Central Banking and Interest Rates for the Layperson

If you've ever cracked open the business section of the paper, you've probably wondered what the central bank does or why interest rates matter. For the typical person, we encounter interest when we save money in the bank, when we buy a house or a car, and probably not much beyond that. We never deal with the central bank; we might know it prints money, but not necessarily how that affects the workings of the economy. Nowadays especially, it is common to hear people saying we need to return to the gold standard or otherwise fundamentally restructure our banking system. Why do we need a central bank? Why do we need the government to create our money? What is the purpose of messing with interest rates? I have found that answers to these basic questions in a form laymen can grasp are often lacking; I hope to provide some sort of clarification for anyone curious enough to wonder about our financial system.

Let us start with the central bank: its real primary role is typically to act as a lender of last resort. What this means is that it lends to banks when they cannot borrow money from anyone else. Banks often borrow money from one another because they are in the business of making investments with other people's money.

Now, these investments banks make are often "illiquid"; this means it is hard to convert them into cash. It takes time to sell off shares in a company, especially when that company is not publicly listed; you cannot just take bricks and mortar and convert them to notes and coins in a few seconds. So banks borrow from one another when they have commitments to meet; if you want to take out money from your bank, they may not have it because they've put it into a condom-manufacturing venture or a bakery or whatnot. So at the beginning and end of each business day, banks borrow money to ensure they have enough to meet the needs of their customers.

The reason a lender of last resort is needed is that in a financial panic, the lending system breaks down. Let's say you hear your bank is about to collapse. This is a false rumour, but you panic and you rush to take out all your money. Everyone else does the same. The bank's investments are illiquid, so it cannot meet its commitments; it may not have borrowed enough to cover all its commitments. The problem is, we cannot distinguish between banks which have valid reasons for not meeting their commitments — banks which just have very illiquid investments and suffered from an unwarranted panic — and banks which do not, banks which have made bad investments and cannot possibly hope to ever repay the banks they want to borrow from in the short term. So other banks may refuse to lend to a bank which is otherwise quite sound, except for the panic, and that bank will fail.

The problem is that this sort of confidence problem is extremely contagious. When one bank fails, other people will panic. And they will actually have reason to; other banks probably were owed quite a bit of money by the failed bank, and they're not going to get it back. For all we know other banks are in a lot of trouble. Better to be safe than sory; we run to our own banks and take our money out too. The cycle continues until only a few banks are left standing.

This whole vicious cycle is completely unnecessary most of the time; maybe the first couple of banks that failed were overextended and made the wrong investment decisions, but because of unforeseen repercussions, caused the collapse of several otherwise sound banks. The whole system is prone to panic. Unfounded rumours can bring the entire economy of a country or even the world to its knees.

Some say this is good reason to abolish the system of letting banks make illiquid investments with other people's money. Banks should just hold people's money for them, and charge them a fee for the service, earning their keep this way. This is all well and good, except for one tiny detail: we need some sort of financial intermediary to act as the middleman between people with money to save and people who need money.

Even if we make banks stop investing, some other institution is going to come along and supplant this function. They will take people's money, and offer attractive interest rates. The old banks will wither and die because nobody will want to put their money in an institution that charges you for the privilege of saving, not when these new institutions can promise to pay you something, and seem largely safe.

Most of the time, banks as institutions work well. They take people's money, and invest it for them. The businessman looking to start a restaurant or a factory needs money from somewhere, and he can't just go to random people with cap in hand. Most people don't have enough expertise to evaluate the soundness of his enterprise anyway. And usually, banks work very well because they do have this expertise. Banks rarely fail because they do their best to compromise between risk-taking and keeping deposits safe; failures are so rare that people forget that banks can be panic-susceptible, and so they put their money there anyway, at least till the next panic, which may not come for decades. In between panics — indeed, especially during panics — we need a specialised institution to match borrowers with lenders, and so like it or not, banks must stay as they are.

So if we must have a panic-susceptible system, how do we deal with these panics? One thing most central banks do is guarantee bank deposits up to a certain amount. If your bank fails, you can rest assured that a certain amount of your money (depending on the country, though it is usually rather substantial) will be safe. Another thing central banks do is lend money to otherwise sound banks which are in danger of failing, to insulate them from financial panics and prevent financial contagion.

One implication of this is that the central bank now has some control over the money supply of the country. By lending money out, it essentially creates money; that money would not be floating around the financial system if not for the central bank. Likewise, the central bank can reduce the amount of money in the system by borrowing from banks. There cannot be a strict gold standard under such a situation.

A common criticism of modern central banking is that the central bank seems to set interest rates as it pleases. What are interest rates? The prevailing interest rate is quite simply the price of holding money. If the interest rate is 4% and you hold $100, you lose $4 by holding that $100 in hand instead of putting it in the bank. The interest rate can thus be thought of as the price of money, and the supply and demand for money vary just as normal supply and demand do. If interest rates are high, the supply increases — banks become more eager to lend because they can profit more — and demand falls — businesses become less eager to borrow because it costs too much. The opposite occurs with low interest rates. So, does the central bank fix the price of money?

While the central bank strongly influences the interest rate, to say it fixes the interest rate is not quite right. The reason the bank influences the interest rate is that it must set a rate for the money it lends to banks; it can't just give them free money now, can it? Neither can the central bank set the interest rate unreasonably high; if that were so, banks in need would rather go bankrupt than borrow from the central bank. So the central bank has no choice but to set a middling rate — typically between 2% and 5% — for the funds it lends out to commercial banks.

This is a bit different from rigid price fixing, because standard price fixing might be the government just threatening to lock up anyone who sells above or below a certain price. The central bank is not threatening to shut down anyone who lends above or below the rate it sets; it really does not care too much as long as the financial system remains sound. Indeed, price fixing in this case is really very necessary because we need a lender of last resort, and that lender must by logical necessity charge something for the money it lends out.

There is one final and powerful implication from this, however: because by necessity we must confer the power to influence the price of money on a central bank, that bank can directly affect how much money circulates in the financial system. And the amount of money churning around has some very powerful effects on the economy; indeed, economists usually focus on these instead of the basic details of why we need a central bank, because they take it for granted. The main problem for central bankers after stabilising the financial system is ensuring price stability — that we suffer from neither inflation nor deflation — and dealing with unemployment (be it unemployment of labour, natural resources, or capital).

Now, these other challenges — the ones besides tackling financial panics — are very controversial because economists and policymakers tend to differ on the precise way of achieving them, especially in a crisis. When the economy is running smoothly, nobody worries. But when things start going wrong, we have to figure out how to make them go back to running smoothly again. Central banks have by and large figured out how to avoid the problem of bank collapses; the last time they made mistakes handling this issue, we had the Great Depression. But the more advanced problems of protecting price stability and restoring full employment are still largely unsolved — and merit a future article on them.