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Old Sep 1st 2009, 10:33 PM
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Michael Michael is offline
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Default Central Reserve Banking

This thread is for a discussion about the role/purpose/function of central banks. As a general rule, this means a discussion of the US Federal Reserve because it is the largest, most powerful and most influential central bank in the world. However, other central banks are indeed very similar to the Federal Reserve in process, if not in private ownership.

Before we get into discussing central banking authority however, I think we need to discuss fractional reserve banking first since it is so important to the whole issue.

What is fractional reserve banking?

This is the financial technique that describes the fundamental character of all western banking systems. In simplified terms, it is the process whereby banks take in money on deposit, keep ten percent of it on hand, and lend out the other ninty percent for profit. In the process of so doing, private banks actually 'create' money in the form of loans deposited into private accounts.

Currency is actual cash money - but it is only part of the actual money supply. Money in current accounts is also considered "money" since you can draw it out in currency and spend it immediately. Thus, growth in bank loans (ie. debt) is how the money supply actually increases over time. The rate at which the money supply grows can be sped up or slowed down by adjusting interest rates (which may reduce or increase the demand for loans). Thus, when the banks make lots of loans, the money supply grows. When the banks don't make any loans, the money supply doesn't grow at all.

Now this is all very simple and straight forward (and very profitable). Banking is done through the process of keeping only a 'fraction' of their reserves on hand to meet daily demands for currency. There is one big flaw in this process and that's the dreaded "run" on a bank. That's when all the bank's customers demand their money on deposit be paid to them in currency. That is physically impossible for the bank to do, so the bank ends up going bust. History is littered with thousands of examples of this actually happening - meaning that this is not a 'theoretical' threat at all - it is very real.

When that happens, lots of people (and corporations) end up going bankrupt or broke since they often lose their life savings in the process. This is generally considered a bad thing and thus great efforts are engaged to avoid it. The principle method to avoid the problem of a "run" on a bank is to have a banking system that instills confidence that it won't have any serious problem. One way to do this is to have a central bank run by the highest banking authorities (or the government) to manage the process.

What is a central bank?

A central bank is a bank that is granted the sovereign and monopoly right to issue currency. They don't really operate like a normal bank since they only exist as a bank for other banks. Central banks have the 'right' to issue currency and thus have the sovereign right to 'create money'. Central banks do this by issuing Treasury Bills (and other similar bonds) and selling them. Thus, the central bank prints off some pretty looking bonds that promise to pay the holder the principle plus interest at the end of a term and sells them to the public. These bonds are considered to be sovereign debt - supported by the wealth of the nation's power to tax.

The central bank receives actual 'money' from the various buyers of these fine pieces of paper and holds that in deposit. These deposits can now be loaned to other banks on the principle of fractional reserve (holding 10% and lending out the other 90%) at an interest rate set by the central bank itself - usually lower than any rate available on the private market. Thus banks can borrow these funds and immediate turn around and loan out 90% of that money at a higher rate of interest. In the process, the private banks make a profit and the money supply will grow. Thus, central banks exist to manage the money supply and to act as a lender of last resort for private banks to prevent inopportune bank failures.

What's the problem?

The key issue is that the central bank issues interest bearing debt against the sovereign in order to facilitate the process of managing the money supply and the issuing of currency. The problem is that the more the economy grows, the more debt builds up. Growth in debt is needed to make the economy grow. Thus governments and central banks have a strong vested interest in increasing debt whenever possible (and low interest rates are thus held to be always a good thing).

The prosperity of the nation is thus apparently dependent upon the populace or the sovereign or both being heavily indebted. That's strikes me as a problem.

What's the solution?

I think the idea of issuing currency directly by the sovereign central bank would be a whole lot better idea. Why go through the silly game of issuing Treasury Bonds and loading up the sovereign with debt against taxes? Why not just issue currency directly? Just run the printing press and print out the currency that is needed. Banks can still play fractional reserve banking games and make lots of profits, and the central banks can still control the money supply and act as a lender of last resort. The only difference is the central banks wouldn't be issuing interest-bearing debt against the sovereign in the process.

What backs up this currency that is just printed by the printing press? Nothing more than a sovereign-backed promise to accept them as money. Precisely the same thing that backs up the Treasury bills in the first place. So why the charade of issuing T-bills? I respectfully submit, the purpose is to create additional debt which creates an obligation and a process to keep the whole system going along.

Anyone have any comments or questions?
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