Why traditional finance needs a full reset – Part 2 – Role of Central Banks

In my last article, I talked about the fiat currency based monetary system. I discussed how fiat currency has been exploited by governments who became powerful at  the expense of their citizens. I discussed how fiat currency system is at the center of a failing finance infrastructure that caused multiple boom/bust cycles, persistent inflation, increase in prices, debt and taxes. In this article, I talk about the second stressor in the existing financial ecosystem, Central Banks.

Origin of Central Banks

What is the Fed: History – Education
Origin of the Federal Reserve, United States (Source: frbsf.org)

While the concept of Central Bank existed since the 16th century, the Federal Reserve in its current form was born in the year 1913. The precursor to its creation was a series of bank-runs where citizens panicked and withdrew everything they could from banks based on some flying rumors. Such instances happened over and over again where even healthy banks suffered a collapse due to mass, panic withdrawals.

Without going into the specific details that led to creation of central banks, the Federal Reserve (and central banks in general) was brought into existence with the original mandate of being a ‘lender of last resort’ to avoid bank runs. By providing liquidity to banks under attack, Fed aimed to bring stability to financial system. What happened subsequently is a constant expansion of power by Central Banks (and Governments, as a proxy) as we shall see in the sections below

Original mandate of Central Banks was to be a bank of banks – a sort of lender of last resort.

Central Bank stated goals

Overtime, Central Banks gained more power & expanded their goals. Today, most Central Banks state the following as their reasons for existence:

  1. Ensure financial stability and prevent financial crisis (eg. bank runs)
  2. Ensure price stability or the stability in the value of money
  3. Stable real economy with high employment rate and a sustainable economic growth

While the first two goals are understandable, third goal is a ridiculously abstract concept which in my view has destroyed the credibility of Central banks.  Expecting Central Banks to ensure stability of the banking system is one thing but expecting them to ensure high employment rate and a high economic growth is a perfect recipe for disaster. It looks like a goal directly lifted from a socialist playbook. Let’s see why..

How do Central Banks achieve their goals?

To achieve the above stated goals, Central Banks across countries exercise varying degree of control over the economy. Here are a few things that Central Banks do:

  1. Grant banking licenses & ensure all banks hold enough reserves with them
  2. Have a monopoly over money supply. Supply & suck money from the economy to spur growth or cause slowdown (and recessions)
  3. Control the borrowing and lending rates in the economy (control cost of capital)
  4. Control the country’s foreign exchange reserves. Buy and sell foreign currency to ensure exchange rate stability
  5. Finance government deficits by buying treasury securities and long term bonds

Central Bank tools

In general Central Banks regulate the supply of money in the financial system. By creating and destroying money, they (theoretically) control the demand and supply of goods and services in the system. Here are the most common tools used by Central Bankers to achieve their goals:

  1. Reserves Requirement

Each commercial bank needs to maintain a minimum reserve capital to accept deposits in the market. Incase of losses for a bank, these reserves will shield depositors and lenders from losing their money. Higher the reserves, lesser is the lending power of banks. High reserves requirement leads to a contraction of money supply in the system.

  1. Open Market Operations

Fed sells and buys securities in the market from commercial banks. Fed buys bonds from banks and injects cash into the banks that can in-turn be be used for lending.  Similarly, Fed can sell bonds in market & suck out cash from bank’s balance sheet reducing their capacity to lend.


Private banks lend to each other in overnight markets, ie. a bank with a shortfall in reserve requirements can go to a bank that has capital in excess of reserve requirements and seek a loan on an overnight basis. The rate of interest charged by the lender bank to borrower bank is referred to as Fed Funds Rate. Fed Funds Rate becomes the benchmark for banks for all short term lending – greater the Fed Funds Rate, higher will be the short term interest rates for borrowers in the market and vice versa.


By controlling how much it sells & buys in open market, Fed controls the cash levels of the bank. Excess cash makes banks lend at a cheap rate & vice versa. The Board of Governors decide on a target Fed Funds Rate and the New York Fed buys/sells securities to get the Federal Funds Rate close to the target rate.

Quantitative Easing

Another popular tool that is an extension of the open market operations is what is called ‘Quantitative Easing’ (popularly known as QE). While the theoretical construct of controlling liquidity by trading securities is the same, QE differs from regular open markets  operations in two ways:

a. Unlike regular open market operations that buys less risky, short term securities, QE involves buying of more risky, long term securities. Quantitative easing consists of buying long dated treasuries, corporate debt, private assets, mortgage backed securities etc

b. Whereas regular open market operations are continuous, QE is pre-determined and usually is announced in advance as a commitment by Central Bank to buy certain amount of securities.

Federal Reserve Debt (Source: FRED, St Louis Fed)
Money supply injected by the Fed (Source: FRED, St Louis Fed)
  1. Discount rate

Banks can borrow directly from the Fed instead of borrowing from member banks – the rate of borrowing charged by the Fed is called Discount Rate. Discount Rate is usually higher than Fed funds rate to ensure that banks prefer inter-bank borrowing over Fed borrowing.

  1. Interest rate on Excess Reserves

Banks have a reserves in excess of minimum reserves parked with the Fed. Fed offers an interest on these reserves (IOER) – If Fed wants banks to lend more, it lowers the rate paid on excess reserves.  In essence lowering IOER and Fed Funds Rate increases liquidity in the economy & increasing IOER and Fed Funds Rate decreases liquidity in the economy.

  1. Foreign exchange control

In addition to above 4 tools, some economies (specially in developing countries) have given their central banks the ability to directly influence exchange rates. These economies fear that a market-driven exchange rate can lead to drastic moves in forex rate leading to economic instability.

Central Banks, buy and sell foreign exchange to peg the currency rate to a particular level. From time to time, central banks have intervened to cut a sharp rise/fall of currency triggered by speculators.

Some draconian central banks  (eg. Venezuela, Russia) impose hard controls limiting its citizens and companies to acquire foreign currency.

Why Central Bank policy fails

  1. Centralization of Power: I’m a Mechanical Engineer by education – as an engineer, I learnt that predicting the trajectory of something as simple as a ball on a billiards table is next to impossible. You need to literally trace path of the ball, measure angle after angle of impact to accurately predict the trajectory. Even a minor error in calculating initial direction, speed or angle of impact can create a huge (and unacceptable error) in the predicted trajectory.
Unpredictable trajectory of a ball

2. Always behind the curveThe continuous flip-flops of central bank governors & constant market interventions are proof enough that central banks are always late to the party. One policy decision to address one problem creates an other structural issue down the road which needs another intervention. Interventions are always reactionary & Fed and Central Banks are always in a chasing game.

Case in the point is quantitative tightening in 2018 to reduce liquidity in market. Just 6 months later, markets crashed leading to a reversal in a Fed policy.  In June 21, Fed thought inflation was short term imbalance that will vanish. By Jan 22, inflation zoomed & Fed starting saying that inflation is here to stay.

3. Creation of Black Swans: Nassim Taleb in his famous book ‘Black Swans’ has given us a powerful thesis – ‘natural systems, by a series of trial and errors & localized failures, become stronger. While individual participants will fail and perish, the collective society will benefit from these failures. Artificial & controlled systems hide local failures in the short term but create large, disruptive black-swan events in future’

No wonder, Taleb, a former derivatives trader, has built the ‘Black Swan’ theory based on his experiences in financial markets. Either under political pressures or a systemic OCD among central bankers, central banks are always in the ‘swat the fly’ mode without realizing that these short term imbalances can create a massive financial armageddon a decade down the line.

Let’s look at two examples that highlight this point:

a. Easy credit by Alan GreenSpan:   Post 9/11, Alan GreenSpan, the then Fed Chairman, aggressively cut fed-funds rate by almost 500 basis points (5%) from the 6.5% to 1.75% by end of 2001.


In 2003-04, American economy was still not responding to these low rates – growth was slow and wars in Afghanistan & Iraq were draining resources. Even though economy wasn’t getting adequate response from previous rate cuts, Greenspan doubled down and reduced the rates to an all-time low of 1% to trigger a housing boom. His thinking was Americans spending on home purchases will turbocharge economic growth (again, a disciple of Keynes ). He artificially kept rates low for continued period of time triggering reckless mortgage lending by financial institutions. This led to the subprime disaster necessitated a 700 billion USD emergency fund (again, tax payers money) to bail out giants like Bear Sterns, AIG, Fannie Mae, Freddie Mac and avoid a financial meltdown.

2008 financial crisis (Source: The Balance)

Every major central bank is piling up toxic assets on its balance sheet in their quest to artificially tinker with economic activity. Below picture shows the asset purchases and monetary expansion of central banks.

Central Bank assets. (Source: Haver analytics)

b. Bank of Japan unlimited bond buying: A more recent example is the ‘unlimited buying’ of 10 year Japanese government (JGB) bond by Bank of Japan (BoJ). BoJ has openly committed to keeping the 10 years yield curve (interest rate on 10 year JGB) at 0.25%, come what may. BoJ wants to support economic growth by keeping interest rates low – unlike Federal Reserve which controls short term interest rates, BoJ wants to control the long term interest rate (10 year rate, to be more precise)

In effect BoJ is artificially keeping the 10 year interest rate at a low level of 0.25% by paying a high bond price to any seller (bond price is inversely related to interest rate – since BoJ pays the highest price and has committed to unlimited buying, no buyer can match its price & hence 10 year interest rate is artificially held at 0.25%).


Here is the 10 year yield curve over the pastas 6 years

10 year JGB bond yield (Source: Bianco Research )

By providing a blank check to sellers, BoJ has been successful to keep the long term interest rate under control. But off late, it is getting increasingly difficult to hold the rate at 0.25%. BoJ is printing more and more money to hold that rate & as a result, JPY is continuously losing its value against US dollar, as can be seen in the chart below..

USD-JPY rate (Source: Bianco Research)

At the time of this writing, Japanese Yen has already crossed 130 and might as well hit 135. A weakening JPY makes it even more tougher for BoJ to continue with this policy in future. Not to mention the enormous strain it puts on JPY economy because of expensive imports, expensive international travel etc.

Conclusion

Central Banks are one of the most important stakeholders in traditional finance infrastructure. By controlling the levers of credit supply, Central Banks induce artificial growth and slowdown in economies. Constant interventions, simplistic assumptions by a group of old people who don’t really understand the second and third order effects of markets, continuous monetary expansion, political pressures etc create massive structural weaknesses over a long term.

In the current ecosystem, individuals always end up becoming hapless victims of large financial blowups. In my view, a sound, predictable monetary policy does not need constant tinkering & people would be much better off in a predictable, rule-based monetary policy (Bitcoin, anyone…). In my future articles, I’ll discuss how Bitcoin led monetary system will be superior to a Central Bank led monetary system,