Central banks are just doing their job

I’ve been reading a lot of comments on blogs complaining about US and other government action in wake of the current crisis of confidence gripping financial markets. Most of the complaints are directed at the US Federal Reserve and based around the idea that western economies are basically free markets and that governments have no place interfering in failing businesses.

The first thing I would say about this is that most western countries are not pure free-market economies but mixed economies where markets operate within a regulatory framework set by authorities and governments themselves perform some economic functions rather than leaving them to the private sector.

This is particularly so when it comes to banks. Banks are different because of the role they play in commerce. We all use Banks and expect them to be safe places for our savings and many individuals and businesses depend on them for loans. Banks borrow money for short periods that they then lend to you and me for long periods. Some of these short term funds they use include deposits that can be withdrawn at will. If too many people were to demand their money back from a bank at the same time, the bank wouldn't be able to pay them and would fail.

The other thing that banks do on a regular basis is settle transactions between accounts held by different banks. This happens every night, night after night (except weekends). Sometimes, banks find themselves short of liquid funds (cash) and they borrow from banks that have more liquidity than they need. In return for this, the lending bank charges the borrowing bank a rate of interest which happens to be the cash rate. This is partly how the cash rate affects retail lending products like your mortgage - its the rate we all currently wait on feverishly every month in the hope that it has fallen. In Australia this is set by the Reserve Bank.

In Australia, Open Market Operations are conducted by the RBA to ensure sufficient liquidity exists between retail banks. This happens on a daily basis as the RBA ‘intervenes’ to keep the price of funds at its targeted cash rate. If the RBA didn’t act in this way the price of funds exchanged between banks in overnight settlements would become erratic. A shortage of funds would ‘bid up’ the price and monetary policy would be ineffective (and your mortgage might become more expensive). In the opposite situation, a surplus of funds would drive the price down (when there is an excess of funds in the market the RBA becomes a buyer to keep the cash rate from falling).

This is what central banks do all over the world. However, given the present conditions retail banks are particularly reluctant to lend to each other both in the US and elsewhere. So the world’s central banks have stepped in and are lending to any bank that finds itself short of funds to complete its daily settlements. They are doing this to maintain stability in the price of funds (the interest rate) and to restore confidence in the banking sector generally. What we are presently seeing is an extreme version of what central banks do every day: manipulating the balance of demand and supply - keeping cash rates in accordance with their present policy settings. At some time in the future, when the market calms, the central banks will re-enter the market and withdraw the resulting surplus of liquidity.

Whether you think we live in free market economy or some other version of it, the banking system depends on public confidence for its stability. It's the responsibility of governments and their agencies to ensure the system remains stable.