Episode 25 Money Matters: Central Banks Began as Crisis Tools and Became Financial System Managers

[00:00:18] Emanuel: Hi there, and welcome to yet another episode of the Curious Pundits podcast. I'm the co-host, Emanuel.

[00:00:24] Kevin: I'm the other co-host, Kevin.

[00:00:26] Emanuel: And today is part two of one of many Kevin's rant about the economy, macroeconomy, how things work, how people think they work, and how they actually work. We had a really interesting episode. I've learned a lot, so I'm gonna look for my notebook, pull it out, take notes, and ask Kevin all the other questions I have regarding the topics.

[00:00:50] Emanuel: If you have your own questions or you notice something that you wanna correct or we said something that's not a hundred percent, feel free to go to curiouspundits.com. Over there you'll find links to all our episodes. You can subscribe to the podcast on platforms like Apple, Spotify, and so forth.

[00:01:08] Emanuel: Leave us a good review that will help reach more people. That being said, Kevin, the floor is yours.

[00:01:16] Kevin: I'd like to make a slight format change since we recorded the prior episode, and the issue is that these topics can be a little bit difficult to wrap your head around. So in the last episode, we did two topics in one episode. I spoke about how central banks do not control the money supply, and I spoke about how in neoclassical macroeconomic modeling, their mathematically rigorous models don't include variables for money, banking, and credit, which means that their models are suspect at best.

[00:01:52] Kevin: So the format change is even if the episodes are shorter, each episode is gonna be about one topic, maybe two, if the topics are tightly related. And I also realized, I edited the prior episode since we recorded it, that you asked a question and you spoke about a topic that never got fully addressed in that episode, so I wanna devote this episode to it.

[00:02:20] Emanuel: Which is?

[00:02:21] Kevin: What are central banks? And then you spoke about the stability of the Canadian banking system, and you spoke about how in Canada, the resilience of the 2008 financial crisis is being attributed to the willingness of the Canadian federal government to spend generously in the aftermath, and that is part of what happened.

[00:02:46] Kevin: So I consider these to be tightly related, so I'm gonna do them both in one episode, but let's start with what are central banks?

[00:02:53] Emanuel: What are central banks? A bank that's in the center of the city, right?

[00:02:58] Kevin: It used to be that way, right? Not literally, but we have to go back to before there were central banks to understand the role that central banks provided. What service did they provide? What problem did they solve that existed by virtue of them not existing? If you go back before that, all banks are private commercial banks.

[00:03:26] Kevin: Now, banking, even back then, was a business of marrying liabilities, deposits, and loans, assets, and keeping a balance between the two. Banks are not allowed to be insolvent, even for five seconds. It's against the rules. So whenever a bank's liabilities exceeds its assets, it has negative equity, and before that happens, even as that situation is approaching, a banking regulator will come in and close down or wind down that bank.

[00:04:07] Kevin: I'm not 100% sure when this rule got established because other businesses are allowed to exist in states of negative equity, but banks are not. I'll have to look up sometime as to what the rationale behind that rule is.

[00:04:22] Emanuel: And where would that be? Like North America, the United Kingdom?

[00:04:26] Kevin: Oh.

[00:04:27] Emanuel: What place?

[00:04:27] Kevin: All over the world. If a bank suddenly finds itself with negative equity, it's done.

[00:04:35] Emanuel: No, I'm referring to when did it happen? You said the time before. So what-- who were the ones that, the leaders that pushed towards this system?

[00:04:47] Kevin: Well, people talk about the Bank of England, at least people in the English-speaking world talk about the Bank of England as being the first real central bank, and I've got it open in my other monitor because I knew it would come up. So it started in 1694. However, it was not the first, it was the second.

[00:05:08] Kevin: I think the first was Sweden. And then the Bank of England was the second. The United States had central banks in the early days. So even in colonial days, there was a central bank called the Bank of North America. Now, bear in mind, this is colonial days, and the United States didn't exist. The Bank of North America is an audacious name.

[00:05:36] Kevin: They had big ambitions. But back then, corporate charters expired. They didn't run in perpetuity the way they do now. So the Bank of North America charter expired. They ceased to exist. There was this whole war with England. The United States exists as a country. And then they created the Bank of the United States.

[00:05:57] Kevin: At some point, its charter expired, at which point it became the First Bank of the United States, because then they opened up the Second Bank of the United States. And its charter expired in 1836, primarily because the then president at the time didn't believe in central banks. He believed that private banking was the way to go.

[00:06:20] Kevin: Now, this was Andrew Jackson, the hero of the Battle of New Orleans, you know yada, yada. But back then, I don't fully understand the details, but back then, there was a rule that if both houses of Congress had passed a bill and it came to the president's desk, he could somehow run out the clock.

[00:06:45] Kevin: He didn't veto it. He didn't sign it. He just ran out the clock, and then the bill died literally in his office. And then the charter of the second Bank of the United States expired. So from 1836, no central bank. So that means that when a commercial bank needed to balance its assets against its liabilities, part of its assets was deposits that it had at bigger banks.

[00:07:13] Kevin: And this is basically how New York became the banking center of the United States. It's on the East Coast, so it was one of the earliest places where Americans lived. People did finance. And then a bank in Boston would have deposits in a bank in New York. A bank in Atlanta would have deposits in a bank in New York.

[00:07:34] Kevin: And I don't know that anybody ever sat down and designed it this way, but over time, banks in New York became the big banks who were holding deposits for banks in other part of the country. And those deposits behaved in a way similar to the way central bank reserves do today. It's an asset of the bank, which is part of the assets in their asset column.

[00:07:56] Kevin: And as long as their assets exceed their liabilities, they're good. But when there was a bank run, let's say that, I don't know, the Bank of Kansas had a run, and all of a sudden the Bank of Kansas is insolvent and is being wound down. Any money in the Bank of Kansas ceases to exist, but they would try and prevent that from happening by providing liquidity to a bank.

[00:08:21] Kevin: So a bank can be in a situation where they have positive equity because they have assets that exceed their liabilities, but they're out of cash. So people are showing up to get their money, it's "Look, I gotta sell something before I can give you your money." And the guy's like, "I need my money now," right?

[00:08:41] Kevin: "I'm not waiting for you to sell something." And that would be a big problem for banks. I'd have to look up the details of how a bank could be wound down due to liquidity rather than insolvency, but I know that this was a problem.

[00:08:56] Emanuel: And most recently in countries such as Cyprus, Greece, and so forth, where we know that probably now ten years ago, it feel like last year, but ten, 12 years ago, they shut down banks. People had a limit on how much they can withdraw.

[00:09:12] Kevin: Oh, yeah. When there's a fairly large-scale run on banks, things get draconian for a while. So what happened was there were... This is another topic. In fact we're gonna do a topic on the gold standard. It's gonna be a different episode, but people who are nostalgic for the gold standard have really never read up much on it, because they have this belief that the gold standard represented price stability, and it didn't.

[00:09:44] Kevin: In fact, gold standard era was incredible price volatility. But over the course of 70 years, if you didn't drill into the detail, it looked pretty stable until you dug in and you saw that we had extreme periods of inflation and deflation in the interim. But anyway, back to when the United States needed to fund the US Civil War, the private banks didn't have enough money.

[00:10:09] Kevin: They simply couldn't loan the government enough money to engage the war. So the United States, at that point, through three acts of Congress, and I'd have to look up the the details of what the proper sequence was, but they created a National Banking Act, which allowed banks to be chartered on a national scale.

[00:10:31] Kevin: They passed a National Currency Act, which created the modern US dollar, so that no matter where you are in the country, a dollar was a dollar, and every bank dealt with the same denomination of money. And then they taxed bank-issued banknotes out of existence, and I think that was the last one. And they did this year one, year two, year three.

[00:10:53] Kevin: So by the end of the Civil War the US dollar was the dollar. They were worth a dollar everywhere in the country, and the various bank-issued monies that had been issued by the various state-chartered banks just ceased to exist. They were just taken out of the economy.

[00:11:09] Emanuel: As far as I remember, I am not an expert in the North American history by far. I'm learning right now, but there were up to a point, there were more American dollars, not just one dollar. There were all kinds of dollars issued in different states. I remember an episode from Married with Children with Al Bundy when he was in a store and, an older gentleman came and wanted to pay at the store and said, "Oh, gee, we don't see that much of a Confederate money around these days." But there were like more currencies, right? And maybe a topic for another conversation, but I just don't wanna forget it is you said they were taxing bank-issued notes. So maybe what were those? How many were they? Where? And so forth.

[00:11:53] Kevin: Basically, they were everywhere. So every bank issued bank notes. So there would be bank notes on, the First Bank of Atlanta, the Second Bank of Baltimore, right? And they're issuing notes which are a claim on gold. Back then, we were still in a monetary system where gold was what backed up all money, even though there was far more money in circulation than there was gold available to be redeemed, right?

[00:12:22] Kevin: It was just a fractional reserve system with gold on the back end. It was no better than our current system, and there's many ways in which it was worse, but that's for another topic. So your comment of there were many different types of money, there were about 8,000 banks, and as a result, there were about 8,000 different types of money.

[00:12:42] Kevin: They were all roughly equivalent, but let's say that you had bank notes issued by the Bank of Indianapolis and, for whatever reason, you're in Boston. Well, a guy in Boston isn't gonna go to Indianapolis to redeem those notes, right? So they would accept them at a discount. So in Boston, a dollar on the Bank of Indianapolis might be worth 87 cents or 92 cents.

[00:13:13] Kevin: I don't know what the numbers are, right? And that was to compensate the people for the costs incurred in redeeming the notes in a bank that was far away and the risk of maybe that bank doesn't even exist and you just had this thing printed, right? So anyway, back to New York becoming the financial, the banking center of the United States.

[00:13:39] Kevin: In order to pay for the American Civil War, the US government suspended convertibility to gold. Went off the gold standard. So just straight up fiat money, like what we have today. And that started in, I think, 1861, maybe '62, and then convertibility to gold was reestablished in 18-- I think it was '76.

[00:14:07] Kevin: So between 1876 and 1907, there were seven systemic banking panics, one every three or four years, and the banks in New York always had to, on the back end, be the ones who provided liquidity to the banks who were experiencing runs and were at risk of going under. And there was a particular guy, he's well known to history.

[00:14:32] Kevin: His name is J.P. Morgan, and he was heavily involved in all of this. So in 1907, we're having another banking panic. At this point, he's in his sixties. He's trying to retire. He basically pulls a whole bunch of guys from a whole bunch of New York banks, and he locks them in a room and he says, "Nobody leaves until we resolve this."

[00:14:58] Kevin: And he said that by the time that crisis was over, he personally had lost twenty-five million dollars, but that it was a good deal because if they hadn't bailed out the other banks, he would have lost a lot more than twenty-five million dollars. So at the same time, he's J.P. Morgan. He's rich. He's influential.

[00:15:20] Kevin: When he sent a message to the president, the president contacted him. When he sent a message to members of Congress, they contacted him. So basically, he said to all these guys, "It's time for the United States to set up a European-style central bank." So that was the incentive to get the central bank of the United States going.

[00:15:42] Emanuel: A small little note on your mention of J.P. Morgan. Right now, I'm currently watching The Men Who Built America, a 10-part or eight-part series documentary about the men who built America. So the first one was about Vanderbilt, the second one about Rockefeller, and now third one Carnegie, fourth one transitioning into a gentleman by the name of J.P. Morgan, who influenced...

[00:16:07] Kevin: Yeah, he's definitely one of the men who built America.

[00:16:10] Emanuel: Yeah, and influenced, and inevitably the entire world has influenced because America has influenced and dominates, still dominates the entire world economically, culturally on most aspects. So I just wanted to mention this to our audience. Comes with great recommendations, worth watching, and especially will help those who aren't actually in North America. When I grew up, these names weren't familiar. I heard about Henry Ford, maybe, yeah. But later in life, I heard about Rockefeller. I think after high school, Rockefeller, Morgan, and whatnot. Obviously, although I like to think I'm twenty-two, I'm not twenty-two, so the environment was fairly different. Podcasts and, access to resources were not as abundant as there are now. But that was a big deviation, but still, The Men Who Built America, worth watching.

[00:17:04] Kevin: Yeah, yeah, I will definitely check it out. I've heard of it, but I don't know if I've ever watched it. But sometimes, it turns out I'll have watched it 20 years ago and just forgot, right? But I'll check it out.

[00:17:13] Emanuel: It's recent.

[00:17:14] Kevin: Oh, okay.

[00:17:15] Emanuel: 2024, 2025, I think. Might be History Channel. I don't remember exactly which one, but a Google search will surface it, and probably will drop a link somewhere in the notes.

[00:17:27] Kevin: So let's go back to 1907, but before we do, let's go back to 1861. So there's a detail here that I haven't read up enough on, but in 1861, the United States needs to fund the Civil War. They go to all the private banks. They're like, "Whoa, that's way too much money. We can't help you." So the United States suspended convertibility to gold, passed these legislations, and just started issuing US dollars, which they could spend into the economy and buy... pay soldiers, buy weapons, blankets, food, et cetera, et cetera, right?

[00:18:02] Kevin: That mechanism, and this is the part that I've gotta look up and read up on, but that mechanism did not involve a central bank because there was no central bank for it to involve. So now it's 1907. We're in the midst of this crisis. J.P. Morgan is convincing the president and the Congress that it's time to set up a European-style central bank, and the original justification for the central bank in the United States was to be the lender of last resort for financial or banking system panics. Because previously, J.P. Morgan and his banks and the banks of his banking buddies had been fulfilling that need, and he's like, "We just can't keep doing it like this. It's not working." So that was the justification in the United States.

[00:18:51] Emanuel: Maybe it's time to clear up the name a little bit because there might be some confusion. The central banks are more of an institution rather than a bank itself.

[00:19:01] Kevin: Oh, no, they are banks. Central banks are banks, right? But I want to contrast the origin of the Federal Reserve with the origin of the Bank of England.

[00:19:13] Emanuel: Okay.

[00:19:14] Kevin: Back in 1694, England wants to finance their war against France, and they're going to the banks in England, and they're getting the same stories like, "Sorry, dude, we don't have that much money. We can't help you."

[00:19:26] Kevin: So in theory, I guess, England at the time could have done what the United States did in 1861, but they didn't. They set up the Bank of England for purposes of financing the war with France. So not every central bank in the world started with the same objective. But fundamentally, what makes central banks is two things.

[00:19:51] Kevin: One, it's where the state does its banking. So the US Treasury has an account at the Federal Reserve. The UK Exchequer has an account at the Bank of England. And then it also provides liquidity - assets in appropriate forms to banks who need them when they don't have enough money to satisfy depositor demands.

[00:20:20] Kevin: Now, in the United States, that depositor demand thing was the initial justification. In the United Kingdom, or actually it was England then, the initial justification was, "We need money to go to war with France." But it seems to me as if central banks have always done both since day one. But make no mistake, central banks are banks.

[00:20:41] Kevin: They're just banks that sit at the tip of the pyramid of the banking system, and they also provide payment, interbank payment, clearing, and settlement services so that when I bank at bank A and you bank at Bank B and I pay you, that payment can clear. So that's what central banks are. And they do have a very special niche in economies today, and there has definitely been what in a corporate environment would be called scope creep or in a military environment would be called mission creep because central banks do a lot more today than they did when they were initially set up way back when.

[00:21:23] Kevin: Like during the great financial crisis, do you recall hearing about the central bank buying toxic assets?

[00:21:30] Emanuel: Yes. And it's not just during the great financial crisis. It's happening all the time, essentially. But obviously during those periods more aggressively.

[00:21:40] Kevin: It seems to be that some crisis happens. They come up with some interesting and creative solution as a temporary thing, and then that temporary thing just becomes one of the tools in their toolkit. So when the central bank in the United States started buying underwater mortgage-backed securities, I don't know if they had ever purchased financial assets in the private market previously.

[00:22:07] Kevin: Maybe they had, but it definitely wasn't done at a large scale, right? And they just... They needed to provide liquidity to banks. Not just liquidity, but solvency.

[00:22:16] Kevin: The difference between liquidity and solvency. Let's say I owe you five hundred bucks, and I say, "I'm gonna pay you by five o'clock today."

[00:22:23] Kevin: So you come see me at five thirty, and I say, "Oh, my God, the bank is closed. Okay lets go to the ATM. I'll give you two hundred today, and I'll give you three hundred tomorrow." That's a liquidity problem. I've got the money, but I can't get the rest of it until tomorrow. A solvency problem is when you show up to get your five hundred bucks, and I don't have five hundred bucks.

[00:22:48] Kevin: I can give you two hundred, but that's it, right? So that's a solvency issue, right? Central banks provide liquidity to commercial banks, and via some maneuvers that some people completely disagree with, they provide solvency. So these mortgage-backed securities were no longer worth what they were purchased for.

[00:23:14] Kevin: They're worth fairly significantly less than the purchase price. So in order to make the banks solvent or ensure the banks didn't fall into insolvency, the Federal Reserve bought those mortgage-backed securities at face value, even though they weren't worth it. And then those mortgage-backed securities became the property of or assets of the central bank, and then they just owned them.

[00:23:40] Kevin: The people who were making their payments made their payments, and that became income to the central bank rather than income to the individual bank.

[00:23:46] Emanuel: So you mentioned the workaround being the Federal Reserve bought those underperforming assets.

[00:23:54] Kevin: And then the question is, what did they buy them with? If the central bank doesn't create deposits but creates reserves? And the answer is they bought them with reserves. But to a bank, reserves are an asset. So basically, it was an asset swap. So I'm gonna use round numbers. So they have this mortgage-backed security that they paid one thousand dollars for, but now it's only worth eight hundred, right?

[00:24:17] Kevin: So they sell it to the Federal Reserve for one thousand dollars of reserves. Now they have an asset that's actually worth one thousand dollars, whereas before they didn't. And people disagree that they should be allowed to do this. And, it's a bit of scope creep and/or mission creep and/or whatever name you like.

[00:24:38] Kevin: But this practice, which is now called quantitative easing, the name quantitative easing, near as I can tell, was coined by a guy named Richard Werner, who's a professor of banking and finance. And it's not a new practice. If I understand it correctly, and I got this from an interview I saw of him, the first known instance of quantitative easing was the Bank of Japan after World War II.

[00:25:05] Kevin: So basically, Japan had been bombed back to the Stone Age, but on paper, there's a whole bunch of businesses who have loans that they're supposed to make payments on. But the factory's gone. The employees are gone. They're just basically starting from scratch.

[00:25:25] Kevin: So in order to wipe the slate clean, the Bank of Japan purchased those loans from the various banks at face value because the market value was, like, zero. There's no way that these companies are ever gonna make good on these debts because they they have no income. They've been bombed back to the Stone Age, right?

[00:25:47] Kevin: So they purchased those debts at face value to spread money around the Japanese economy so that people could use that money to start rebuilding Japan. So according to Werner, if I got it correctly, that's the first known incidence of what we now call quantitative easing. So in 2008, when the Federal Reserve starts buying underwater mortgage-backed security from banks and insurance companies and whoever, it's not that this was a brand-new thing, but I think it's the first time it was done in the United States.

[00:26:22] Kevin: So I don't know. Does that kind of explain the issue? Or do you have further questions about what is the central bank?

[00:26:29] Emanuel: No, I don't. Thank you for clarifying some...

[00:26:33] Kevin: Should we talk about the stability of the Canadian banking system in the next episode?

[00:26:37] Emanuel: I think it might be worth its own episode because we can go into details Yeah. It's a little bit more complex than just a few minutes that we can tackle in this one. I think it deserves its own episode. Even if it might be shorter, I still think that one of the-- what makes Canada different and safer is the Canadian banking system.

[00:26:58] Kevin: Oh, yeah.

[00:26:59] Emanuel: Many things. I tell a lot of people, even with inflation, even with the value of the dollar, still, I was born in, let's say, in the '80s, if I would have put a hundred bucks in a bank account the year I was born, in 2026, that hundred bucks would still have been there. Give or take, minus banking fees and whatnot, which weren't a thing even a few years ago, right?

[00:27:25] Emanuel: They accumulated in time and accelerated over the past, let's say, six to seven years. If I remember, when I opened up my Canadian bank account, it was like one to three dollars the administration fee of an account. And now I think I'm paying, I don't know, between business and personal accounts, I think I'm paying close to a hundred bucks just in administration fees. Maybe...

[00:27:45] Kevin: Yeah, that sucks.

[00:27:46] Emanuel: But it gets there, and I'm pretty sure US is not far from it either. But that thing, able to rely on that hundred bucks still being there, it's something unique that hasn't happened anywhere else in the world.

[00:28:00] Kevin: Actually, that's not true, and I don't really understand the full set of similarities, but it turns out in the 19th century, Scotland had very few bank failures in the same way that Canada did in the 20th and still does. And I do not know... I've taken a very high level, broad brush look at what was similar between the two systems, and one of the most important aspects of banking, near as I can tell, is the degree to which the rules are followed.

[00:28:35] Kevin: And...

[00:28:36] Emanuel: I don't know any Scottish bank. I'm assuming there's a Royal Bank of Scotland or something, but I...

[00:28:40] Kevin: Ultimately it's the Bank of England, right? Today, right? But Scottish banks were not a fan of central authority, and Canadian banks have been a fan of central authority from day one, and that's a huge difference, and I don't fully understand how the two systems could be... Like, I view that as a very significant difference.

[00:29:01] Kevin: At some point, the Bank of England told the banks in the UK banking industry, "You gotta stop issuing bank banknotes. No more Bank of Scotland, Clydesdale Bank, Royal Bank of Scotland banknotes. They gotta go," right? And those three particular banks in particular said, "I don't think so." And those three banks issue banknotes to this day.

[00:29:26] Emanuel: Then that's our topic for the next episode, the stability of the Canadian banking system, and maybe we can tackle and, do some more research and tackle the 19th century Scottish banks and similarities with today's Canadian banking system.

[00:29:39] Kevin: I think I have an answer, and the answer came from, ironically, a research paper that was recently published with the assistance of some artificial intelligence tools. And I'll look up the details, and we'll talk about that.

[00:29:53] Emanuel: Excellent. Until then, my name is Emanuel.

[00:29:57] Kevin: My name is Kevin.

[00:29:58] Emanuel: We're The Curious Pundits. We have a podcast. You can find us at curiouspundits.com and on all the podcasting Apple, Spotify, YouTube, Stitcher, and so on. Until the next time...

[00:30:12] Kevin: Thank you for listening.