Central Banks As Banks

My plan is to write a draft what should become a chapter for my banking book. The inflation manuscript is in good shape (but way behind schedule), but there’s nothing I can publish from it (other than reposting the edited version of articles posted earlier). This article is somewhat lightweight — it might turn into the introductory section, which I normally just keep as a summary of the chapter contents. The advantage of putting this summary out is that it sort-of explains why I might cover some digressions in the first articles.

Central banks, as the name suggests, are in fact banks. This rather straightforward perspective was lost in the decades after World War II, when central bankers bought into mainstream thinking and they thought of themselves as “benevolent central planners.” Instead of worrying about mundane distractions like credit risks within the system, the researchers were running around pretending they were 1960s control systems engineers optimally determining the trade off between growth and inflation. Of course, this neglect of banking led to the rather awkward Financial Crisis in 2008, where central bankers suddenly had to get a handle on banking risks once again. Since then, central bankers have been quite vigilant about banking risks — at least the ones that are similar to the last crisis.

I see two major sources of confusion about the relationship between banks and the central bank, that come out of two generic schools of thought.

1. As alluded to earlier, central bank operating procedures changed after World War II. The Anglo Allied central banks were stuffed with government paper (bonds and bills) as part of their role in wartime finance. (Everyone who didn’t default on their debt in the war was stuffed with government paper — debt/GDP ratios were typically 150+%.) The pre-war debates about the role of central banks — e.g., the “real bills doctrine” — were now archaic. Plus, the rise of the neoclassical Old Keynesians means that central banks conceived of their policy space as consisting of setting a policy rate and the number of government bonds/bills it buys — the banking system was literally written out of the models. Instead, the focus was on “money growth” which could allegedly be controlled via the control over the monetary base.

2. People who draw their experience from currencies with pegs — either to gold or a hard currency. Although the gold and crypto enthusiasts remain the largest source of economic misinformation on the planet, relying on pegged currency thinking is widespread. This is not a heterodox/orthodox divide, as some post-Keynesians push pegged currency orthodoxy.

So What?

Although my analysis on the central bank and banking is mainly the result of reflecting upon Modern Monetary Theory (MMT), it is not particularly unorthodox. My view is that quite a few people with different views think there is some magical economic special sauce available from rethinking central banking. My view is that we have a much better chance of understanding what is going on by not falling into the previously listed misleading views, but the economic policy space opened in the real world is not that large. Banking is the art of accounting for where money is, but the economy is driven by money flows — mainly income. Central bankers do not have that much influence on income flows, other than the debated interest rate channel. Meanwhile, fiscal policy is all about income flows, hence the focus on fiscal policy in most MMT primers.

Central Banks and Banking

The topics of interest I see follow from these points.

• The central bank is a bank that the fiscal arm of the government (Treasury, Ministry of Finance), private banks, and foreign central banks do their banking at. Although the Bank of England used to have accounts for non-banks, modern central banks do not compete for retail or business customers. The problem with understanding these operations is the generic problem of understanding how banks operate in general — popular discussion seems to veer between the perspective of a bank’s customers and the bank itself. For example, balance sheet entries often end up on the wrong side of the balance sheet in discussions, since people are thinking about their balance sheet, and not the bank’s.

• The payments system allows the cash flows between banks to happen. There are a number of problems with discussing payments system. (As based on comments made, I want to emphasise that this is the wholesale payments system. How retail customers pay for their Cheezy Poofs™️ is not my concern.) They vary between currency blocs, and they are complex, with only the banks involved with an interest in them. As such, discussion is dominated by experts who want to underline the importance of their expertise. This complexity is offset by the observation that the payments system nets out to zero if it is functioning properly. The only reason to care about the payments system is if it is about to blow up. However, the payments systems experts do not like being ignored, so they blow every single potential hiccup out of proportion.

• It is extremely unusual for banks to issue their own currency (“bank notes”) in the modern era. They instead exchange their deposits for governmental bank notes. This creates an asymmetry between the central bank and private banks. That said, banknotes are not a major part of modern economies (outside the underground economy), and their importance is overstated in online discussions.

• The major area of debates revolve around whether the currency is pegged or not. If the currency has a peg, then the central bank ends up in a position that is not radically different than a private bank. However, if the currency is not pegged, the central bank is freed from real obligations, and it is in the position of being able to do whatever it can get away with. This means that any “constraints” it faces can usually be worked around via some form of regulatory/financial engineering — which gets everyone attached to currency peg thinking mad.

The last topic should represent the bulk of the chapter, but I think I need to touch on the earlier ones before I get there.

Concluding Remarks

If we put aside the debateable effect of interest rate policy, central banking is mainly about ensuring cash flows flow where they are supposed to. So long as central bankers do not completely drop the ball on banking system regulation — which they did going into 2008 — the system should work as expected, and the economic forces that matter are elsewhere. In a country without a pegged currency, financial constraints on the central bank — like its equity level — are only of symbolic importance, and can be worked around. If the country has a peg, then does matter if there is any chance of the peg being broken. These fragmentary remarks should be explained in more detail in following articles.