Let’s discuss what is arguably the most
powerful institution in the world, the central bank. Nearly every country in the world has a central
bank, or institution that manages the currency and monetary policy of an entire country. Unlike a commercial bank, a central bank has
a monopoly on how much money can be created and put in circulation. That’s quite a power, as historically, countries
have risen and fallen due to the value of their currency. Because of the powerful nature of central
banks, most countries have made theirs institutionally independent from political interference, meaning
that governments can’t use them to control society. So why do we let these central banks have
so much power? The simple answer is to prevent economic crashes
and keep markets stable, based on all the devastating recessions throughout history
that occurred when we didn’t have central banks. Let’s look at an example. In 1837, a financial panic led to a major
depression in the United States. What caused the panic? A dramatic drop in cotton and land prices,
along with a dramatic drop in lending, which led investors to attempt to withdraw all their
funds from banks. Due to these panicked withdrawals which caused
banks to fail, the crisis became known as the Panic of 1837, and most economists today
argue it could have been avoided had there been a central bank in place to regulate banking
transactions and aid failing banks. While the role of central banks is constantly
debated by politicians, central banks have many extremely important functions. First, as we mentioned, they control monetary
policy by setting the official interest rate for lending, and determining how much currency
can be created and in circulation. Second, central banks manage how a country
exchanges currency with other countries, as well as a country’s gold reserves and government
bonds. They use what is known as “open market operations”
to buy and sell securities from banks in order to also influence the money supply. Third, central banks often regulate the banking
industry. Fourth, and perhaps most importantly, central
banks act as a government’s banker, and as the “bankers’ bank,” or “lender
of last resort.” In other words, the central bank is the provider
of liquidity when no other institution is able to be. Other functions of central banks that aren’t
as common include economic research, statistical collection, and advising governments regarding
financial policy. The most influential central bank system in
the world is likely The Federal Reserve System of the United States. You may have heard a lot about the Federal
Reserve, including some conspiracy theories, but you likely know little about it. While the Fed also has a reputation for being
secretive, much of what it does is publicly available, and frankly, kind of boring. So why was it created? Well, after the Panic of 1837, the United
States had many more panics and recessions and depressions for the next 80 years, until
Congress finally passed the Federal Reserve Act, primarily in order to prevent future
panics. Much of the conspiracy theories about the
Fed today are related to the secret nature of its creation. In 1910, six wealthy and powerful men secretly
met on a secluded island off the coast of Georgia to lay its foundations, although at
the time most economists supported their proposal. Today, the Fed’s three objectives for monetary
policy are: one, maximizing employment. Two: keeping prices stable. And three: managing interest rates to influence
lending. Often, these three are related. For example, in order to keep prices stable,
the Fed may have to adjust interest rates. If inflation is sharply increasing, it likely
will increase interest rates to lower borrowing and spending. If unemployment is high, it will likely lower
interest rates to encourage borrowing to pay for more workers. Part of the appeal of the Federal Reserve
System is that it is decentralized. It’s made up of 12 different banks that
control 12 districts. Each reserve bank has a board of nine directors. While the President of the United States appoints
and the U.S. Senate approves a Federal Reserve Board of Governors that oversees all of the
Federal Reserve banks, the Fed itself is largely independent. The Federal Reserve System doesn’t have
to be approved by the President or any other part of government. It also doesn’t get appropriated funding
by Congress, and the terms of the members of the board of governors span multiple presidential
and congressional terms. Because of that, the Fed is often immune from
politics. Still, due to its secretive nature and vast
amount of power, the Fed remains controversial. After all, like most central banks, it is
set up like a corporation. Therefore, it is both private and public. Additionally, central banks are inherently
political institutions due to their power, whether they want to be or not. Regardless, most economists maintain that
we need central banks to help stabilize economies, and history has shown that economies are generally
much more volatile without them.
