An Idiots guide to Central Banking

By Asif Punjwani December 2, 2012

Acronyms: Recently, there has been a spotlight on the activities of the Global Central Bankers who manage the global money supply. Primarily, there are 3 major active Central Banks the US Federal Reserve (FED), the European Central Bank (ECB) and the Bank of Japan (BOJ). These banks usually collaborate with each other when making changes to their policies. Ofcourse there are other central banks, but their issued currencies do not buy Oil, settle Balance of Payment (BoP) or satisfy International Debt (SDRs). Then we have the Bank of International Settlement (BIS) in Basel, Switzerland. BIS and the Society for Worldwide Interbank Financial Telecommunication (SWIFT) are supposed to function as a global clearing house for International payment and regulators of the Global Banking system. BIS is more infamous for manipulating the Dollar/Euro rates, also affecting the LIBOR rates, sort of the Global Banking Interest rate. Money: Some call it the root of all evil. Others call it lubrication for trade. Heres how its generally created. No, the Government doesnt simply print money. That job has been outsourced to its Central Bank. The Government borrows cash from Primary Dealers (PDS), the elite commercial banks, and issues them borrowing receipts called treasury bills (TBILLS). The Primary dealers buy cash using those TBILLS from a special bond market called the REPO market. It is at this Repo market the central bank buys those TBILLS using newly printed cash or electronic credit. This process of injecting liquidity into the market is called Open Market Operation (OMO) or Quantitative Easing (QE). So why doesnt the Central bank directly lend to the Government? They say these steps maintain the banks autonomy. So why doesnt the Government simply print the money itself? The unofficial answer is, simplicity and transparency reduces the room for confusion. Complexity breeds confusion and corruption. Just to be fair, whatever income the Central Bank gets in interest for the borrowed funds, is deposited back into the Government treasury account (minus administrative cost). The PDS retain their cut called spread. Chartalism or Modern Money Theory This process of money creation is called Chartalism or Modern Money Theory (MMT). Per MMT, value of money is derived from taxation. Here is how this policy is supposed to work in theory. Governments can run deficit budgets as long as the total debt remains proportional and manageable compared to the overall GDP. Government should be running surplus during good times and switch to deficits during bad times to pick the slack of the private sector. But when the deficit starts to get bigger, the Central bank is supposed to raise the rates. Since interest income to the Central bank is poured back into the Treasury as dividend income, this in turn reduces the deficit gap. If the central bank gradually continues to raise rates to bring Government spending in line with income, it will stabilize the currency and pricing.

Fear the Carry Trade:

Just like price fixing/floors/ceilings causes hoarding, black markets and shortages, fixing interest rates causes mispricing of risk, artificial currency appreciation, accumulation of risk in the financial sector and the buildup of the Carry Trade Tsunami in the Forex. Reason why countries peg their currency to the dollar is to reduce their borrowing cost in the international markets, causing distortions in their economies. Realities: There is no such thing as an apolitical central bank. Debt, along with implicit backing of central bank through intervention in the REPO markets, injects moral hazard in the Government decision making and entire banking system. Dilution of Currency shifts wealth from the productive real economy to the Government and Financial sector. Debasement of currency increase commodity and import prices, squeezing profit margins of the private sector as the cost of raw materials, energy and imports goes up. This is the reason why low interest rates do not spur real economic growth, but boosts speculative investment. Its true that Inflation is a monetary phenomenon but hyper-inflation is a political phenomenon.

Asif Punjwani trades Equities, Bonds and derivatives in the International Capital Markets. He can be reached via Twitter @AsifAmeer_AP