American Central Bank in 1913, an institution that was modeled after the Central Bank of England. Thus was born the Federal Reserve System in America to survive to this day and be affectionately called the Fed.
Still, the question remains: From where did the early pseudo-banks and the latter day full-fledged banks get the money? Well, they did what the central banks do today, they printed the thing. Each institution was associated with a printing press and had a currency of its own which, in most cases, was convertible into the currencies of the other institutions. And it was possible to do these conversions because all currencies had a face value that was equal to a given amount of gold whose store value was stable, well defined and trusted by everyone.
And so the various banks were for a time the gods that created the money because they controlled the printing presses. But when the Central Bank came to the United States, it emulated its British counterpart in that it took charge of the situation and became the sole issuer of money. And the same happened to the rest of the world. Now there is only one god per economic jurisdiction everywhere on the planet; and none of them need the printing presses except to print the bills that they circulate among the public. Otherwise, the central banks deposit money into the account of the member banks or withdraw it by electronic means.
In recognition of the fact that paper money was nothing but a note promising to pay the bearer in gold the value indicated on the note, the banks of yesterday were required to carry in their vaults an amount of gold equal to a given percentage of the paper money they had in circulation. This amount was called the reserve and its level was mandated by law so as to avoid the collapse of the bank in case there was a genuine run on it. The same applies today except that the mandated level of reserve and its quality have been greatly relaxed.
And since most of the money in circulation was brought back and re-deposited at the banks for safekeeping and for earning interest, the banks turned around and lent the money to those who wanted to borrow and were willing to pay a higher interest than the depositors were willing to receive. Thus, the banks of yesterday profited as do the banks of today from the difference, known as the spread, between the two levels of interest.
But what is different between the old days and the modern days is that the banks do not have to carry gold in their vaults anymore to back the level of business they carry on their balance sheets. Now they can show foreign currencies on their books which they deposit in foreign institutions and earn interest. The banks may also buy government securities and corporate papers for which they earn interest as well. Thus, while carrying these new forms of liquid assets in reserve as mandated by law, the banks are no longer burdened by an asset that earns no interest but sits in the vault and glitter.
In time, the Fed has come to play a bigger role than print money and circulate it among the commercial and chartered banks. It now formulates and implements a monetary policy that allows it to set the level of the money supply thus control the rate of inflation and maintain the stability of the currency. And learning from the deflationary period that hit Japan in the Nineteen Nineties, the Fed and the central banks everywhere are now practicing something they call Quantitative Easing. The banks started doing this to respond to the financial crisis that hit the world near the end of the year 2008.
What the bankers do in essence is that they, who are supposed to be independent, are now playing a role comparable to that of the treasurers in the executive branch of government. More than that, they play the role in concert with the treasurers. The role of the treasurers has always been to set and to implement the fiscal policy of the nation, a function they used to fulfill alone by deciding how much money they will collect through taxation, by borrowing and by other means; how much of it they will spend and how they will spend it.
Now, having brought the interest rates close to zero in their effort to get the economies moving again only to see the latter remain frozen in the wake of the 2008 crisis, the central banks had no choice but to emulate the fiscal policies of the treasurers and flood the marketplace with liquidity to save the chartered and commercial banks from certain death. This is what Quantitative Easing is all about. It is as if the gods of money had decided to hand to the banks enough cash to pay off the angry mortals who would come at them asking for their deposits back. Of course, there was a secret wish in there too, the expectation that when the depositors get the money, they will spend some of it and thus help revive the economy.
There is no doubt that sooner or later the economies of the world will come to life again and, to quote Desiderata, the Universe will unfold as it should once more. This will happen because there will always be commerce among human beings given that people must eat, wear clothes, have a roof over the head, move around, go to school, receive medical care, communicate with each other and be entertained. You can slow down these activities for a while, you can stop them for a short while but you cannot stop them altogether for a long while. Thus, we may feel uncomfortable at the sight of many of us being unemployed but life will not end here or end now. Activities will one day resume again and they will go on to build more strength and more vigor.
As long as no physical plant such as a factory or a hospital is destroyed during the economic downturn -- as would be the case in a war -- the economy can get back to normal at a rapid pace. Activities will pick up when the people organize, which they will do when they begin to trust the competence of the leadership that is organizing them. Of course, questions will still remain as to the set-up that brought the system to the current state. In addition to understanding the why and the how of the thing, the public will want to know what is being done to see to it that the experience will never repeat itself.
Yes, the public will want to see those who were responsible for the current troubles punished so as to deter future operators from slipping into the same sort of incompetence, neglect or wrongdoing. And the public will also want to see a new system replace the old one. Such system will be so transparent, it will again earn the confidence of the public. And given that confidence is the most important ingredient that is needed now to get the economy going, those who are in a position of leadership should work tirelessly to capture it.
And maybe what will come out of this ordeal is a new era where the close cooperation between the Fed and the Treasury will be institutionalized and made into a permanent feature of the system. The existing arm’s length approach between those two was put in place in 1951 to allay fears that the government will be tempted to use its considerable power and politicize the operations of the Fed. But things have changed so dramatically in the past half century that the arm’s length Accord should now be revised.
Governments everywhere have weakened in the face of forces operating on the global stage that no government can understand, much less control. These are forces that can wreak havoc on people everywhere and they do so now without hesitation. Thus, a little more power being restored to government may not be a bad thing at this time. The pendulum has swung in this direction so let us ride it into an era of Quantitative Easing that will ease up on the commercial banks and ease the pressure on mortals like you and me.