Nick Rowe has a new post that explains what’s special about central “banks:”
What makes a central bank special?
The Bank of Canada can borrow and lend. So can the Bank of Montreal. So can I. Nothing special there.
The Bank of Canada can set any rate of interest it likes when it lends. So can the Bank of Montreal. So can I. Nothing special there. “If you want to borrow from me, you have to pay x% interest.” We can all say that. (Whether anyone will want to borrow from us at x% interest is another question.)
The Bank of Canada can set any rate of interest it likes when it borrows. So can the Bank of Montreal. So can I. Nothing special there. “If you want to lend to me, you have to accept y% interest.” We can all say that. (Whether anyone will want to lend to us at y% interest is another question.)
And yet there’s this utterly bizarre belief among many economists that it is the Bank of Canada that has the power to set Canadian interest rates, just by borrowing and lending. And that the Bank of Montreal, and ordinary people like me, somehow lack this special power. Even though we can borrow and lend too.
Now it’s true that the Bank of Canada is a lot richer than me. But what if I were a Canadian Bill Gates or Warren Buffet? And is the Bank of Canada richer than the Bank of Montreal? That can’t be the difference.
Now it’s true that the Bank of Canada can create money at the stroke of a pen, and I can’t. But the Bank of Montreal can. What makes the Bank of Canada special, compared to the other banks? What power does the Bank of Canada have that the Bank of Montreal lacks?
I’m going to give the same answer I gave nearly three years ago. And then I’m going to expand on it.
The fundamental difference between the Bank of Canada and the Bank of Montreal is asymmetric redeemability. The Bank of Montreal promises to redeem its monetary liabilities in Bank of Canada monetary liabilities. The Bank of Canada does not promise to redeem its monetary liabilities in Bank of Montreal monetary liabilities.
And then he ends the post as follows:
There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power. That’s what makes central banks central.
Now let’s consider a different monetary system. Imagine a gold standard and a monopoly producer of gold. The gold mine company would reduce short term interest rates by increasing the supply of gold. Like currency, gold is irredeemable. But no one would call this gold mining company a “bank” because it possesses no bank-like qualities. Banks don’t create irredeemable assets, gold mines do.
Central banks may have some bank-like qualities, but what makes them special is their ability to produce currency–i.e. paper gold. And that has no relationship to banking at all.
For years I’ve dealt with commenters who wanted to turn the discussion to banking:
“How do you know negative IOR will increase lending?” I don’t care if it does, because banking has nothing to do with monetary policy.
“The Fed can’t cut rates any lower–how are they supposed to boost the economy?” It doesn’t matter whether they can cut rates, because rates aren’t the transmission mechanism.
The Fed affects NGDP by changing the current supply and demand for the medium of account, and also the expected future path of the supply and demand.
“Monetary policy is already quite easy.” No; credit is easy, monetary policy is ultra-tight.
In the comment section Nick says:
I just remembered. Back on the I=S post, IIRC, some people were complaining I didn’t talk about banks enough. OK, here’s a post on banks.
I’d say it’s a post on why central banks aren’t banks.