Why central banks have lost their leverage
Samuel Brittan wrote this in 1999, but it rings ever more true today.
In this editorial he explains why central banks lost much of their power, because of the increasingly small supply of money that they effectively control.
He refers to the following paper: The Future of Monetary Policy, from Benjamin Friedman.
By the way, read this analysis in Counterpunch as well: it explains how the new bail-out plans are designed to enrich the very people who destroyed the financial system.
Samuel Brittan:
“Mr Friedman provides three main reasons why central bank power may disappear. The first is the erosion of the demand for bank money. “Smart” cards – for example the single vendor advanced payment cards already used by many telephone services and the New York subway system – could develop into genuine private money. So long as issuers of these cards ask for settlement by transfers from bank balances conventional bank deposits are still required. But within 25 years from now firms and individuals might simply accept and swap balances on the books of a transport or telephone authority. In other words they would be means, not only of payment, but also of settlement.
Central banks could of course try to retaliate by imposing reserve requirements on more and more kinds of financial institutions. The issuers of private money would respond by changing their products to evade the new regulations. The central banks would almost certainly be one step behind the ingenuity of institutions in devising new products.
Some might object that the central bank would still have control over outstanding currency – notes and coins. But currency is now issued automatically in response to public demand. Monetary policy mainly operates through the banks.
A second development is the proliferation of non-bank credit. At present, when a bank extends credit, deposits are created on the other side of the balance sheet which have to be backed by reserves at the central bank. But bank credit has been steadily contracting as a proportion of total credit. Advances in data processing and the easier availability of information are likely to reduce the special advantages of banks in deciding on credit-worthiness. Moreover, even where banks still issue loans there is a trend to “securitisation”. This means that the loans are sold to non-bank investors who are not subject to reserve requirements.
Third, reserves with central banks are often held as a necessary means of settling interbank transactions. This gives the central bank leverage to affect total deposits by means of small operations. Yet the evolution of private clearing mechanisms like the US net settlement system CHIPS threatens to erode the central bank role even here. The combined results of all these developments could well be to reduce, perhaps to the point of elimination, the need for bank reserves and even the need for banks and cash altogether.
Mr Friedman is disarmingly frank about some of the further consequences. For instance, he cannot say what will determine the price level, or rate of inflation, in this brave new world. Nor does he know whether national authorities will find an alternative way of limiting inflation and deflation or ironing out the worst of the business cycle. Some British economists may gleefully rub their hands and say that we will have to return to the postwar orthodoxy and use fiscal policy. Really? In a world where central banks cannot stop the creation or destruction of huge amounts of credit, it is difficult to see how moderate variations in the budget surplus or deficit can act as a substitute.”