The kids are over on the internets using the Tweet machine to ask Ben Bernanke some questions. There are also some adult questions mixed in there. For instance, Jim Grant asks:
“Could you help me understand the difference between central banking and market manipulation?”
Now, I’m no Ben Bernanke, but I would like to take a stab at this one.
First of all, it’s important to understand what central banking really is. For instance, in the USA, the Fed system exists because rogue independent banking like we had in the 1800’s proved highly unstable. In essence, payment processing was inefficient and extremely unstable during times of crisis. The primary role of the Fed system is to bring payment clearing into one place. We call this the “interbank” market in the USA. It is where all the banks settle interbank payments. They do so by being required to maintain deposits at the Fed. You can think of it as being the best of all worlds between having a nationalized money system (like one national bank that clears ALL payments smoothly) and maintaining private competitive banking. The Fed is a buffer of sorts. It is neither a pure public entity nor a pure private entity.
But this system is a bit of an inconvenience for private banks who would really prefer not to have to engage in all of this “oversight” and central clearing to begin with. In a perfect world they’d monopolize the money game and tell the government to take its ball and go home. Obviously, that’s not what we have. So we have a reserve system. And to the banks who participate in this system it is, by mere existence, “excess”. You can think of all reserve balances in this interbank market as being “excess” to private competitive banks. So, they would prefer not to hold them. This puts pressure on the overnight rate because the banking system will naturally try to rid itself of excesses. So the Fed must make a choice. Will it let the overnight rate drop to zero or will it support it in various ways? Obviously, the Fed chooses to support the rate. In other words, it manipulates the rate higher.
Things get a bit tricky here. In addition to facilitating this essential clearing system, the central bank can manipulate the spread at which banks make a profit on their loans. This can have a significant impact on profits generated by banks. The problem is, this manipulation is far from an exact science. And when you layer operations like QE on top of that we have to start worrying about market disequilibrium and potential unintended consequences of this intervention. But yes, make no mistake, there is a clear distinction in the roles of the central bank. Its most important role is as a facilitator to a smooth payment system. Its secondary role is in influencing the price of inside money (bank money) in order to steer the economy. The primary role is unquestionably positive. The secondary role of what is definitely “manipulation” is up for debate.
Did you have a comment or question about this post, finance, economics or your love life? Feel free to use the discussion forum here to continue the discussion.*
*We take no responsibility for bad relationship advice.