Central Banking-USA

The Central Bank: A Profile
Despite their name, central banks are not “banks” in the same sense as commercial banks. They are governmental institucions that are not concerned with maximiying their profits, but with achieving certain goals for the entire economi, such as the prevention of commercial bank failures, or of high unemployment, and so on. Central banks, even if in a formal sense owned by private stockholders, carry out governmental functions, and are therefore part of the government.

Origin of central banks
Central banks have developed in two ways. One is by way of a slow process of evolution, the prime example being the Bank of England, which started out as a commercial bank, but acquired over the years the added powers and responsibilities that slowly turned it into a central bank. In this process of evolution it is hard to say when it ceased to be a commercial bank and became a central bank. In contrast to the Bank of England, many central banks did not just grow into central banks, but were central banks right from the start. Such central bank is from the outset owned de facto by the government, although it may have private stockholders. When a bank acts as a central bank, determines its actions on the basis of the public interest rather than its stockholders’ interest, it operates as a public institution.

Purposes and functions of a central bank
The two most important functions of central banks are: to control the quantity of money and interest rates, and to prevent massive bank failures. But they also have certain “chore functions”.
Central banks act as advisers to their governments, particularly in the area of intertnational finance. To do so, many central banks have large research staffs.

CONTROLLING THE MONEY SUPPLY
Each commercial bank, as it obtains reserves, expands its deposits. In the absence of some mechanism for controlling the volume of reserves, deposits, and hence the money stock, could grow at an inappropriate rate. One way of contorlling the growth rate of deposits is to require banks to stand ready to redeem their deposits in some valuable commodity, such as gold. Another is to institute a central bank charged with keeping reserves, and hence deposits and the money supply, growing at an approtriate rate. This does not mean that central banks always succeed in keeping the growth rate of money on the right track.

PREVENTING BANK FAILURES
One aspect of controlling the money supply is the need to guard against bank failures, particularly if there are many relatively small banks. This is not to say that central banks always did prevent widespread bank failures. But a central bank should acts as a lender of last resort, that is, as an institution able and willing in a crisis to make loans to banks when other banks cannot, or will not, do so.

Being ready to act as a lender of last resort is a extremly important function of a central bank. When one looks at the day-to-day activities of a central bank, its lender of last resort functions seems irrelevant and unimportant. Although a central bank does not normally act as a lender of last resort, it must always stand ready do do so, even if it means that it must temporarily abandon other goals such as fighting inflation.

CHORE FUNCTIONS
One set of chore functions consists of services the central bank provides for commercial banks. Thus it acts as a banker’s bank, holding most of the reserves of commercial banks. These reserves have no physical existance. They are just entries on the liabilities side of central bank’s balance sheet.
In addition to its services for commercial banks, a central bank provides many services to the government. Thus it acts as the government’s bank. The government keeps an account at the central bank, writes its checks on this account, and in some countries, sells its securities through the central bank.


Another group of services to the government arises directly out of the central bank’s close relation with commercial banks. Thus the central bank typically administers certain controls over commercial banks.
In some countries, in particular the less developed countries, the central bank also makes loans to the Treasury. But having the central bank make loans to the Treasury can by highly inglationary since it does so by creating new money, and such an increase in the money supply often results in inflation.

Another function of central bank is to issue currency. In many countries all the currency notes in circulation are issued, that is, placed into circulation, by the central bank, though sometimes the Treasury issues some currency notes as well.

Other aspects of Central Banking
There are two items, which must to be discussed: the relation of central banks to the rest of the government, and their ability to create reserves.
Relations between the central bank and the government are complex. Although central banks are part of the government, they maintain a certain detachment from the rest of it. They usually have much more independence from the administration than do such government agencies as the Treasury Department.


Central banks have the power to create reserves. Unless there is a law stating that the central bank must keep twenty cents in gold for each dolar of its outstanding currency notes or deposits, it can create as many reserves for the commercial banks as it wants to. These reserves consists, apart from currency, merely of entries on the central bank’s books. Hence, if a central bank wants banks to have more reserves, all it has to do is to buy securities from them, and pay for the securities by writing up their reserves on its books.

The fotmal structure of the Federal Reserve System
Although other developed countries generally had central banks much earlier, it was not until 1913 that the United States established the Federal Reserve System. Until then, the Treasury carried out some quasi-central-banking functions, but it did so only in a rudimentary way. One reason the United States had not establishd a central bank was the fear of concetrated financial power. Populists were worried that a central bank would be dominated by the big banks, who would employ it as on instrument of monopolistic control. Conservatives, on the other hand, were worried that a central bank would by dominated by politicians beholden to debtor interests, who would use it to impose inflationary policies.


Those who urged the establishmen of a central bank pointed to the waves of bank failures and the resulting financial crisis that from time to time plagued the U. S. economy. Other countries avoided these problems because they hand central banks. In addition, without a central bank, check clearing, was cumbersome and slow.


In 1907 an unusually financial crisis provided the final push needed to establish a central bank. In december 1913 was signed the Federal Reserve Act by president Wilson.


The Federal Reserve Act was a carefully crafted compromise that tried to allay the fears of both populists and conservatives by a well-planned system of checks and balances. Instead of a monolithic central bank, the Act resulted in the establishment of twelve Federal Reserve Banks located in various parts of the country, with a Federal Reserve Board in Washington, D. C. Thus power was decentralized geographically and shared amont the Federal Reserve Banks and the presidentially appointed Federal Reserve Board.


The Federal Reserve System was established primarily as a way of pooling the reserves of member banks. It was supposed to make loans out of these pooled reserves to banks that were short of reserves. By being pooled in the Federal Reserve Banks the reserves of member banks could be mobilized for use where they were most needed. Solvent banks would no longer by destroyed by bank runs when there were other banks that had large reserves that they did not need, and thus could be lent.


The high hopes of the founders of the Federal Reserve System were not met. In the 1930s the Federal Reserve did much too little to meet the demand for reserves, and the United States experienced the worst financial crises and most severe bank failures in its history. Largely as a result of this experience, the Federal Reserve System we have today is quite different from the one instituted in 1913. It has been changed both by important legislation in 1935 and 1980 and by that slow evolution in modes of functioning that is a matter of internal organization and practice rather than of statutory change.



Thus the 1935 Banking Act centralized power in the Board of Governors by reducing the power of the Federal Reserve Banks. It also made the Fed more independent of the president by eliminating the appointment of the Secretary of the Treasury and the Comptroller of the Currency to the Federal Reserve Board, now renamed the Board of Governors. The 1980 legislation eliminated the most important distinction between member banks and other banks, since it required all banks to meet the same reserve requirements, regardless of membership in the Fed.

The Federal Reserve Banks
The assets of various Federal Reserve Banks are far from equal. More than half the assets are held by just three: New York, Chicago, and San Francisco. The New York Bank alone accounts for about 30 percent of all Federal Reserve assets. Apart from its size, the New York Bank is the “first among equals” because its location gives it direct contact with the country’s main money market. Hence, it is this bank that carries out all the purchases and sales of securities on behalf of the whole Federal Reserve System. In addition, it is the Federal Reserve System’s contact point in many, though not all, of the Fed’s dealings with foreign central banks and international institutions.


Each of these Federal Reserve Banks is controlled by a board of nine part-time directors. Three of these directors, called Class A directors, are elected the member banks, an are bankers themselves. Member banks also elect three Class B directors. These directors may not be officers or employees of banks. To prevent domination by any particular size group of banks, member banks are divided into large, medium, and small banks, and each of these groups votes for one Class A and one Class B director. But actually, neither Class A nor Class B directors are “elected” in the proper sense of the term since there is usually only a single candidate for each election. Frequently the single candidate for the election as a Class B director, and often also the single candidate for a Class A directorship, is someone suggested to the banks by the president of the Federal Reserve Bank.


Finally, thera are three Class C directors. These are not elected by the member banks. They are appointed by the Board of Governors to embody the boarder public interest beyond that of banks and their borrowers. One of these Class C directors becomes the chairman of the board, and another the vice-chairman.


In desribing the various classes of directors we avoid saying that any of the three classes “represents” a particular group, because all directors are supposed to represent the public interests rather than the narrow interests of bankers or borrowers. The public interest, however, is like proverbial elephant described by the blind men. One’s associations and experience affect one’s perception of the public interest.


The chief executive officer of each Federal Reserve Banks is its president. He (she) is chosen by the directors with the approval of the Board of Governors. In recent years he (she) has frequently been someone initially suggested to the directors by the Board of Governors. Most of the recently appointed presidents, unlike most of the directors, have been professional economists.


The Federal Reserve Banks examine member banks, approve or disapprove some bank-merger applications, clear checks, withdraw worn currency from circulation, and issue new currency. In addition to those chore functions, the Federal Reserve Banks have some policy functions too. Each “sets” a discount rate, that is the rate the Fed charges on its loans to banks and other depository institutions in its district. But this rate has to be approved by the Board of Governors and, furthemore, the Board of Governors, by its power to approve or disapprove the existing discount rate, can force a Federal Reserve Bank to change its currency rate. A more important policy role of the Federal Reserve Banks is to participate in the Federal Open Market Committee.


Still another function of the Federal Reserve Banks is to provide the Rederal Reserve System with local contacts. Most statistical data become available only with a delay. However, by talking to local business managers, the directors and the president of the Reserve Banks hear of future economic developments.


Another important function of the Federal Reserve Banks is to explain and justify Fed actions to the local business community, thus generating political support for the Fed. The Fed needs such political support to fight pressures brought on it by some members of Congress, and sometimes by the White House. Like any other policy-making agency, the Fed has to act as a political animal.

The Board of Governors
At the apex of the Federal Reserve System is the Board of Governors, located in Washington,
D. C. The seven governors are appointed by the president of the United States with advice and consent of the Senate. A full term of office is fourteen years, and governors cannot be reappoited after saving a full term. This is supposed the remove them from needing to seek the president’s favor, or fearing his threats. In the ideal case all governors would serve out their full fourteen-year terms, which are staggered. If so, there would be only two vacancies on the Board every four years, so that within a single term a president could not dominate the Board. But the chairman’s term, as chairman, though not as board member, is only four years so that each president can appointed his own chairman. These provisions are examples of the checks and balances built into the Federal Reserve System.


The Board of Governors makes monetary policy; it controls the discount rate and, within limits, can change reserve requirements. Together with other members of the Federal Open Market Committee it controls the most important tool of monetary policy, open-market operations. In addition, its chairman is one of the main economic advisers to the president, as well as to Congress. And governors sometimes also act as U. S. representatives in negotiations with foreign central banks and governments. Beyond this, chairmen frequently press their views on fiscal policy and other economic issues in statements to Congress and to the general public. The Board has a large and competent staff of economists to aid it in this work.


Despite the fact that determining monetary policy is by far the Board’s most important task, much of its time is spent on bank regulatory problems. For example, it passes on many bank-merger applications and decides the permissible lines of nonbank activity for bank holding companies. In addition, it administers the laws that prohibit discrimination and untruthful statements in lending. In these activities the Board of Governors’ control extends beyond banking to credit in general. Since the Federal Reserve has a reputation as an efficient agency it tends to have many peripheral tasks thrust upon it. Closer to home, it exercises some rather loose supervision over the Federal Reserve Banks, which have to submit their budgest for Board approval.

The Federal Open Market Committee
The focal point for policy-making within Federal Reserve System is the FOMC, the Federal Open Market Committee. This committee consists of the seven members of the Board of Governors, whose chairman is also chairman of the FOMC, and five presidents of the Federal Reserve Banks. The FOMC meets about eight times a year, and sometimes hold telephone conferences between meetings.


The FOMC’s function is to decide to open-market operations, that is, Federal Reserve puchases and sales of securities. The FOMC does not carry out security purchases or sales itself. Instead, it issues a “Directive” telling the New York Federal Reserve Bank the open-market policy it should follow for the accounts of all the Federal Reserve Banks.
There are some other Federal Reserve components, but they are much less important than the FOMC. One is the Federal Advisory Council, which consists of one commercial banker from each district.

The informal structure of the Federal Reserve System
Merely to know the formal, legal aspects of an organization is rarely sufficient. The Fed, like any other organization, has developed certain traditions and other attributes that strongly affect its operations. These informal aspects are neither definite nor clear-cut. One of thes is the distribution of power within the Federal Reserve System.

Distribution of Power within the Federal Reserve System
Although the distribution of power over monetary policy within the Federal Reserve System and among “outsiders” is a matter of judgement, there are two qualifications: First the distribution of power cannot be quantified precisely; Second, the distribution of power depends, in part, on the personalities involved.


The chairman’s power is based on five sources. First, as the head of the Board, his/her opinions and statements carry great weight with the public. Second, a number of decisions do not even come before the Board, but are taken by the chairman solely as the Board’s representative. Third, the chairman arranges the agenda and exercises the leadership role at the Board’s meeting. Fourth, the chairman maintains supervisory powers over the Board’s staff members, who therefore have a greater incentive to please the chairman than other Board members. In trying to debate with the chairman, the other governors are severely limited by a lack of staff support. Finally, the foregoing powers of the chairman give him/her an aura of authority, which tends to induce other Board members to vote the way the chairman does. But the chairman does not always get his way.

The Federal Reserve’s Constituency
To refer to the Fed’s constituency is to use the term in a broader sense than when it is applied to the geographic constituency of a member of Congress. A government agency tends to view itself as speaking for a particular group, and tries to represent this group’s interests within the government. In return, the agency receives political support from its constituency.

Finance of the Federal Reserve System
The outstanding stock of the Federal Reserve Banks is owned by its member banks, who receive a fixed 6 percent dividend on this stock. Ownership means two things: the right to appropriate all the net earnings, and the right to control the property. Member banks have no claim on the residual earnings of the Federal Reserve Banks. They get their 6 percent dividend, regardless of the Fed’s earnings. Similarly, they have very little control over the Federal Reserve Banks, and none over the Board of Governors. Hence, they do not control the Fed.


The net earnings of the Federal Reserve Banks come from the securities they hold, and to a much smaller extent from interests on the loans they make. They also charge financial insitutions for the services they perform for them, such as clearing checks. But wher do the funds that the Fed invests in securities come from? The main source is the issuance of Federal Reserve notes, that is, the currency notes that we carry in our wallets. Suppose the Fed prints $ 1 million of Federal Reserve notes and ships tham to a bank that asks for them. It then debits the bank’s reserve account. If it wants to keep total bank reserves constant it then offsets this decline in bank reserves by buying $ 1 million of securities in the open market. Hence, on its books its liabilities for outstanding Federal Reserve notes are up by $ 1 million, but so are its government security holding. Apart from this, the Fed can buy securities in a way akin to deposit creating by banks. It simply pays for the securities by giving banks credit on their reserve accounts. Similarly, when the Fed makes loans to member banks it just writes up their reserve account.


Out of the earnings on this capital the Fed pays its dividends on member bank stock. After taking care of this item it places a relatively small amount into its surplus account; the great bulk of net earning is normally turned over to the U. S. Treasury.

Federal Reserve independence
The Fed has a great deal of independence, much more than other government agencies. While the president of the United States appoints new governors as vacancies occur, and chooses his own chairman, once he has made these selections, officially he does not have any more power over them. Once appointed, they can ignore the president’s wishes. This may well happen because new governors tend to become co-opted by the Fed, this is, to accept the prevailing Fed view. Governors rarely dissent from the Fed’s line, at least in public.


In a formal sense, Congress can control the Fed. The Fed has been set up to be a “creature of Congress” as Congress likes to remind it. But Congress is not organized to exercise day-to-day control over it nor, under present legislation, does it have the right to do so. Thus, while the Fed reports its targets for the growth rate of the money stock to Congress, in priciple it could ignore any congressional reactions to these targets.

Actual independence
But the formal situation as set forth in legislation is only part of the story. Acually, the president and Congress have considerable ingluence over the Fed. One source of the president’s influence is moral suasion; the governors are reluctant to oppose the views of the one person elected by the whole nation; they go along if they feel they can do so without dereliction of duty. Second, the Fed is continually active in Gongress, trying to obtain certain legislation that would help ti in regulating banks, or to block other legislation. It wants the support of the president in these legislative struggles, and hence has an incentive to keep on good terms with him. Third, the chairman wants the president’s googwill, so that when the president appoints a new governor, it will be someone the chairman prefers.
In general, the Fed cannot take the continuation of its independence for granted. It is to som extent“a prisoner of its independence”. It may have to give in on some issues to prevent Congress from taking away some of its independence.


But the influence of the president and Congress should not be overestimated; on some issues the Fed can mobilize an extraordinarily powerful lobby of bankers in each congressional district to pressure Congress into preserving its independence. Congress, by and large, doubts its ability to challange the Federal Reserve, in part because the Fed claims to possess esoteric knowledge about monetary policy, and in part because the Fed claims that it is our protector form explosive inflation. Moreover, members of Congress would reap little political benefit from becoming informed enough about monetary policy to challange the Fed in a sophisticated way. Demagogic attacks on the Fed may win plaudits from some people back home, but the Fed can usually show that these attacks are naive. At times when sharply rising interest rates upset many voters, however, the Fed is vulnerable to congressional pressures. Fortunately for the Fed, such periods of rapidly rising interest rates usually pass before the opponents of the Fed can mobilize public opinion.


The Fed fosters its independence from Congress, and from political pressures in general, by providing little information. Compared to foreign central banks, the Fed is much more open, but that is not saying much. One of the necessary skills of a Fed chairman is the ability to evade giving clear answers.

The Subtlety of the Fed’s independence
As mentioned earlier, the Fed’s independence is ill-defined. Here is an illustration. Officially, the extent to which the Fed is independence is set by law. Since Congress changes the relevant laws infrequently, one might expect that the range of the Fed’s independence is constant. But laws set only the general framework. Both tradition and unfolding events play an important role in determinig the actual degree of the Fed’s independence.

Independence: Pros and Cons
Does the Fed have too much or too little independence? From time to time this question becomes a political issue, and it may sooner or later become a major issue in presidential election. Political debates about the Fed’s independence do not result so much from fundamental disargeements about the proper role of the Fed in the fovernment as from strong disagreement about the policy that the Fed is following. One way to change this policy is to bring the Fed under control of those in Congress or the administration who oppose this policy. Another way is to frighten the Fed enough so that it will change its policy. Thus, in 1982, when interest rates were extraordinarily high, several bills to reduce the Fed’s independence gained powerful support in Congress. Shortly thereafter the Fed changed its policy, perhaps in part because of these threats.

The Case for Independence
There are several arguments on both sides of the independence issue. Supporters of independence argue that monetary policy, and hence the value of the dollar, is too important and too complex an issue to be left to the play of political forces.


In this view the political process is myopic: being overly concerned with the next election, it overplay the importance of short-term benefits, and hence is unwilling to make those hard and unpopular decisions – such as tolerating more uneployment in the short-run – that are needed to obtain the long-run benefits of a stable price level. Moreover, politicians, if they can, are likely to use the central bank to finance increased government expeditures without raising taxes. In addition, pressure groups impart an inflationary bias to government policy. Hence an independent central bank largely removed from political pressures is needed to ensure justice to those who lose from inflation. Anyone familiar with the case for a gold standard will probably see a similarity with the argument that the gold standard guards against unwise inflationary actions.


In addition, even if the politicians’ desire for a certain monetary policy accurately reflect the public’s wishes, it is not obvious that the Fed should necessarily go along. One might argue that the public has better things to do with its time than study economics. It therefore delegates certain decisions to the Fed. Specifically, the public suffers from what William Poole has reffered to as the “number one problem syndrome” – during a recession all that seems to matter is to lower the unemployment rate, while during an inflationary expansion, reducing the inglation rate is all that matters. But a too expansionary policy to fight unemployment ultimately results in too much inflation, and a restrictive policy that lowers the inflation rate also raises unemployment temporarily. Hence, the public may well prefer to have the Fed pay less attention to its temporary policy preferences.


Moreover, there is the danger of a political business cycle. Essentially it is a situation in which, prior to an election, the president induces the Fed to adopt an expansionary policy that temporarily lowers interest rates and reduces unemployment. Then after the election the Fed reduces the inflarionary pressures resulting from that policy by becoming more restrictive. Interest rates and unemployment now rise. But the president does not mind – the election has been won.

The Case against Independence
Critics of central bank independence reject these arguments. They believe that it is fundamentally undemocratic to say that elected officials should not be trusted to judge monetary policy. To be sure, monetary policy involves difficult decisions that need a long-run point of view, but the same thing is true of foreign policy or defense policy. Moreover, for better or worse, the public holds the president responsible for the enonomic conditions that result from all the policies followed during his administration. Hence, he should have control over monetary policy, one of the most important of these policy.


In addition, some economists maintain that the Fed has not used its independence well and therefore should be deprived of it. At times it has tolerated inflation, as in the late 1960s and 1970s, and in other years.


Finally, monetary and fiscal policies should be integrated, and adequate integration cannot be achieved, the opponents of Fed independence claim, merely by a process of informal consultation. Rather it requires that the Fed need not necessarily weaken its influence, and might even strengthen it. If it were part of the administration, the Fed’s counsel would then be better heeded by the administration.

Possible Compromises
These pro and con arguments may give the misleading impression that the choice is between two irreconcilable extremes. But this is not so. Even if the Fed were to lost its formal independence, and become part of the administration, there would still be at least an attempt to keep it out of partisan politics. Moreover, as just pointed out, the independence that the Fed currently has is far from complete.


On a more practical level, the relevant debate does not deal with such “fundamental” issues as the Fed’s complete independence, but focuses on proposals for relatively minor reductions in its independence. For example, one proposal would make the chairman’s term of office coincide better with the president’s so that each president could appoints his/her own chairman a year after taking office. Other proposals would shorten the term of the governors or eliminate the FOMC and shift its work to the Board of Governors. A more radical proposal would put the Secretary of the Trerasury on the FOMC, and an even more radical one would make the Fed turn all its gross earnings over to the Treasury and finance its activities througj congressional appropriations. This would give Congress much more control over the Fed.