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Thought of the Week: Back to School: Summer Vacation Ends for Central Bankers

September 14, 2012

The fact remains, however, that the monopoly power over base money creation clearly creates the potential for mischief and bumps up squarely against the fiscal role of government.

-Andrew Boczek, Senitinel Asset Management

The heady days of "Maestro" Alan Greenspan may be long gone. Nonetheless, most of us still take for granted that similarly wise men and women, aloof from the pressures of politics and short term market fluctuations, have the capacity to set the proper price of our most precious commodity: time. Or said another way, to set an effective interest rate policy that encourages either savings or spending, today or in the future, to help manage long term economic stability. And there remains a persistent view among investors and market commentators that central banks have the power to rescue markets, if only they have the will to do so. Given the global rally in stocks last week in the wake of the European Central Bank's (ECB) addition of Outright Monetary Transactions (OMT) to the alphabet soup of "extraordinary" policies, and in anticipation of a third round of "Quantitative Easing", already nicknamed QE3, by the US Federal Reserve, the markets certainly seem to think so. But is such hope warranted?

In order to answer this question it's helpful to understand the origins of central banking and what central banks actually do. If we think back to the era of the pure gold standard, before modern central banks existed, we picture a world where growth in the monetary base was limited by man's ability to dig more of the yellow metal out of the ground. Money sloshed around the world, chasing opportunities and leading to bubbles and busts as banks here or there expanded the broader money supply by extending credit and taking deposits, but the total supply of gold in the world didn't change much from year to year. On one hand, in the absence of central banks, such business cycles were necessarily self correcting, and so tended not to last long. On the other hand, the strains that the resulting volatility placed on financial systems and economies shouldn't be underestimated. When asset prices corrected, commercial banks could be wiped out, often taking down not just greedy bankers but innocent depositors as well.

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