The Economics of Central Banking

Livio Stracca

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781351583350
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

This book offers a comprehensive analysis of central banks, and aims to demystify them for the general public, which is the only way to have a rational debate about them and ultimately to make them truly accountable.

The book originates from the author's graduate lectures on Central Banking at the University of Frankfurt J.W. Goethe. It contains an overview of all the key questions surrounding central banks and their role in the economy. It leads the reader from the more established concepts (including monetary theory and historical experience), necessary to have a good grasp of modern central banking, to the more open and problematic questions, which are being debated within academic and financial market circles. This structure enables readers without specific knowledge of central banks or monetary economics to understand the current challenges.

The book has three defining characteristics, which set it apart from competing titles: first, it is pitched at the general public and uses simple and entertaining language. Second, it is rooted in, and makes frequent reference to, recent academic research, based on content for a graduate level course. Third, the author thinks 'out of the box' in order to describe the possible evolution of central banks (including the prospect of their disappearance), and not only the status quo.

1

Money and central banks

Central bankers are increasingly in the limelight of public attention, monitored with the same obsession traditionally reserved to celebrities. In the post crisis environment they have greatly enlarged their span of action, resulting in what some observers regard as over-reach and mission creep. Central bankers also venture more and more into new fields, speaking on a large range of issues that were traditionally well outside their remit, including, for example, climate change or the quality of schools. One century ago there were only 15 central banks in the world; there are now over 200.

Increased public attention and scrutiny is to be welcomed. Central banks are and always have been important. They do matter for citizens’ welfare, and should be held accountable for their actions, which they typically pride themselves to be. At the same time, increased public attention has not been accompanied by a rise in public trust in them. Quite the opposite in fact – trust in central banks is on the decline worldwide in the wake of the global financial crisis. This is visible not only in angry blogs ruminating on worldwide conspiracy theories of world domination by bankers and their associates but also, and more relevantly, in survey data. It is a worrying trend, because central bankers as unelected officials ultimately derive their legitimacy from public trust. They cannot perform well for long without it.

Falling trust is also accompanied by enduring lack of knowledge about central banks and their actions. Money and finance are often seen as ephemeral concepts, created out of thin air, now as ever. To be fair, we don’t know much about what the public knows. My own, surely very casual and anecdotal, evidence suggests that the knowledge gap is worryingly large. For example, it is quite remarkable that very few people appear to realise that nominal interest rates are bound at zero – not an irrelevant curiosity but a fact that alone may well explain why millions of jobs have been lost, as we will see in Chapter 4.

In one of the few available studies, Dutch researchers investigated public knowledge about the European Central Bank (ECB).¹ Respondents to the Dutch survey appear to know relatively little about the ECB. Moreover, knowledge appears to be positively correlated with social status and desire to be informed about it. Interestingly, though not surprisingly, information on central banks is mainly derived from media. And it matters: more knowledge about the ECB is associated with a better ability to formulate correct inflation expectations, important for household decision-making. Another study on UK citizens reaches similar conclusions.²

Knowledge matters both in order to buttress trust in central banks – there is indeed evidence of a positive correlation between the two – but also for central bank accountability. As long as the public is not informed or does not understand what central banks do, their representatives in parliaments are equally unlikely to exercise their prerogatives to hold the central bank to account in an effective way. There is no true accountability without knowledge.

The main aim of this book is to strengthen the general knowledge and understanding of what central banks are and do. Clearly, one of the reasons why knowledge is poor is that people have better things to do in their life than poring over central bank balance sheets. Still, I will try to show that key questions around central banking are both accessible to non-economists and intellectually interesting, in some cases even entertaining. The challenge I want to pose to myself in this book is to explain modern central banking, in its open and problematic aspects, to a wider audience. Hopefully this has led me to a better understanding of some issues – there is nothing as instructive as having to explain to a non-technical audience for recognising our own ignorance, often glossed over without a real and deep understanding under the cover of technical jargon.

Therefore, this book goes over all main questions surrounding modern central banking, starting from the very question of why money exists. Although the way in which the material and the ideas are presented is hopefully original, in fact I do not claim to be breaking new ground in almost anything the book covers. For ease of exposition, sources are contained in the notes at the end of each chapter and not reported along the way, but it should be clear that the book is based on a large body of policy and research work, overwhelmingly produced by others. My contribution has mainly been to summarise and present this large body of work in an accessible and hopefully entertaining way. Another contribution of this book is to provide an ‘update’ to earlier books on central banks, which is important since a lot has happened in central banking in the past two decades.³

Any analysis of central banks must necessarily begin with the question of money’s existence. After all, what central banks contribute to society is essentially money, or monetary services.

Let us then get started with that question. Why do we need money at all?

The inefficiency of barter

In modern financial systems money is a slippery and elusive entity. However, the origins of money are very material indeed, and indeed the name of most currencies used today can be traced back to measures of weight – this is obvious in some cases, for example for the pound or the peso.

A good place to start to make progress in understanding monetary economics is to note that in a complex and specialised economy barter is a very inefficient form of trade. The absence of a double coincidence of wants (I produce bananas, you produce pears, but I want apples) is often mentioned as the key reason why barter is inefficient, but it is only one of them. If transactions were completely costless, double coincidence of wants would not be a problem by itself. I can sell my bananas to you, and with your pears in my hand, I can exchange them for apples with somebody else. In fact, this is what would happen in all standard general equilibrium models in economics that are currently taught at graduate schools – these models are practically ‘money-less’ and money is at best appended in an ad hoc way. More generally, the transaction could involve the exchange between a specific good and any good that can serve as a numeraire, say apples. The numeraire could then be used in exchange for any other good, after taking into account factors like expected depreciation - the apple may rot and lose value before the next transaction. For example, an apple as a numeraire can be exchanged for 2 pears and 1.5 bananas, which completely defines the price system in this three-good economy.

The price level in this economy without transaction costs is simply the relative price of the numeraire with respect to a representative basket of goods and services. Any good can be used in this way, in principle, as long as it has some intrinsic value. It is important to keep in mind therefore that money would not need to exist in the absence of transaction costs, even in the absence of a double coincidence of wants.

But transaction costs do exist, as purchasing and selling do require time and effort. The economics of transaction costs is not an easy one to develop, as it is difficult to conceive general rules. Transaction costs are probably very transaction-specific and contingent on the space and time where the transaction takes place. For this reason, it is hard to build a general theory of transaction costs and this is one of the main difficulties eventually confronting monetary theory.

Key functions of money

According to the typical textbook description, money has three main functions: store of value, unit of account, and means of exchange. The first function is arguably the least important and is more a precondition for the other two: if something is not seen as a store of value at least to some extent, it is unlikely to be used in transactions. The two other functions are crucial but also, importantly, closely intertwined. In particular, the use of something as means of payment – implying a role in minimising transaction costs – makes it easier for the same entity to also be the unit of account. There is a reason, for example, why prices are expressed is euros in Europe and not, say, in US dollars. The US dollar is an excellent unit of account, but the fact is that in Europe euro banknotes are used for transactions. There is also the other direction of causality: something used as a unit of account is more likely to be used also as a means of payment – although, in my opinion, the causality running from the means of payment function to the unit of account function is the stronger one.

Commodity monies

If a good is used as an intermediate step in trade, it plays a monetary function which may add to its intrinsic value as a commodity. This is the case of commodity money; indeed as just discussed all goods can in principle become commodity monies if transaction costs are zero. Suppose that bananas, pears and apples all provide the same utility and are equally difficult to produce. If for some reason pears are more amenable to transact on, then pears may acquire a monetary value in addition to their intrinsic value.

In practice, not all goods serve this purpose equally well. A good that is subject to large fluctuations in value (say, hit by frequent demand and supply shocks, or with rapid depreciation) may not have a monetary function and may even increase transaction costs. Even more damaging for the transaction role of any commodity is asymmetric information on the value between the buyer and the seller. (In economics, asymmetric information denotes a situation where one party of a contract has more information than the other and can use it to his advantage.) For this reason, say, used cars are not a good form of money. Commodity-based monetary standards, such as gold and silver, have been based on goods that are relatively scarce and difficult to produce, and also – perhaps more importantly – relatively easy to verify.

An ideal form of commodity money should be relatively scarce, but also not too scarce. Diamonds, for example, have never had any monetary value. For the opposite reason, water can hardly ever be used as money (except, perhaps, in the middle of a desert). The commodity must also be divisible, of course, so as to be used in all transactions – another characteristic where diamonds would fail since even the tiniest of them would be too valuable to pay for a small transaction. Portability is another obvious characteristic of good money – hence immobile assets can hardly acquire a monetary value unless portable rights can be written on them.

Fiat money

If we dissociate the monetary value from the intrinsic value, we can create fiat money – a good only used as an intermediate element in order to transact in other goods – that is intrinsically worthless. The term ‘fiat money’ derives from Latin, where ‘fiat’ means ‘let it be’.

How can something without intrinsic value (with a relative price of zero against any other commodity) arise as a credible means of payment? It can only do as a result of a social convention based on collective imagination. A society can pretend that something intrinsically worthless has positive worth if used as an intermediate element in transactions. A euro coin is, objectively speaking, almost worthless – not completely worthless in fact because it is costly to mint, but almost. I can produce a banana, exchange it for a euro coin and buy one apple with the euro coin. This means that the relative price of a (worthless) euro coin vs. a banana is 1. It is easy to generalise the concept to an entire basket of goods.

The economic system faces a fundamental coordination problem with fiat money. In theory, any form of paper currency and any other worthless object could have a monetary role. Evidently there are economies of scale in having only one, or at most a few, monies, in the same way as it is more efficient to speak one language rather than several languages. The government can play a useful role in coordinating expectations on a particular means of payment; this is a view traditionally emphasised by Cartalists, who point out that sovereign power and money creation are closely associated, and even commodity monies could not exist or circulate without some government intervention. Government-issued banknotes, officially defined as legal tender, represent a way to reach that coordination. We will come back to the role of the government in money creation in the last chapter of the book.

An ideal solution to the inefficiency of barter: a ledger of transactions

Imagine an economy populated by persons who produce different goods, for example each person can pick only one kind of fruit from fruit trees. At the same time, each consumer wants a composite good (say, a mix of fruits); all consumers are perfectly honest and truthful, a characteristic whose importance will be clear in a moment. People buy different goods from other people but need to find somebody else who wants their good, and this takes shopping time that is costly and wasteful. This explains the inefficiency of barter. It is quite easy to see that a benevolent social planner, who cares about the performance of the whole economy, would want shopping time to be reduced, and an ideal solution would be to establish a ledger of transactions. Whenever a person sells the good that he produces he receives a positive entry in a register for the amount that he sold defined in terms of the composite good. When he purchases another good for his consumption, his entry in the register is reduced accordingly. This arrangement allows each person to buy and sell without the need to find a counterpart who wants the good he produces.

But now suppose that people are not honest and would walk away from their obligations, especially if they exceed their dues, in the ledger. Therefore, the ideal solution of the register is not feasible because there would be too much cheating and distrust. A good second best solution is for something, that we call money, to ‘proxy’ for the entry in the register that is readily accepted for payment. That something can be intrinsically valuable, such as gold, but also not so, such as a contract like paper currency; the idea that money is a substitute for the ledger of all transactions is more evident for monies that are not intrinsically valuable, but rather give the right to purchase a basket of goods and services, now or in the future. In a sense, money is the first example of a financial asset.⁴

Evil is the root of all money

Money, especially intrinsically worthless money, can be seen as a second best alternative to a credit-based system based on a ledger of past transactions. Rather than marking a debit or credit into the ledger, the transfer of a unit of money symbolises the same action and makes the registration unnecessary. Both fiat money and a registration system are entirely the result of imagination and social convention – though the effect of that imagination is very tangible in the form of transactions that would otherwise not take place.

Part of the problem with a ledger is that credit history is unobservable, so preventing cheating would not be feasible – or at least it was not feasible in the past due to limitations in credit register technology. In the words of Nobuhiro Kiyotaki (Princeton University) and John Moore (University of Edinburgh), ‘evil is the root of all money’.⁵

To recap, money is essentially a good second-best and low-tech recordkeeping system, which tracks who contributed or did not contribute to trade. One item used as money is like a symbol saying ‘I have contributed and, in an ideal register of credits and debits, I would have a plus’. As pointed out very aptly by Narayana Kocherlakota at the University of Rochester, ‘money is memory’.⁶

We will see later in Chapter 8 that technological advances might make the first best solution, a ledger of all past transactions, feasible but also that technology is not all that matters, public trust and the quality of institutions may be even more important.

Characteristics of good money

In monetary economics it is often empha...