Summary: Although one of the most power agencies of the US government, obsessively discussed in the financial news, it remains one of the least well understood. Here we examine the limitations on its power. Readers can decide for themselves if these limitations are too tight, or too loose.
Chapters in this series about Central Banks, giants of State power:
- Limits on the Fed’s power
- About QE3 and the power of Expectations
- The Fed as our national Shaman
Contents of this post
- Power of Central Banks
- Hyperinflation, the quick killer
- Deflation, the quiet killer
- Legitimacy — the ultimate limit
- For More Information
(1) The power of central banks
The development of central banking in the century before WWI was one of the last few innovations necessary to produce the nearly omnipotent modern State. Central banks provided the mechanism to not only easily finance large projects, such as wars and great societies, but also harness large banks to the State’s needs (for their mutual gain).
The ability to print money, set interest rates, and harness banks’ power to lend gives the illusion of omnipotence. But life means limits. Central banks have both hard boundaries to their abilities — and a hidden weakness.
Central banks have well known limits to their powers of monetary stimulus, no matter how exercised.
Posts about the Federal Reserve:
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
— Milton Friedman, The Counter-Revolution in Monetary Theory (1970)
Central banks can stop and start inflation by controlling the nation’s money supply. Stopping inflation requires painful measures, but with the certainty of success. Starting and managing useful inflation requires more skill.
Why create inflation? Unanticipated inflation acts as the magic sauce of monetary policy. Quiet, mild, relentless. It lowers the real interest rates. If we also have wage growth slightly above inflation, then our crushing debts evaporate painlessly (as we erased aprox 1/3 of our WWII debt). Bernanke literally wrote the book on this, Inflation Targeting (1998).
There are two limits to central bank’s ability to manage inflation. First, the nation’s currency. The central bank can expand the money supply without limit — with effects varying depending on its internal circumstances. But it will depress the value of the currency. A weak currency can boost exports, beneficial if not offset by the increased cost of exports (eg, China and Germany have done this successfully). At some point, however, a currency collapse comes — with horrific consequences.