A Problem of a Central Bank

In today's economy, banks essentially deal in the business of buying and selling money.

When you put your money in a bank, they are buying that money off of you and offering interest in return. Similarly, when you accept a loan from a bank, you are buying money from them and they charge you interest. Because of this, the interest rate banks charge is essentially the money's price, and like all things that are sold, is subject to supply in demand.

If they have a low supply of money, they have a high price (high interest rate), and if they have a high supply of money, they have a low price (low interest rate). This is very important and acts as a price signal to tell people when it's time to save, and when it's time to invest.

If the interest rate is high, people want to sell their money to the bank and deposit their savings there. And if the interest rate is low, then people want to buy money from the bank to start up new businesses.

This is also beneficial because this tells entrepreneurs that there are savings in the bank, and once their new product or service is on the market, there will be people with plenty of money to buy it. Not only is that the cheapest time to invest, it is also the most appropriate time to invest.

So again, put more simply, a bank that has a:

1. Low supply of money = Wants to attract savers = high interest rate

2. High supply of money = Wants to attract entrepreneurs = low interest rate

But then we get a problem.

Arrogant politicians and economists come in and establish themselves as a Central Bank. This is a kind of super-bank that is meant to steer the economy and has the ability to print currency.

Thinking themselves smarter than the free market, they manipulate these interest rates to where they believe the economy will be stimulated. Because fiat currency (money that is valued not because it is tied to some kind of standard like gold, but is legally mandated to be valued) is easy to print, this Central Bank has as much money to lend out as it can print.

So at one point this Central Banks sets their own interest rate unnaturally low, which it does easily and happily, since it can have a high supply simply by printing money, it falsely believes it's stimulating the economy, it wants to exert control debt, etc. It could be any of those reasons, and is most commonly some combination of them. The point is, banks quickly buy up the new cheap money.

So now that the banks have a high supply of money, they set a low interest rate of their own. Those looking for loans, naturally, love this. But this new money has been confused with real loanable funds, backed by savings, when it is really just inflation. This easy money leads to a short time of prosperity, as people and businesses can get cheap loans very easily. Prices drop and risky investments get funded. This is known as an economic "boom". Oh, and this boom proves to the Central Bank that they successfully stimulate the economy.

But this boom cannot last forever. People are consuming without the savings to back it, and soon enough they are grasping for resources that just aren't there, and were never there to begin with. This along with the failure of some riskier investments that would not have been funded in a free market (malinvestment) at the worst possible time leads to a bust. In worse cases, this leads to a bank run, where everyone panics and demand their money from a bank at once. Of course, since the banks loan out a good portion of your money, they don't have it all, leading to the bank collapsing.

The Central Bank that wanted to improve the economy ends up inevitably wrecking it. And with the general idea that we need to increase spending to get out of this bad economy (i.e. quantitative easing, bailouts, stimulus packages, etc.), we end up damning ourselves even further. A true market needs to be backed by real savings. Only after that can we have spending, investment, and true, safe, growth.

Also, don't forget that because the Central Bank is giving itself free money, it is causing inflation and devalues the dollar, which essentially works out as a tax on you, since your money is worth less and less now that they gave themselves money for free. So yeah, enjoy that.

For more on the problems of a central bank, and to see where I got those cartoon pictures, it is from a 30 minute video called "The American Dream".

Here's a link to the video: http://www.youtube.com/watch?v=ExBE651_vOY&feature=plcp
Here's a link to their site: http://www.theamericandreamfilm.com/index.php