The kids are over on the internets using the Tweet machine to ask Ben Bernanke some questions. There are also some adult questions mixed in there. For instance, Jim Grant asks:
“Could you help me understand the difference between central banking and market manipulation?”
Now, I’m no Ben Bernanke, but I would like to take a stab at this one.
First of all, it’s important to understand what central banking really is. For instance, in the USA, the Fed system exists because rogue independent banking like we had in the 1800′s proved highly unstable. In essence, payment processing was inefficient and extremely unstable during times of crisis. The primary role of the Fed system is to bring payment clearing into one place. We call this the “interbank” market in the USA. It is where all the banks settle interbank payments. They do so by being required to maintain deposits at the Fed. You can think of it as being the best of all worlds between having a nationalized money system (like one national bank that clears ALL payments smoothly) and maintaining private competitive banking. The Fed is a buffer of sorts. It is neither a pure public entity nor a pure private entity.
But this system is a bit of an inconvenience for private banks who would really prefer not to have to engage in all of this “oversight” and central clearing to begin with. In a perfect world they’d monopolize the money game and tell the government to take its ball and go home. Obviously, that’s not what we have. So we have a reserve system. And to the banks who participate in this system it is, by mere existence, “excess”. You can think of all reserve balances in this interbank market as being “excess” to private competitive banks. So, they would prefer not to hold them. This puts pressure on the overnight rate because the banking system will naturally try to rid itself of excesses. So the Fed must make a choice. Will it let the overnight rate drop to zero or will it support it in various ways? Obviously, the Fed chooses to support the rate. In other words, it manipulates the rate higher.
Things get a bit tricky here. In addition to facilitating this essential clearing system, the central bank can manipulate the spread at which banks make a profit on their loans. This can have a significant impact on profits generated by banks. The problem is, this manipulation is far from an exact science. And when you layer operations like QE on top of that we have to start worrying about market disequilibrium and potential unintended consequences of this intervention. But yes, make no mistake, there is a clear distinction in the roles of the central bank. Its most important role is as a facilitator to a smooth payment system. Its secondary role is in influencing the price of inside money (bank money) in order to steer the economy. The primary role is unquestionably positive. The secondary role of what is definitely “manipulation” is up for debate.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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Tom Brown on 
Nice explanation. I think the fed doesn’t get enough credit for its overseer of the payments system. That is an unbelievably important role in our economy.
You totally dodged the essence of the question by putting up for
debate what manipulation is. Very Clintonesque.
Changing the rate AT ALL is always manipulation. That’s the point. But the more important point is that not all central banking is manipulation.
True, even Bernie Madoff surely made some good trades.
Cullen, regarding “manipulation” the main issue you are up against in taking on this topic is that most people view “manipulation” in whatever form and for whetever purpose as being bad and totally evil.
People need to be able to appreciate that there may in fact be some “good” manipulation, even from the most evil of all the world’s evil, corrupted institutions – the USA Federal Reserve.
Just because the FED is engaged in the role of manipulating certain things doesn’t mean its inherently bad…
100% agree!
Cullen, by “fixing” the price of borrowing money, and on top of that, by providing tiered (i.e. preferential and less preferential) rates on borrowing that fiat, AND ON TOP OF THAT, by subsidizing “preferred” entities with the lowest costs of borrowing (many of whom enjoy TBTF status, as a major bonus), which equals a massive competitive advantage, the federal reserve IS a central planning entity by any definition.
You are engaging in mental gymnastics in order to apparently refuse to call a spade as a spade, or you are hopelessly obtuse.
“Central planning” is an exaggeration. The Fed influences the spread at which banks lend and make money. The FAR more important component of the spread is the long end which is largely based on demand for loans. You give the Fed WAY too much credit for being able to steer the economy. They control a portion of the lending spread. More importantly, the Fed helps oversee a smooth payments system. We can categorize this as “central planning” in the same way that speed limits and govt roads are “central planning”….
Speed limits are not central planning. They are a simple regulation. Central planning would be if the government actually controlled the speed of your car. Or maybe you’d also like Ben Bernanke to tell you where you can and cannot drive?
That’s my point! Speed limits and govt roads aren’t central planning. Just like regulation of the payments system is not central planning. One can argue that QE and changing rates is central planning, but I think that gives a bit too much credit to monetary policy’s impacts on the economy….
Fine, but it does not have to be an all-or-nothing proposition in order to be bad. I agree, the Fed cannot control the entire economy. But my point is they should not be controlling ANY of it. Let the market work it out. Regulated of course, but free of interventions and manipulations.
I disagree. I think a centralized payment clearing system is a huge benefit to the nation. But we can agree to disagree!
Hold on. Why does having a central clearing system necessitate interventions and manipulations?
It doesn’t. Altering rates is a policy choice. That’s the whole point of the article. To highlight the different roles the Fed plays in the economy. One (the organization of the payments system) is unquestionably positive in my opinion while the other (monetary policy and rate setting) is dubious….
The Federal Reserve is doing nothing short of picking winners and losers.
I challenge anyone, including Cullen, to set forth a compelling case that the Fed isn’t aiding the success (or at least survival rate) of entities deemed too-big-to-fail while dooming others entities to literal death/bankruptcy via use of its monetary policy “tools,” especially the extraordinarily radical ones now practiced routinely by Bernanke & Crew.
If this isn’t “central planning,” what would be?
Again, the Fed MUST, by design, pick the banks as winners. The Fed is designed to support private banking. I don’t think you guys are totally familiar with my positions on this stuff….
Fine. But you say it like you approve. Just because something is so, does not make it right.
I am not here to be judge and jury of the system. I am here to describe the system. I said I was dubious of monetary policy. Which you seem to agree with….Not sure why you’re attacking my position….I’m just the messenger.
Wait, are you claiming that the Federal Reserve intentionally formulates monetary policy with the intention of aiding the banking sector, even to the detriment of the non-banking portion of the U.S. economy?
(I believe you have already stated this, at this point.)
Would you then be willing to concede that the Federal Reserve is helping private banks to socialize their losses (onto the backs of present and future taxpayers) while simultaneously not requiring them to disgorge profits (much of which are “earned” using fungible fiat provided by the Fed itself, through rampant speculative activities)?
The Fed is designed to support private banking. So yes, of course it engages in monetary policy with the intention of helping banks. To the Fed, healthy banks = healthy economy.
Healthy banks = healthy economy?
Really?
You’ve lost all credibility.
If your ridiculous proposition was correct, just stuff all the banks with copious amounts of fiat, and backstop them with a taxpayer-based hedge against any risk of losses from speculative activities, no matter how reckless.
Oh wait, the Fed has already done that.
How’s that working out?
I said, “to the Fed, healthy banks = healthy economy”. TO THE FED….Not to me. I am beginning to see that you’re not here to actually engage anyone in a productive manner. You’re simply calling me names and misconstruing what I say. Please try to be a bit more constructive with your commentary. Thanks.
PS – I never had any credibility to begin with.
Okay, with that distinction, where you seem to acknowledge that healthy banks (or at least ones intentionally stuffed to the gills with fiat provided by Bernanke) are not necessarily a reflection of a healthy economy, and that in doing so (stuffing the banks full of fiat, engaging in endless QE, engaging in ZIRP, etc.) are you now conceding that the Fed is injuring a massive portion of the organic, real economy, distorting prices, warping the supply/demand curve, encouraging malinvestment, and essentially engaged in economic central planning, just as Jim Grant essentially stated?
When you have the power to “print” money you also have the power to decide who “lives” and who “dies.” The Fed certainly has this power as we saw during the crisis. And no one should have that power, as it most certainly corrupts. Good point.
When I was in school, I asked my sociology teacher why people behave they way they do under certain social circumstances. He responded by saying that sociologist don’t ask “why.” They just observe. I’ll never take another sociology course.
Cullen, you’re a smart guy. You can be more than just a messenger, if you decided to.
As an engineer trained in feedback control system theory and implementation, I highly doubt the economy is “controllable” from the point of view of the levers available to the Fed, let alone even “observable” (a necessary, but not sufficient condition for controllability via feedback) given the “econometric” data available to the Fed. Combine that with the almost certain extreme non-linearity of the system, and it’s amazing that it’s not a LOT more unstable than it is (what with all those highly non-linear unobserved, uncontrollable states out there).
I agree, but I wonder if that makes the Fed less or more dangerous by the fact that they DO try to manipulate the economy on behalf of the banks and the government. Also, are you sure you’re not really Nassim Taleb? Just kidding ;).
Tom Brown, as an engineer, you would know Dynamic Instability. I think there is a good case for calling our economy so, and not capable of a “solution”.
Non-linear feedback control systems were never my specialty! Sometimes you can address an underlying non-linear “plant” (which is what the control engineer calls the system he wants to control) by linearizing them (by essentially hacking off all the higher order terms) but you have to re-linearize at a high rate in general. You’re not changing the plant of course… you’re just changing your model of it! (and essentially hoping for the best!). Then you can bring a ton of powerful linear system theory to bear on the problem. But sometimes this technique doesn’t work… and you’re left with *maybe* being able to at least guarantee stability of the system (e.g. Lyapunov stability, etc.).
I like it! I wish all the Fed conspiracy theorists out there (including Ron Paul) would look into your statement “For instance, in the USA, the Fed system exists because rogue independent banking like we had in the 1800′s proved highly unstable.” I’d love to know more about that myself! Any recommended references for that?
Tom Brown, the following is a quote from President Jackson about the central bank. “Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves.”
Nice! We need more speeches like that from our presidents! I like how he starts out “Gentlemen” and ends up “vipers and thieves.”
I would say that central banking manipulation runs in the trillions, while regular manipulation runs in the billions, but LIBOR has proved that to be wrong.
Regarding this interbank market clearing, when JPM pays their rent, and the payment clears, and JPM’s landlord maintains an account at BofA, how does JPM’s balance sheet look immediately afterwards? One rent payment less in JPM’s reserves? … while BofA’s reserves are up one rent payment… and BofA’s liabilities (landlord’s deposit) also up one rent payment?
Cullen do you believe that the Fed manipulates long term rates higher or lower (via jawboning and QE etc)?
Nice post. Shouldn’t we distinguish between ‘interest on required reserves’ and ‘interest on excess reserves’ rather than just talk about ‘overnight rate’? I recognize that they are currently at the same level, but aren’t their purposes somewhat different ones?
“Rogue independent banking like had in the 1800s proved highly unstable.” Lol…because we’re dealing with an excess of banking stability these days…
Good point, however, I’m not an expert on post-Civil war to pre-WWI economic booms and busts in the US economy, but I think there were a lot of them and they were severe. Here’s an example of one (the Panic of 1907) which had a direct bearing on the creation of the Federal Reserve System:
http://en.wikipedia.org/wiki/Panic_of_1907
Better than the world of the 1800′s when we had a banking crisis once ever 10 years and a depression once every 20….
Your constant comparison to the 1800′s is specious. The financial system, monetary system, and the economy are vastly different today. So just because decentralized banking may have been less efficient or less stable over a hundred years ago when the epitome of communication technology was the telegraph, does not mean the same would apply today. You’re comparing apples to orangutans.
Having a central clearing system does not necessarily mean we need monopolized, centralized control of the money supply. Why not let the market decide the value of money according to real demand? Well then the central banks and governments couldn’t collude so easily to generate interest-based profits from government debt for the banks and an inflation tax for the government, could they?
Come on Cullen, wake up. Even if you trust the intentions of the central planners, central planning never works in the long run. History proves it. And you don’t have to go all the way back to the 1800′s to see it.
We don’t have “monopolized, centralized control of the money supply”. We have a money system controlled by a private oligopoly of banks. The Fed helps keep these entities from fully monopolizing the system by forcing them to be overseen by an independent agency and to clear their payments in a centralized interbank market. It’s amazing to me how many myths are floating around about the Fed and our money system….It’s almost like no one has it all quite right….
Making myths float around (the darker and scarier the myth the better) about the Fed is quite an industry in this country! You can sell a lot of advertising time doing that. So obviously the sinister central planners at the Fed are behind these myths! Ah HA!
Oh really? Tell me, how many other institutions in the United States can currently issue legal tender?
And how can an entity be independent of its owners? You have it backwards, Cullen. The Fed was created by the big banks to serve their interests.
You’re preaching to the choir. Have you read my work? I always say that the Fed is an entity designed to facilitate and support private banking….
Fine, but in our case, the Fed, in its support of
private banking, primarily supports the tbtfs/
primary dealers with ZIRP and QE. ZIRP is one thing…
QE is quite another. $85B per month is more than
enough to distort prices in both the stock and bond
markets and the primary dealers/tbtfs are the primary
conduit by which this “free money” enters the markets.
This has been going on for four years now….and
arguably, has decreased interest rates by about 1% and boosted stocks by about 30% according to many
“conservative” estimates.
What is your view on the Fed’s utilization of asset price distortions to facilitate bank forbearance?
This can’t be a good thing in the long run.
Good Points, JP Morgan had to ride in and rescue the system in the panic of 1907.
I think it’s better to have a central bank as a lender of last resort rather than a few private bankers telling the Govt give us Yellowstone in return for a loan.
The comment about the 1800s banking system is spot on.
Not only that, but the compound real GDP growth rate back then was higher than it is in the last 20-30 years or so. Check the data. The only difference is that the growth rate in the 1800s was more volatile.
The Savings and Loan crisis, the Mortgage Backed Securities crisis … seems like we have a banking crisis every 10 years today, too.
Not to mention the Japanese banks for the past 20 years, the European banks headed that way, the Southeast Asia crisis, the Russian defaults.
Plus whatever is cooking up right now that we don’t know about yet.
That is the icing of the cake – regulated and still blowing up. But…the payment sytem has been stable so far (with minor exceptions – e.g. RBS, Greek banks, deposits over 250k etc)
I don’t necessarily disagree, because I don’t know my financial history that well, but the S&L crisis was a LOT smaller that the MBS crisis of 2008. It was never in danger of plunging the whole economy into crisis. William K. Black estimates that the S&L crisis was about 70x smaller than the MBS crisis (and yet the number of prosecutions for the MBS crisis is TINY by comparison) Plus that was more like an 18 years separation between the two, if not more (S&L started in the mid 80s… the prosecutions took place in the late 80s and early 90s. The nations first too-big-to-fail bank was bailed out in the mid-80s… that’s when the term was coined.
And before the S&L… well, there wasn’t that much was there? Going all the way back to 1945 or so? It seems the 1930s regulations (dismantled partly be the de-regulatory Reagan admin in the 80s and finished off by the “Securities Modernization Act” of 1999 and the bill in 2000 deregulating derivatives under Clinton perhaps could have caused some extra instability? My opinion is that the 1930s regulations serves us well for decades before the deregulatory craze of the 80s, 90s, and 00s.
So if the Fed is designed to facilitate and support private banking (which I agree with) how does that reconcile with this from your article;
“But this system is a bit of an inconvenience for private banks who would really prefer not to have to engage in all of this “oversight” and central clearing to begin with.”
We have the current system because the banks want it. None wish to go back to pre fed days when they were all for them selves. Sure, the assholes amongst them will always have to blame regulators or regulations for their issues rather than take responsibility but we have the system the BANKS WANT. They have worked very hard the last thirty years monopolizing the output of US workers and making sure every citizen has to pay fees to them for almost everything they do.
You know, one of the ideas talked about around here has been that govt cant create production. Same applies to banks. They are not creators either they are just facilitators too. They loan to people who already have stuff and leverage it for THEIR profit. Yes this can at times create a profit for the borrower too but that is a secondary consideration to the bank. Banking is mostly extractive from its customers. In essence a bank is only lending me my future potential income and charging me a fee to do it
Au contraire. I GUARANTEE you JP Morgan would much rather not have a regulated govt system so they could become the monopolist of money. The Fed system is one piece of a govt puzzle that keeps them from achieving just that. The natural state of capitalism is towards monopolistic control. Banks are no different from Microsoft or Bell Atlantic in this regard. They’re private competitive entities. A fed system helps maintain this private competitive nature, but keeps them contained to some degree.
Wrong – JP Morgan needs a way to be protected when his FRL ponzi scheme gets overextended. He needs to be bailed out. He needs a way to privatize profits and socialize losses. He WROTE the Fed Reserve laws.
Well that may be true of Mr Morgan, but Mr Chase doesnt want Mr Morgan with the monopoly or even Mr Lynch. All those guys trusted each other even less than they trusted the govt when things went south, as they frequently did. They all looked out for self and they invented fed to look out for all.
My point is simply the Fed system and its rules is generated BY and FOR the banks. We have what the banks (collectively)want.
An excellent article. What was Bernanke’s answer to Grant’s question???
Wait a minute – why is the banking system instable in the first place, so that it needs a central clearance? Because FRL is allowed. The Fed is there to protect FRL – the goose laying golden eggs for the bankers. Ensuring a stable payment system is only smoke an mirrors. Ditto with macro steering of the economy. They pretend to care about GDP growth and unemployment, but all they do care about is inflation to the degree needed so that banks do not get insolvent in a deflationary mass defaults regime. That is all.
The Fed was installed in 1913 during Christmas, the laws were written by JP Morgan and Rockefeller and Co. As a trigger was used the 1907 crisis, which was artificially created by JP Morgan (and then generously solved by him a well).