Central Banking and the Incidence of Financial Crises

By Sylla, Richard | Financial History, Fall 2013 | Go to article overview

Central Banking and the Incidence of Financial Crises


Sylla, Richard, Financial History


The centennial anniversary in 2013- 2014 of the founding of the Federal Reserve System, America's central bank, is a fitting occasion to consider the question: Why do we have a central bank? To many people, the answer is far from obvious. Here I want to discuss in particular one good reason why we have a central bank, namely that our history as a nation shows that central banks reduce the incidence of financial crises.

The Fed and Its Critics in the Recent Crisis

During the financial crisis of 2007-2008, the Fed acted dramatically to prevent a financial meltdown. It made currency swaps with other countries' central banks to alleviate dollar shortages overseas. It made loans, often termed "bailouts," to US and foreign financial institutions to prevent them in one way or another from failing. It more than doubled the size of its balance sheet in 2008-2009 by purchasing government and mortgage-backed securi- ties with the intent of providing ample liquidity and keeping interest rates low to promote recovery from the economic recession triggered by the financial crisis.

In the aftermath of the crisis, the Fed again has nearly doubled the size of its balance sheet through further securities purchases, termed "quantitative easing." Despite these actions, the recovery from the crisis has been protracted and rather anemic. So the Fed announced in Septem- ber, to Wall Street's and others' surprise, that it intended to keep on pursuing its low interest policies as long as unemploy- ment remained too high and inflation showed no signs of rearing its ugly head.

The Fed's unprecedented actions have produced a backlash. Its critics charge the central bank with creating the financial crisis by keeping interest rates too low from 2001 to 2006, thereby underwrit- ing the housing bubble that collapsed in 2007 and 2008. In recent years, possibly with some inconsistency, the critics have claimed that the central bank has too much power and that its quantitative eas- ing policies have proven ineffective. Con- gress responded to the first charge by reining in some of the Fed's powers in the Dodd-Frank Act of 2010. But that did not go far enough to please a vociferous critic of the Fed such as former congress- man Ron Paul, who in 2009 published a book entitled End the Fed, a not-so-thinly- veiled policy recommendation.

Deja Vous

If the Fed's actions during the recent crisis were unprecedented, Ron Paul's recom- mendation to get rid of it was not. Early in US history, Americans got rid of not one, but two central banks. So our country has some experience in ending central banks. It also has even more experience in creat- ing new central banks. We have created three, and ended only two.

Congress chartered our first central bank, the Bank of the United States, in 1791 on the recommendation of the first Secre- tary of the Treasury, Alexander Hamilton. A decade earlier, while he was serving as an officer in the Continental Army, Ham- ilton had already (at age 24) made himself an expert on modern finance in a new nation whose financial arrangements were decidedly pre-modern. In 1781, during what turned out to be the late stages of the War of Independence, Hamilton wrote a long letter to Robert Morris. Morris had just been appointed by Congress to clean up the financial mess created by over-issuing paper Continental currency to the point that it became worthless. That problem had virtu- ally destroyed the credit of the United States with foreign supporters of the American cause and with its own citizens.

Hamilton's solution, based on European precedents, was to create a national or cen- tral bank - one he already had termed the "Bank of the United States" - that would create a sound currency, attract foreign loans, lend money to Congress to finance the war effort and stimulate the growth of the American economy. He told Morris:

The tendency of a national bank is to increase public and private credit. …

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