Bankers to Bankers

What do central banks do?

Eccles Building in Washington, DC. Source: Wikipedia

The Federal Reserve was formed in 1914 as a way to stabilize the banking system. The late 19th century had been plagued by a series of financial panics and stock market crashes, topped off by the Panic of 1907. This was headed off by J.P. Morgan and a consortium of bankers, who set themselves up as lenders of last resort to banks that were in trouble. Newspapers at the time repeatedly reported on how Mr. Morgan was feeling, implying that a healthy J.P. Morgan was necessary for a healthy economy

This was crazy. Even back then, the US had one of the largest and most dynamic economies in the world. It shouldn’t depend on one man’s decisions—or even a small group. Other countries had central banks—bankers to the banks. When depositors lined up outside the door, the central banks could stem the tide.

So Congress established 12 regional Federal Reserve banks and an Open Market Committee to oversee the entire organization. Over time, the Fed has evolved from purely technical functions to regulatory oversight and policy management. Now it is the principal government agency tasked with maintaining the stability of our economy and financial system.

Source: Openclipart

And the system needs to be stabilized. We live in a world of fractional reserve banking. Money is created or destroyed when people take out loans or pay them down. When a bank makes a loan, it creates an asset on its balance sheet and creates a checking account deposit at the same time. The borrower uses the deposit for some kind of economic activity, and eventually pays back the loan. The faster bank loans grow in an economy, the more the money supply grows. Financial panics happen when people become convinced that they won’t be able access the deposits in their bank, so they pull them all out at once. By standing behind other banks, a central bank boosts confidence—ironically creating the conditions where people don’t see the need for a central bank in the first place.

Source: Econstories

The Federal Reserve enjoys a lot of independence. It’s actions—taking away the punch-bowl just when the party starts to heat up—are rarely popular at the time. And stabilizing good banks during a panic can look like bailouts for cronies. But sustainable economic growth requires a stable foundation. And having a safe place to keep your cash—and a reliable place to get a loan when you can use one—is pretty foundational.

Douglas R. Tengdin, CFA

Chief Investment Officer

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