Central Banking - The organisation of the FED and their politics within the last years (esp. in comparison to the ESCB)

Contents

1 Preface

2 Introduction

3 The Federal Reserve System (Fed) in the USA
3.1 The History
3.2 The Structure

4 The European System of Central Banks (ESCB)
4.1 The History
4.2 The Structure

5 The Comparison

6 Conclusion

7 Literature

List of used Appreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Preface

The following essay with the title „Central Banking – The organisation of the Fed and their politics within the last years (esp. in comparison to the ESCB)“ is part of the final examination of the course International and Baltic Finance at the University of Applied Sciences Stralsund.

This paper will explain central banking in general and than have a closer look on the U.S. Federal Reserve System. After that it will have a look on the European System of Central Banks, continuing with comparing the two systems, looking for the similarities and differences.

During my research I read quiet a lot of books and articles and after some time I really got interested in the topic. I really wanted to know how all this central banking works, and what kind of system (the American or the European) is the better one. But I also recognised that there are of course plenty of books, dealing with this topic, but everybody seems to have a different opinion, of what is better, what suits the society best. So while writing this essay, I tried to give back what I found interesting and what seems to be the opinion of several people.

Unfortunately I could not stick to the required 3000 words, because my topic was so complex and wide, that it forced me to write some more words on it.

2 Introduction

The rapidly changing development within financial markets requires that governments and their banks react, by reformulating or re-evaluation of their current practices. Central Banking seems to be the answer to that development. Fifteen years ago, only the German Bundesbank, the Swiss National Bank and the Federal Reserve System in the USA enjoyed legal independence. Nowadays more and more countries are establishing independent central banks, from Chile and New Zealand (in 1989) to Argentina (1992) and the Philippines (1993). Developed as well as developing countries are getting aware of the great importance of a central and independent bank^[1].

But what is a central bank? What is typical for it? To say it in general a central bank is a government sanctioned bank that has specific duties related to the performance of the macro economy. Mostly these central banks are charged by the national governments to control the money supply, so that they may promote the economic stability. Of course it is possible that a central bank has other duties as well, such as regulating the financial system, operating as check-clearing institutions or just performing general banking services for the government. As already mentioned there are quite a lot central banks existing today, and of course each central bank is having its own structures and powers. But nonetheless every central bank shares the responsibility of controlling the nation’s money supply.^[2]

But why do central banks exist? They are public institutions with a variety of different tasks, depending on the country. To fully understand how and why a central bank in a specific country is operating, one has to have knowledge of the country’s history. Governments have changed their views of what and how central banks should operate over times. So in normal times central banks were supposed to promote economic stability. But the definition of that stability measurement can of course change from country to country and from time to time. In the times of Keynesian macroeconomic policies (the 1930s – 1970s) the main goal was to achieve stability of the real economy, while this development varied in earlier and later times, focusing on price levels and financial stability. But there are of course also other reasons why central banks exist. There is the point that central banks may improve private payment systems by offering different solutions to problems, and they may directly provide mediums of exchange or money in different ways. They do this by backing them up with real resources like gold and/or by being willing to exchange golf for money all the time at pre-determined prices. They may also provide fiat-money (Money printed by a government as legal tender which is not redeemable and which lacks economic value.^[3]). Furthermore central banks provide means of payment both on the “retail level” as well as on the “wholesale level”, by clearing and settling large value payments. One of the most important points why central banks have been created is their task of controlling other banks, financial institutions and financial markets in general. There main reason of being is the general concern about the financial infrastructure. Central banks are therefore created to handle the core of the structure of monetary matters. Seen in this terms, inflation can be thought of as a tax on money, and high and volatile inflation will by that lower the efficiency of payment systems. But anyway central banks should not aspire price stability at any cost. In some cases it might be useful that rapid increases (decreases) in the money supply occur to support the stability of the payment system, even though this might be an inflationary (deflationary) action.^[4]

Mostly central banks serve as lender of last reserve (LOLR) to banks that cannot raise their cash to make the necessary payments they or their depositors has to do. Banks are normally funded with short-term liabilities, deposits, or borrowings, which they invest in longer-term assets. By serving as an LOLR the central banks can extend short-term credits until the panic is over. So simply by being there the central banks can forestall panics.^[5]

So central Banks are quite powerful and are able to influence economic conditions direct and indirect. A good example for direct intervention is a country intervening its own currency values. If a central bank for example sells some of its currency reserves for different currencies the demand for foreign currencies in the foreign exchange market would increase, causing an appreciation of the other currency against the currency within the country. By selling some of the foreign currency reserves the country could strengthen its own currency.^[6]

There are three main principles of the art of central banking. First of all a central bank has to safeguard its equity like any commercial entity, meaning that it has to act like any other bank, even though it might be the lender of last resort. The second thing is that the responsibilities of the lender-of-last-resort have to be assigned to the central monetary authority. The third and last point is that a monetary union requires not only a central monetary but also a big swift and fiscal authority, that has to safeguard the lender-of-last-resort responsibilities under all circumstances.^[7]

3 The Federal Reserve System (Fed) in the USA

The Federal Reserve Bank of the United States, also known as the central bank of the country, is widely known in financial and political circles. The Fed’s principle functions are similar to those performed by most of the other central banks throughout the world. The Fed is responsible for conducting the monetary policy, maintaining the liquidity, safety and soundness of the banking system, and assisting the fiscal authority (the U.S. Treasury) in carrying out some of its duties.^[8]

3.1 The History

The First Bank of the United States was created in 1791. It was made up to oversee the commercial banking system and attempted to maintain a stable economy within the USA. In 1811 it was closed, due to the fact, that Congress did not renew it. One aspect to that was, that it interfered with the development of the banking system and economic growth. Only five years later, in 1816, the Second Bank of the United States was created. It also had an only 20-year charter and was not renewed by the Congress in 1836. Several years of banking panics followed, culminating with a major crisis in 1907.^[9] So something had to happen, the country needed a kind of banking system.

On December 23rd 1913 an Act of Congress, the Federal Reserve Act, created the Federal Reserve System in the United States. It is composed of a central governmental body (the Board of Governors) and twelve additional regional Federal Reserve Banks within the country, which opened in 1914. All of them have been established under the umbrella of the Federal Reserve Board, consisting of seven members. By creating such a system, the government gained quite much influence over the affairs of the Bank.^[10]

In the beginning the functions of the Fed mainly included currency issues. At this time currency was collectible into gold, and had to be 40 per cent backed by gold or gold certificates. Furthermore the Fed had influence on the provision of banking services to the government, the provision of discounting and clearing facilities to member banks, as well as the regulation and supervision of member banks.^[11]

Another important task of the Fed in the beginning was the setting of two short-term interest rates, the discount rate and the interest rate, influencing long-term rates – bonds, business loans, and mortgages – often causing them to move in tandem. The discount rate is the less important one, which is charged for overnight loans of other banks. Even though it just has a small effect on the economy, this discount rate was the first interest rate that was publicly announced at that time. Due to that, considerable psychological impact on the financial markets and the economy were measurable when the discount rate changed.^[12]

In 1923 an Open Market Investment Committee was created, carrying out the responsibility for open market policies of the System.

After the creation of the Fed it has not been an independent institution. In the early years of its existence, the Federal Reserve Systems authority was much more decentralised and disputed than it is suggested. This decentralization of course created problems, which were not foreseen by the framers of the Fed. So reforms had to follow. Non the less the first 22 years of the Fed (1913 to 1935) can be called a trial-and-error process, which lead to the effective centralization of authority.^[13]

Since 1978 the Humphrey-Hawkins Act requires the Fed to report all its target ranges for money growth to the Congress two times the year. Of course, the Fed does this, but it is just an empty ritual that has to be done.^[14]

In the beginning of the 90ies (1990-1991) the Federal Reserve policy faced a recession. To do something against this, the Fed lowered the federal funds rate to three percent (in real terms it was about zero). This took some time and culminated into the fall of 1992. The next step, in February 1994, was to move back the funds rate toward neutral. Due to that attempt the nominal funds rate peaked at six percent (real rate being slightly above three percent) in February 1995. This rate was held until July 1995, when it went down again. This downward slight, coming in a three-step procedure, brought the funds down to 5.25 percent at the end of January 1996. At this time the inflation rate was in the 2.5 percent to three percent, meaning a real rate between approximately 2.25 and 2.75 percent.^[15]

During the past thirty years, the activities of the FED have changed. Due to the facts that public interest and confidence in monetary policy have grown, while inflation got lower, the Reserve Banks now charge fees for many of their financial services. Even member banks of the System have to pay for services. That development mainly occurred because of the competition of the Fed with commercial banks. On one hand Reserve Banks have striven to be more efficient, more responsive, and more innovative. On the other hand they have played quite active and increasingly visible roles in their communities and Districts, by providing expertise and civic leadership.^[16]

3.2 The Structure

So what makes the Fed work that well? First of all, the federal structure is important. The creators of the new system made up a unique formation that focused on federal issues, while being sensitive to the scope for regional conflicts. The second point was, that the framers thought of possible problems on forehand, so that they could create special instruments to react on these problems.^[17]

[...]

^[1] Lastra, R.M., (1996) Central Banking and Banking Regulation, Wilson Moss Limited, London, p. 9

^[2] Flaherty (2001)

^[3] http://www.investorwords.com/cgi-bin/getword.cgi?1928

^[4] Santomero et. al., (2001), Challenges for Central Banking, Kluwer Academic Publishers, Massachusetts, p. 2-5

^[5] Mayer (2001), The Fed: The Inside Story of How the World’s Most Powerful Financial Institution Drives the Markets, The Free Press, New York, p. 57 and 63

^[6] Madura, J., (2001), Financial Markets and Institutions 5th edition, South-Western College Publishing, Ohio, p. 409

^[7] Heinsohn/Steiger, (2002), The Eurosystem and the Art of Central Banking, Zentrum für Europäische Intergrationsforschung, Bonn, p. 4

^[8] Broaddus, A., (1998) A Primer on the Fed, Federal Reserve Bank of Richmond, Richmond, p. 3

^[9] Madura, J., (2001) Financial Markets and Institutions 5th edition, South-Western College Publishing, Ohio, p. 75

^[10] Capie, et. al., (1994) The Future of Central Banking: The Tercentenary Symposium of the Bank of England, Cambridge University Press, Cambridge, , p. 175

^[11] Capie, et. al., (1994) The Future of Central Banking: The Tercentenary Symposium of the Bank of England, Cambridge University Press, Cambridge, p. 176

^[12] Woodward, B., (2000) Maestro: Greenspan´s Fed and the American Boom, Simon & Schuster, New York, p. 17

^[13] Eichengreen, B., (1992), Designing a central bank for Europe: a cautionary tale from the early years of the Federal Reserve System, p. 14

^[14] Blinder, A.S. (1999) Central Banking in Theory and Practice, MIT Press, Cambridge, p. 29

^[15] Blinder, A.S. (1999) Central Banking in Theory and Practice, MIT Press, Cambridge, p. 35

^[16] Kopcke, R.W./ Browne, L.E. (2000) The Evolution of Monetary Policy and the Federal Reserve System Over the Past Thirty Years: A Conference in Honor of Frank E. Morris, Conference Series No. 45, Federal Reserve Bank of Boston, p. 1

^[17] Eichengreen, B. (1992) Designing a central bank for Europe: a cautionary tale from the early years of the Federal Reserve System, p. 15