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Central Banks: The Neurosurgeons of the Global Economy

August 5, 2008 by Cheryl Grey

Every few years, some anti-governmental organization pushes the bright idea to abolish the U.S. Federal Reserve System or make its officers answerable to the voting citizenry at large. The idea seems to be that such “quasi-bureaucratic” agencies are unacceptable under our Constitutional, democratic system, even though it’s no secret that similar central banks perform essentially the same functions in every other civilized nation around the globe.

What is the Fed?

The Federal Reserve System was founded in 1913 by Congress to stabilize the burgeoning nation’s financial system and provide a basis for its future economic growth. At the same time, the U.S. monetary system was nationalized (prior to that time, even the most local of banks could print their own money).

The Federal Reserve’s mandate from Congress is to regulate and support the banking industry and to maintain price stability through the control of inflation and economic growth, a process called monetary policy. It also provides financial services to the U.S. government and to depository and investment banks around the nation as well as to some foreign institutions.

The Federal Reserve sets monetary policy via the wholesale or between-banks lending rate, which influences the supply of money in the U.S. A low interest rate, also called loose or dovish monetary policy, pumps a lot of money into the system. This “cheap money” encourages people and businesses to purchase on credit, from buying a house to expanding a factory, which in turn stimulates the economy and helps create jobs.

However, if the economy is growing too fast and inflation rears its ugly head, the Fed can raise rates, creating tight or hawkish monetary policy and removing money from the system. This makes credit purchases more expensive and slows the economy until higher prices and the resulting low dollar purchasing power are squeezed out of it.

This is a delicate and difficult process, what Charles Wheelan in his primer Naked Economics calls “the economic equivalent of brain surgery.” To accomplish this task, the Federal Reserve must operate independently and be answerable to no one but the judgment of history. (Collectively, the world’s central banks consider their worst performance to be their insistence on maintaining the gold standard through the Great Depression.) Just think, if the chairman and governors of the Fed could be influenced by voters or bureaucrats, then the economy would be at the mercy of special interest groups.

Emergency Economic Neurosurgery

In January 2008, on Martin Luther King, Jr. Day, with recessionary fears whipsawing the emotions of traders from terror to avarice and back again, stock markets around the world began to crumble, led by a sell-off by the French investment bank Société Générale that began in Tokyo. Thanks to the Internet’s instant communication across international borders, the crash swept across Asia and Europe as each successive market opened in the neighboring time zone. Investors went into a selling frenzy, hoping to cut their losses and exit the markets with whatever they could salvage.

Because of the Monday market holiday, that first around-the-globe rush skipped over the United States. As opening hour crossed the Pacific and the International Date Line, the crash again assaulted Tokyo, marched across Asia, then Europe, punched the United Kingdom in passing—and came to a screeching halt at Wall Street.

Before the New York market opening on Tuesday, January 22, the Federal Reserve announced an emergency three-quarter percentage point slash to the U.S. interbank rate. This dramatic move, the first emergency cut in seven years and the largest cut in a quarter century, stunned the U.S. stock market into pausing for a deep breath in what a Wachovia Bank analyst described as a “who’s your daddy” moment. Then the bell rang, the market opened and normal trading began.

The Dow Jones lost around 4% for the week. The Hang Seng in Hong Kong, the German DAX, and the EuroStoxx 50 all lost over three times that amount. The Fed’s move prevented a bloodbath on Wall Street.

No single depository bank, and arguably no other central bank in the world, could have stopped a global stock market crash with one surgical interest rate stroke. It’s a testament to the creativity of the Bernanke Fed and the irrefutable argument to those misguided souls who consider the Federal Reserve to be unnecessary.