Crisis! (Part 1 of 2)

The past few years have been turbulent for the global economy, especially in Europe and America.  With the rise of the Asian economies like China, and recovery of others like Japan, the West has sometimes had an increasingly difficult time keeping up.  Industries like manufacturing have, to some extent, moved overseas where the costs of production are cheaper.  In response, the developed world has had growing pains as its populace has been forced to shift away from low-skill labor to high-skill labor. In the financial industry, there have been shockwaves from change as well, though in a different form.  Over-speculation has been a major cause of much banking turmoil in the past couple decades.  Additionally, much of the financial problems that have arisen can be attributed to poor expectations for the economy, which has the potential to become a self-fulfilling prophesy.  To combat these national hardships, central banks intercede for the people in the hopes of healing the economy and staving off further damage.

            Where do central banks come from, and what are their purposes?  A working knowledge of a central bank’s functionality is crucial in understanding its actions in the economy and what effects it has brought about as a result.  For this paper, the Bank of England and the Federal Reserve, England’s and America’s central banks respectively, will be considered in particular. Before that however, it is helpful to look at the political context and country from which each of those banks arose.  Both America and England are fairly similar in that the foundation of their systems was the Magna Carta.  This 1215 charter of freedom gave citizens the right to be free from oppression by their rulers. It was a short leap to a government “of the people, by the people, and for the people”.  Fast forward to modern times and the world looks a lot different.  People have been enjoying their rights and have bettered all of society.  Markets and industries grew up and developed.  Much of this flourishing can be attributed to a banking system that evolved into the complex organism that it is today.  The ability to store value (money as purchasing power) and facilitate loans for investments has been a great boon to civilization.

            This is where the central bank comes in.  Each country, at some stage in development has required the service of a single bank that oversees the national monetary policy: setting interest rates, making sure that enough money is in circulation, being a lender of last resort, and setting reserve ratios.  Interest rates are “the price of money”.  More specifically: it states how much it costs a borrower to have access to money now that an individual, or firm, would not have had until later, had the money been saved up.  Interest rates also give people with excess money an incentive to loan their money to other institutions, whether it takes the form of a bank account, stocks, bonds, etc.  The ability to borrow money for investment purposes is what allows people to buy capital and hire workers when initially starting businesses.  This is the only way to begin unless the entrepreneur is already wealthy or has a beneficiary who is.  Conversely, the ability to gain interest by saving money in one of the ways mentioned above can teach people from a very young age the value of saving and being frugal.

            Zoom out to the national level where instead of individuals lending and borrowing, banks are lending and borrowing.  Who fills the need of lending and borrowing to banks?  In America, it is the Federal Reserve (a “bankers’ bank” as it is sometimes called); in the United Kingdom it is the Bank of England.  When banks need money for large investments, they can get that from the Reserve, which can both expand and contract the economy’s money supply.  Not only that, but the Federal Reserve sets the “reserve ratio” which stipulates the percentage of money that a bank must have on hand for each dollar of a loan they grant.  At the present time, American loans less than $11.5 million require zero percent to be on hand.  Loans between $11.5 million and $71 million require three percent of the amount to be in deposits.  For loans exceeding $71 million, 10 percent of the liabilities must be available¹.  Finally, central banks like the Federal Reserve and the Bank of England have the ability to act as a “lender of last resort”.  This means that if a banking institution is at risk of going out of business, it can get an emergency loan for as much as it needs to stay afloat.  The power to grant large amounts of money became a point of tension in both the American and British economies during the pecuniary turmoil of the past few years.  While the particulars of operations and rates are different in the United Kingdom, the purposes and powers of the Bank of England are essentially the same as the Federal Reserve’s.  “The Bank’s job is to work with others to help ensure that problems at one financial institution don’t disrupt the way the [financial] system as a whole operates.”²

            The most recent English recession and subsequent financial crisis started in early 2008, though the gavel did not sound until the beginning of 2009 when the Office for National Statistics declared that the economy had shrunk for the past two quarters.  The closures of several major retail chains such as Waterford Wedgwood and Woolworths in the glassware and clothing industries respectively were major contributors to the downturn at this time.  In response to this and the trend of general decreasing GDP, the Bank of England reduced interest rates in March of that year to .5 percent.  While such action is generally used to incent spending and borrowing by the populace, this did not have the desired effect and the economy continued to shrink.  Over the course of the year, the economy contracted significantly more.  Unemployment also increased to around 2.5 million by September of 2009³.

            The single most important instance that sparked the powder keg of England’s recession actually happened a couple years prior with the collapse and subsequent bailout of one of the country’s largest financial institutions: a bank called Northern Rock.  In September 2007, executives from Northern Rock called on the Bank of England, as the national lender of last resort, for an emergency liquidity funding.  The Chancellor of the Exchequer approved the bailout citing, “the difficulties that [Northern Rock] has had in accessing longer term funding and the mortgage securitization market, on which Northern Rock is particularly relevant.”⁴ The main trouble Northern Rock had was not in small-time savings, but rather in the mortgage industry.  An identical situation had been unfolding during this time and the years preceding in America’s real estate and banking industries.

Sources

Board of Governors of the Federal Reserve. Reserve Requirements. October 2011. Web. 14 April 2012. Web. <http://www.federalreserve.gov/monetarypolicy/reservereq.htm>

Bank of England. Your Money-What the Bank Does. Web. 14 April 2012. <http://www.bankofengland.co.uk/publications/Pages/other/whatthebankdoes/default.aspx>

Wearden, Graeme. Timeline: “UK Recession.” BBC News [London] 23 October 2009 Web. <http://www.guardian.co.uk/business/2009/oct/23/uk-recession-timeline>

Bank of England. Liquidity Support Facility for Northern Rock plc. London: 17 September 2007.  Web. <http://www.bankofengland.co.uk/publications/Pages/news/2007/090.aspx> 

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