Starting from mostly humble beginnings in the seventeenth century to becoming some of the most powerful institutions in the world of today, central banksâ ascendency has been a process of both evolution and planned institution building. This book aims to record and explain this remarkable journey, thereby contributing to a better understanding of an often vaguely perceived policymaker.
Before becoming the true money masters residing in imposing edifices, central banks underwent long periods of relatively smooth evolution interspersed by deep-seated changes. As these shocks mostly resulted in a greater degree of independence from their governments, the power of central banks increased commensurately, save for a limited number of instances where they lost ground to the political branches of government. But such set-backs were almost always reversed over time. For instance, the Federal Reserve (Fed) lacked real influence in the first years after its establishment, but came to play a significant role in fostering the boom of the American economy from the First World War up to the collapse of October 1929. After finding itself in the monetary desert of the Great Depression in the 1930s, partly caused by its policy mistakes, it regained an influential position in 1951 after reaching a landmark agreement with the US Treasury. From then on the American central bank, which had already reestablished its international monetary credentials, was once again an important player on the US economic chessboard. And after slaying the dragon of inflation of the 1960s and 1970s, its place in economic policymaking was never again seriously challenged, despite regular criticism from the more extreme members of the US Congress until recently. However, soon after taking office, the 45th American President became increasingly critical of the Fed to the point that he released an unprecedented barrage of invectives directed at its chairman.
Now the most important central bank in the world, the Federal Reserve was created only after a great number of other central banks had been established, some of which had inspired the founding fathers of the Fed in designing its structure. The first central banksâthe Swedish Riksbank and the Bank of Englandâwere founded in the seventeenth century. They were followed by France and after a long lag by other Continental European countries, in the early nineteenth century. More official monetary institutions were established after the widespread adoption of the gold standard around 1870, the German Reichsbank being the most prominent among these. Three more waves of new central banks followed. The first took place after the ravages of the First World War, actively promoted by the now long forgotten League of Nations. The second wave emerged during the process of decolonization, the newly independent nations emerging on a period of institution building, this time actively promoted by the International Monetary Fund (IMF). Finally, after the implosion of communist Europe, a brief third wave emerged with modern central banks replacing the state banks of centrally planned economies. Here too, the IMF, together with the assistance of Western central banks, played an important role. Thus after a long, sometimes rough journey, the citizens of practically all countries are now served by their own central bank and currency.
The latest chapter in the central bank saga played out during the Global Financial Crisis of 2007â09. Operating in uncharted waters and taking bold action to avert a meltdown of the international financial system, the worldâs money masters were lauded for their actions, adding to their prestige and power. More recently, the post-crisis recession turned out to be deeper and longer lasting than expected, raising fears of another Great Depression and presenting central banks with another daunting challenge. By introducing new and innovative policies, such as (sub) zero interest rates and quantitative monetary easing, and keeping monetary conditions exceptionally loose, slow but sure success was achieved in returning to satisfactory rates of economic growth in most advanced countries. And in some instances, unemployment fell from high peaks to historically low levels, especially in the United States and Germany. However, monetary policy became overburdened, raising calls for a return to normalcy, meaning letting go of unconventional monetary policy and returning interest rates closer (but still lower than) to historical levels. Moreover, a more active role for fiscal policy, dormant for a long time, is considered by many observers to be overdue.
The economic turmoil of the mid-2010s placed central banks squarely in the limelight, enhancing the perception that these were very powerful institutions. Members of the public, for whom institutions like the Federal Reserve and the Bank of England were largely unknown, have in recent years gained a degree of recognition of what central banks do (they raise interest rates!). All of this has incited renewed questions and criticisms about the proper role of central banks in relation to governments and the economy as a whole. The feeling that (some) central banks are too powerful and need to be reined-in, or in extreme cases, abolished, have taken hold among activist politicians in quite a few countries. As such, increased scrutiny of central banks has become part and parcel of modern democracies. Understanding these needs and to meet the demands of politicians and stakeholders in the private sector for transparency, central banks have over time become much more forthcoming in explaining their actions. While this has led to a better understanding of what goes on in the hushed offices of the worldâs monetary policymakers, there remains room for improvement, without giving away all the secrets of the temple. In fact there are a limited number of areas within the inner workings of central banks, such as information about intended foreign exchange intervention and the position of individual banks, which have to remain confidential, as is true for government departments such as Ministries of Justice.
But crucial questions remain, such as how powerful central banks have actually become, how did their power accrue over time and how will they operate in the future? These important questions are at the essence of the rise, and sometimes fall, of the influence of institutions managed by government appointed but unelected officials. The history and present state of central banking are crucial for understanding the challenges that official monetary institutions may face in the future. How they will deal with them will help shape the future of national economies and, given the present-day interconnectedness of sovereign nations, the entire world economy. Learning from the past requires an in-depth examination of the path along which central banks became what they are today, taking into account their diversity, not only geographically, but more importantly their stage of development. Advanced economies (as defined by the International Monetary Fund) generally possess more established monetary institutions and are held to a higher standard than those in developing countries. But considerable progress has been made by the latter, as will be explained in dealing with the more recent history of managing money.
In order to clarify how from their early, modest, beginnings, central banks became major players in the shaping of economic policies, the first chapters of this book are dedicated to their history. For a large part of their existence, the inner workings of central banks remained largely unknown. They were seen as secretive bodies who believed that openness about their activities was undesirable, partly because some of them started off as privately owned entities that did not wish to reveal their business strategies. The mystique of central banking was often cultivated by the institutions leaders, contributing to the notion that conducting monetary policy was more of an art than a science. Writing in 1867 the British economist Stanley Jevons posited that the management of a âcurrency is to science what squaring the circle is to geometry and perpetual motion to mechanicsâ (Jevons 1867, vi). A century later, a former Chairman of the Federal Reserve, Arthur Burns, devoted a lecture to The Anguish of Central Banking, stressing the uncertainty that central banks have to deal with (Burns 1979). More recently the Belgian economist Paul de Grauwe observed that despite central banking having been assiduously examined scientifically during the 1980s and 1990s, âthere is still the feeling that, after all, central banking is still an art, and that the success of a central banker depends on such intangibles as feeling the mood of the marketâ (De Grauwe 2002). And journalist Neil Irwin contributed to the perception of uncovered dark practices by naming his book on central bankers The Alchemists (Irwin 2013). However, one of the purported alchemists, Mervyn King, former Governor of the Bank of England, argued in his book The End of Alchemy (King 2016) that the mystique of central banking has been largely unmasked. Yet the magnitude of professional private sector central bank watchers would seem to suggest that while there is perhaps no more alchemy, the making of monetary policy is not fully predictable and a degree of uncertainty remains.
The history of central banks shows that for most of the time they were considered to be among the least dynamic of financial institutions and government agencies. Chapter 2 relates how in their early days central banks were entities with simple tasks or mandates which only gradually evolved in reaction to new economic and financial developments. Starting with providing loans to the government and issuing banknotes, central banksâthe Bank of England leading the wayâover time added operations in money markets by buying and selling bills of exchange to their activities. Concerns about financial crises, which erupted from time to time, led central banks to act as lenders of last resort which became an important part of their policies. Increasingly sophisticated open market transactions aimed at influencing conditions on money markets followed. Moreover, the tasks of central banks were drastically altered with the widespread adoption of the classical gold standard between 1875 and 1914 (Chap. 3).
The arrival of the Federal Reserve System in the United States in 1913 injected new ideas and central banking practices, as described in Chap. 4. After the demise of the gold standard in the 1930s, monetary policy became decoupled from the objective of maintaining fixed exchange rates. While initially a period of prosperity, the interwar era was marked by the Great Depression, caused by misguided policies which are analyzed in Chap. 5. How central banks regained prominence in the post-war years with the introduction of the Bretton Woods system of fixed but adjustable exchange rates is the subject of Chap. 6. As related in Chap. 7, the initial success of the new international monetary regime proved to be a shot in the arm for central bank power and prestige. But the dramatic events resulting from the breakdown of the Bretton Woods regime and the widespread surge in inflation of the 1970s complicated the lives of central bankers, especially in the United States where the independence of the Federal Reserve came under siege. At the same time, the now flexible exchange rates allowed central banks to focus monetary policy primarily on domestic economic conditions (Chap. 8). After slaying the dragon of inflation by means of severe monetary tightening in the early 1980s, central banks were on top of their game again, their power and prestige having been restored.
Chapter 9 explains why central bankers enjoyed a relatively eas...