The Failure of Central Banking: Interest Rate Policies

The Failure of Central Banking: Interest Rate Policies
Tuomas Malinen

The one thing the central banks were never meant to do was the takeover of our economies. This, unfortunately, is what has happened, and it all begins with the creation of the Federal Reserve, or the Fed in 1914.

There had been several attempts to create a national bank in prior decades, but these efforts had failed for a series of reasons. The Panic of 1907, the first American financial crisis of the twentieth century, was a game-changer.

The crisis started after banks suffered crippling losses from loans to F. Augustus Heinze and Charles W. Morse, used in a failed cornering attempt of United Copper Company. Bank runs ensued because depositors wanted to move their money from dubious and loss-bearing Heinze-banks to more reliable ones. While the New York Clearing House was able to stem the bank runs by issuing an audit, which stated that Heinze-related banks were “solvent,” rumors of linkages of trust companies, which were unregulated financial intermediaries outside the banking system, to dubious banks started a run on them. After the failure of Knickerbocker Trust a full financial panic ensued and the New York stock market fell by almost by 50 percent in a matter of weeks. To stem the panic, banker J. Pierpont Morgan personally guaranteed key firms in the U.S. banking system. However, despite Morgan’s success, the panic gave credence to assertions that the stability of the U.S. banking system required a permanent institution of last resort to provide liquidity to the financial system when required.

Yet the creation of the Federal Reserve system was dogged by worries that it would lead to the “socialization” of the economy. These fears quickly materialized.

The Fed started its “open market operations” almost immediately in the 1920s. In an operation of this kind the Fed buys or sells U.S. Treasury securities from or to banks to control the short-term interest rate (more precisely the “Fed Funds Rate”) used in overnight lending activities between banks, and to influence the availability of credit in the economy. The Fed effectively started an experiment to find out whether it could affect the interest rates in the economy by manipulating the interest rate of its overnight lending facilities, and it succeeded.

In a gold standard, which most of the world used in the 1920’s, the national stock of gold and the demand for it affected the availability of money and inflation. The process was simple. The increase in the supply of gold increased gold reserves and thus the supply of money and credit in the economy. To neutralize, or “sterilize” this increase, the central bank could let the ratio of gold reserves to notes in circulation rise, or it could raise interest rates to tighten the supply of short-term credit thus reducing the public’s demand for money. In the 1920s the Fed allowed the ratio of gold reserves to notes to rise, effectively sterilizing all gold purchases from abroad. This was seen as the principal means of keeping consumer price inflation at bay in the United States. However, the flow of gold to the United States and its sterilization also exported deflation to other countries, which were not willing to let their gold reserves fall commensurably and therefore chose to cut back the supply of domestic credit.

While the money stock of the United States was controlled by letting the share of gold reserves rise, this also meant that interest rates were kept relatively low from roughly 1922 to 1928. Speculation in the asset and real estate markets increased as a result. The credit boom intensified, first peaking in 1925 and again in 1927. A substantial industry of non-bank lenders also developed during the 1920s which fueled the boom in consumer durables, the commercial property market, the automobile industry and, of course, in the stock market. Effectively the Fed’s market interference fostered a gigantic credit expansion, whose subsequent deflationary collapse, which began from the ‘Great Crash’ in October 1929, helped to create conditions for the Great Depression of the 1930s.

Since the 1930s “monetary policy” has grown from being seen a policy aimed primarily at inflation and financial stability into an all-purpose economic tool, particularly well-suited to combat recessions. In 1987, the then-Chairman of the Fed, Alan Greenspan, expanded intervention by bailing-out financial markets when he slashed interest rates and provided billions in liquidity (a lot of money at the time!) after the collapse of the stock market on the 19th of October. This perceived liquidity guarantee became known as the “Greenspan Put.”

After the Global Financial Crisis of 2007–2008, which the Fed exacerbated through low-interest rates, central bank meddling went into overdrive with various banks setting low—or even negative—interest rates.

When one lends or borrows money, the interest rate he receives or pays is the price of uncertainty, essentially the price of time. Everybody understands that, as the future is uncertain, the price of time cannot be zero or negative. Yet the European Central Bank, the ECB, pushed rates to negative on June 11, 2014, and the Bank of Japan, or BOJ, on Jan. 29, 2016.

A large share of the profits of banks still comes from the interest rate differential between lending and borrowing (deposit taking). Specifically, the difference between lending and deposit rates then determine a bank’s profitability. With very low interest rates, this difference becomes almost non-existent, and with negative rates, it can invert completely. When a central bank drops rates to negative, banks need to pay interest on their central bank reserves. However, they are usually not relieved of the obligation to pay interest on customer deposits, who tend to be reluctant to pay interest on money they place at a bank. Thus, if banks are forced to pay interest on loans and receive interest on deposits, their whole earnings logic goes haywire.

When the profit margins of banks are squeezed, they start to cut back on lending, which further damages the profitability of banks. Moreover, because low and negative interest rate policies hurt the profitability of banks, they tend to target high-risk but non-profitable firms, or “zombies,” in their lending practices to avert any further losses. Very low rates thus feed the low-interest credit of unprofitable companies (more on them later).

Alas, central bankers, with their ultra-low or even negative rates have managed to make both the banking sector and economy unprecedentedly fragile. It’s painfully obvious what will happen to the economy, when rates are raised, and we are now on that path.

Tuomas wishes to thank Dr. Peter Nyberg on his insightful comments and suggestions.
Tuomas Malinen is CEO and chief economist at GnS Economics, a Helsinki-based macroeconomic consultancy, and an associate professor of economics. He studied economic growth and economic crises for 10 years. In his newsletter (, Malinen deals with forecasting and how to prepare for the recession and approaching crisis.
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