Central Banks

While central banks are indeed banks, they are the least like banks as far as people’s perception of them, as places where you store your money and obtain loans at. Central banks do perform both of these functions and more, although it is other banks who are their clients, who have money on deposit with them and borrow money from them.

So central banks are really the bank of banks in a country, although this is just one of their functions, albeit an important one. They also issue and manage currency, as well as a country’s money supply, interest rates, and other financial matters and goals of a government.

If the function of a central bank could be described in one word it would be stability, as they seek to stabilize both the banking system and a country’s economy generally, by way of their actions and the tools available to them.

A lot of people may realize that the function of a central bank does affect the economy and the investing environment in some way, but aren’t really aware of how these things work and may just gloss over the subject, thinking it’s really not important to them. It may not be in some cases, but should one be investing or looking to invest, it can be helpful to at least have a basic idea of what these banks do and how what they do can affect the market and the economy.

Even free market advocates understand the need for the banking system and the economy to be actively managed at least to some degree, as otherwise we become subject to the whims of the market completely. This may be fine for a lot of industries, but things like the banking system and the money supply are too important to be left to this, and the invisible hand often needs a visible one to point it in the right direction.

This looks to both minimize the downside of business cycles as well as provide people with a secure foundation to bank in without excessively worrying about things toppling over. Banking plays such an integral role in today’s economies that widespread bank failure is now unthinkable. Although we have flirted with this in the past at various times to various degrees, banking and the economy require a very solid foundation to function properly. Central banks play a leading role in providing this, together with other programs that the government may have such as deposit insurance.

Why Stability Is Important in an Economy

The very nature of banking makes it a lot more vulnerable to negative business conditions than most people suspect. This is especially the case with people who think that banks just store people’s money for them and it is always there when they need it. This is far from the case though.

When you realize that banks instead borrow this money from depositors and use it to lend out primarily, it is necessary to have controls on this. If a large number of depositors went to a bank to take their money out, this would simply bring down the bank, as they don’t have the means to satisfy requests like this.

The bank may be plenty solvent and have this money under management, but it is often loaned out to others on longer terms, and the bank cannot simply call in enough of these loans to provide enough liquidity should their depositors request it. Only a small percentage of deposits are kept on hand, and even then, a lot of this is due to regulation from the central banks, or there may be even less than we actually see to satisfy this demand.

So the first thing we need to do is prevent such things from happening, and this requires depositors to have a high level of confidence in their banks, with people knowing that when they need the money they have on deposit, it will be there for them, provided somehow. Otherwise, depositors will be prone to line up and look to engage in bank runs, which can have devastating consequences.

This isn’t unlike someone applying for a loan and needing good credit to obtain it at favorable rates, and when you deposit at a bank, it is their good credit that makes this all work, and their good credit is to a large degree protected by central banks.

Central banks are known as lenders of last resort, a concept and a benefit that has been around for a long time, where if a bank cannot meet its obligations to its creditors, it can borrow from the central bank to do so. This serves to keep the whole thing together and prevent the panics that we have seen in the past in the banking system, when conditions were far less regulated.

Central banks also impose various fractional requirements upon banks, although this does vary by country, with some countries not having fractional reserves and leaving this up to the market pretty much. However, central banks are there to step in when required to keep banks from not being able to provide enough liquidity to their depositors, and a bank refusing to process withdrawal requests is certainly an event no bank or no country ever wants to see.

Central Banks Also Manage the Economy

Reserve rates are also used as a tool for managing the economy, where central banks will lessen the requirement when they want to increase the money supply and increase these requirements when they want to contract it.

The governments which operate or oversee central banks have economic objectives that they seek to employ, and like the goal with managing the banking system, seeking stability is the fundamental one.

Left unmanaged, left up to the market in other words, business cycles can fluctuate a lot due to momentum, producing both boom and bust cycles, periods of high inflation and periods of economic recession. The goal of the government is to look to blunt both these cycles, as they have economic consequences, and you don’t want an economy to expand too fast either because this can become too inflationary, devaluing present assets too much.

Most people are aware of what happens when a government prints too much money, and the more they print, the less valuable it becomes, due to it being diluted. While central banks do manage currency, and do print money, this is only part of their monetary policy, and what they really manage is the money supply, the total of all money in circulation, which is different than just how much cash is printed.

The money supply becomes expanded by the banking system to various degrees, due to fractional requirements. So a certain money deposited into the banking system, by the central bank, becomes magnified quite a bit, because it is deposited and then lent out, and this money loaned becomes deposited as well and lent out again, and so on, creating several times more money supply than was originally introduced.

Fractional banking is absolutely necessary by the way, as if banks had to keep all their deposits on hand, or too high of a percentage of it, they wouldn’t have the money to lend out that people want to borrow, and the credit crunch would bring down the economy by causing a severe contraction.

When the money supply expands, this has the same effect as printing money, there is more of it in circulation and if too much is in circulation this is inflationary, devaluing money in circulation generally.

If there is not enough money in circulation, this contracts the economy, by tightening credit. Less money is therefore spent, and there’s less to go around, people may lose their jobs, and this leads to even less spending, and this is what we call a recession. So central banks will take actions which will increase or decrease the money supply to look to promote more stability in the economy.

This may involve their buying or selling government securities, called open market operations. This serves to add to or take away from the money in circulation, and the money supply in turn, to achieve the central bank’s desired objectives at the time to keep the ship on a more steady course.

Central banks also rely on manipulating interest rates to this end, and while banks and the market sets their own interest rates, by changing the rates that the central bank charges banks for loans, this does affect the interest rates that the banks can charge. Higher interest rates contract the money supply, while lower ones expand it, and this is why we see interest rates set lower by central banks during recessions and higher during periods of high inflation.

Once again, this serves to look to keep the economy stable by looking to control the money supply, to make sure that it is not too big, not too small, just right for the current economic conditions. In periods of expansion they will look to keep this expansion from getting too out of hand, and in periods of recession, they will look to stimulate the economy by getting more money in play.

All of this may seem to be pretty distanced from everyday life, but it does have quite an effect, especially if one is exposed to the market through variable return investments. Even if one’s income is fixed, one needs to realize that money is only valuable relative to inflation, which devalues it to various degrees, and therefore it is important that it not be devalued too much.

One does not want their investments subject to too much risk either, and therefore the stability that central banks provide to the economy is something we all need to appreciate and have at least some understanding of. This is especially true if one is trading currency, which is extremely dependent upon a country’s economic policy, and actions of central banks have a lot of influence on how currencies move against one another.

So central banks play a central role indeed in providing stability to the banking system and the economy as a whole, and their effective management is needed to provide the foundation for the kind of economy that we all benefit from.