During this dreary time of the year, it is nice to encounter news stories that make you giggle. That happened last week when I read a wire service story reporting, with much hand-wringing and tut-tutting, that the European Central Bank lost more than a billion dollars in 2004 because of the decline in value of the U.S. dollar.
The writer didn’t understand that the profits and losses for central banks are less important than what brand of soap is available in their marbled restrooms.
Central banks are fundamentally different from commercial banks. Unfortunately, the general public and many journalists fail to appreciate that fact. Public misunderstanding about the role of central banks in modern economies increases the likelihood that central banks will make policy mistakes.
Profits or losses are critical for commercial banks because they are for-profit businesses that have to create acceptable returns for their owners or they go out of business. One way commercial banks maintain profitability is by ensuring that they do not make too many bad loans.
Central banks exist to serve society as a whole by managing a nation’s money supply. In the course of their operations, they may generate “profits” that are turned over to the nation’s treasury. Whether they make a profit, however, is of minuscule importance compared with success or failure of monetary policy.
A successful monetary policy avoids inflation and maintains a generally stable price level. It also ensures the stability of the nation’s banking and financial system by stepping in as a lender of last resort when financial crises loom.
That means a central bank often must be ready to lend money precisely when financial conditions are such that the loans they make will not be repaid. When a central bank pulls back from lending money (or buying up bonds) in a financial crisis because it fears eventual loan write-offs, it fails in its core mission.
That is what happened the first two times the U.S. Federal Reserve system faced national financial crises. The Fed was established as Europe entered World War I. The war proved to be an economic boom for the United States. Commodity prices rose sharply. When the war ended, bubbles in farming, timber and mining land prices popped. Industrial order books shrank. The economy went into recession.
This was precisely the time the Fed should have pumped out liquidity. It failed to do so because key Fed officials, largely recruited from private banks, forgot they were central bankers — not commercial bankers — and shied away from lending because they feared loan losses. The recession was unnecessarily severe.
The Fed repeated this failure from 1929 to 1932 when it stood by and let the nation’s money supply shrink by half as the world spiraled into the Great Depression. The Fed, less than two decades old, was 0-for-2 in dealing with the crises it was created to handle. The cause of failure was thinking about its own bottom line rather than the needs of society.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.