Are Central banks necessary?

The Bank of England was established in 1694, following successive English defeats to France during the Nine Years’ War. Its purpose was to finance the construction of naval ships. Due to the lack of credit at the time, the government couldn’t borrow the required £1.2 million to build them. In this way, a Central Bank helped the British War effort, giving birth to the rise of England as a major world power. Nowadays, Central Banks are known for conducting Monetary Policy, whilst acting as the ‘lender of last resort,’ through providing banks with money in times of economic calamity. This was particularly evident in the midst of the Financial crisis and subsequent Great Recession of 2008, as Central Banks globally flooded the market with liquidity in an attempt to rescue their respective Banking systems. However, Central Banks have also historically contributed to economic downturns, with the Federal Reserve in the US responsible for worsening the impact of the Great Depression of the 1930s. This begs the question of whether Central Banks benefit the economy as a whole. Whilst Central Banks have been the source of inflation and recessions in the past, it is undeniable that in recent times they have successfully stimulated economic growth, rendering Central Banks an integral part of the modern economy.

Proponents of abolishing Central Banks argue that their actions do more harm than good, as witnessed in the years leading up to and during the Great Depression. In 1924, following two years of sharp increases in both productivity and GDP per capita in the US, the Federal Reserve cut the discount rate by 1.5 percentage points, from 4.5-3%. This contributed to the explosion of credit, with financial institutions lending more money given the lower interest rates they could charge. Civilians became more inclined to borrow money, thereby consumer debt increased greatly. These debts would eventually need to be repaid, foreshadowing a sharp decrease in consumer spending which would trigger an economic downturn. The long-awaited recession began in late 1929, following the Wall Street Crash. However, amid an economic recession in 1931, the Federal Reserve doubled interest rates. This proved disastrous, reducing the money supply and leading to deflation. Investment in the economy was impossible, given the high debt repayment costs of borrowing, putting the US in an economic slump that lasted until 1939. According to Monetarists, had an alternative to the Federal Reserve existed, the sharp decline in the money supply that created the Great Depression wouldn’t have occurred.

Monetarists also point to Central Banks as responsible for the little economic growth experienced in Japan during the previous 30 years. In 1988, the Central Bank for International Settlements (BIS) began to mandate an 8% capital reserve requirement for all standard banks in member states. As most banks in Japan had capital reserves of 3-5%, this policy forced them to contract credit to comply with these new regulations, imposed by the BIS. This contraction in credit drastically slowed consumer spending, as most civilians were forced to repay their debt immediately, leading to businesses failing due to a lack of customers, further precipitating the crisis in a seemingly never-ending spiral. The Bank of Japan has been stuck in a liquidity trap ever since, with interest rates in the negative and inflation averaging below zero percent over the past 30 years. The regulations imposed by the Central Bank for International Settlements caused this calamity, rendering the institution the cause of the lack of economic growth experienced in Japan.

Perversely, Central Banks have provided much-needed liquidity in times of recession, as was the case during the financial crisis in 2008. Following the collapse of the real estate market, the Federal Reserve quickly slashed interest rates by cutting to the discount rate and quantitative easing. The former was slashed from 6-0.5% between 2006 and 2008. This was to encourage consumer spending through greater borrowing, as the debt repayment burden would be reduced. In addition, the cut in the discount rate led to the reduction of interest on money in savings accounts, further incentivising consumer spending as inflation would outpace the interest paid on savings. To further increase the money supply, the Federal Reserve introduced quantitative easing. This involved the purchase of various assets and securities by the Central Bank. QE injected more money into the banking system, encouraging individuals to spend more, thereby boosting economic growth. These measures are contrasting to the actions taken by the Federal Reserve in the late 1929s and 1930s, and as the Great Recession was the largest economic downturn since the Great Depression, both periods are comparable. Following the Great Recession, the unemployment rate in the US rose from 5% to a peak of 10%. However, during the 1930s, this peaked at 25% in 1933. Thus, the expansionary measures taken by the Federal Reserve in the late 2000s helped in the economic recovery, given that the downturn experienced was not as severe as was the case during the Great Depression.

Moreover, Central Banks in the US and UK effectively handled the inflation crisis of the 1970s. Increases in the money supply had a large part to play in precipitating said crisis, however, excessive government deficits (not Central Banks) were responsible for this. The budget deficit reached 5% by the mid-1970s in the UK, as a posed to the budget surplus achieved five years prior. These large expansions in the money supply, outpacing that of productivity growth, created rampant inflation. In 1975, inflation reached 25% in the UK; inflation soared to 13% in the US during the same year. This hurts savers, as the declining value of money caused them to lose money in real terms, further worsening the inflation crisis as savers felt compelled to spend their money or otherwise lose it to inflation. Central Banks in both nations stepped in to restore inflation to moderate levels. The Bank Rate in the UK was increased to 17% in 1980 to encourage saving by increasing interest payments and discourage spending through higher debt repayment costs. This policy worked spectacularly, as inflation declined to under 5% by 1984. In this way, Central Banks have proved effective at combatting economic crises caused by external factors. Had the Bank of England not increased interest rates through the bank rate hike, the inflation crisis of the 1970s would likely have continued into the 1980s.

Ultimately, Central Bank policymakers are seen to have learnt from their previous mistakes and are now well placed to combat economic issues of today. Mistakes by the Federal Reserve in the years prior and during the Great Depression have not since been repeated. Through increasing liquidity in the years following the Great Recession of 2008, Central Banks globally have prevented their economies from slipping into depression, emphasising the important role that Central Banks play in stabilising the economy.