Designing Central Banks

Heinz Herrmann, David Mayes, Geoffrey E Wood

• Publisher: Routledge
• Year: 2009
• Print ISBN: 9780415476164
• eBook ISBN: 9781135214357
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The activities of central banks are relevant to everyone in society. This book starts by considering how and why in general central banks evolved and specifically the special aspects of the contribution of the Northern European Central Banking Tradition. With that foundation, the book will then turn to a series of contemporary themes. Firstly, this book looks at independence, how central banks can actually influence their respective economies, goals, responsibilities and governance.

This collection of papers, formulated from the joint conference of the Bank of Finland and the Deutsche Bundesbank in November 2007, will help motivate continuing research into the institutional design of central banks and promote a better understanding of the many challenges central banks are facing today. This volume gives a detailed perspective on the benefits of price stability and central bank independence and, due to the advances in macroeconomic theory, has prompted a substantial rethink on central banks' institutional design.

With contributions from such scholars as Anne Sibert and Forrest Capie and a foreword by Erkki Liikanen and Professor Axel A. Weber, this volume will be useful reading for monetary economists around the world as well as all those with an interest in central banks and banking more generally.

1
Some scattered thoughts from history on evolution and design in central banking*

Forrest Capie

Introduction

My reaction when asked to offer a chapter on the history of central banking was, could there be anything left to say? But there might be, for while the ground is well-trodden and the pattern of development in central banking well-known, people can be relied upon to forget old truths and in any case interpretations differ. First, a caution is needed. Economists almost invariably ask for a model. There is no model in this chapter. There isn’t even a strong hypothesis. Rather some thoughts are offered as a contribution to a conversation on the design of central banks and why they are the way they are. Second, the chapter may appear overly Anglocentric. I don’t make much apology for that. Apart from the fact that it is what I know most about, there is some justification in that the Bank of England was the first central bank and it was frequently used as a model for others. It was hugely influential. Its story is central to the development of central banking. Finally, there is a vast literature on the subject, much of which I have read and perhaps absorbed but make no attempt to list here.

The pattern in the development of central banking that is commonly accepted is: there was a classical period when central banks were often privately owned and independent—the late nineteenth and early twentieth centuries; that was followed in the mid twentieth century by a period when discretion on monetary policy ruled but the banks were largely dependent; and then there was a return to a concern with price stability and independence in the latter part of the twentieth century. To some extent it is implicit in this that there was an ebb and flow as the banks either adjusted to whatever environmental changes were taking place— evolution—or accepted the direction of the state—design. Charles Goodhart’s book with ‘evolution’ in the title has undoubtedly been influential in encouraging the evolutionary view and the idea of evolution still grips. Goodhart set out to show how central banks ‘have evolved naturally over time…rather than conforming to an initially planned structure’.¹ But it is clear that not all was evolutionary. But if not, then what? Were they consciously designed? One possible title for this chapter was, ‘Evolution, design (intelligent or otherwise), or what?’ But such a title could have continued: ‘or transplant and then back to the drawing board and perhaps some of all these and not necessarily in any particular order’, though that would have been a bit long. The chapter suggests that the beginnings of central banking, in the classical period, were evolutionary, and the period that followed was essentially one when design prevailed. It then hints at what evolution and design might suggest for the story of independence and performance that followed.

Definition

First, some definition is needed since there is frequently disagreement over how central banking should be defined, and there is certainly room for discussion. It is sometimes asserted that the Riksbank was the first central bank. That is not the case. Some would want to argue, possibly on stronger grounds, that the Wisselbank, an earlier institution, was the first.² One way of approaching the subject might be to list what it is that central banks do, or have done, so that a decision could be made as to whether a particular institution qualifies. Unfortunately, such a list runs to greater length than there is room for in this chapter. The list would range over note issue, all kinds of agency work for government, through the gamut of supervisory and regulatory roles, to advice, to promoting economic development and economic growth, and still not get to what are currently recognised as their two key or core purposes: price stability and financial stability.

For a long time the view was that the lender of last resort was the key defining feature of a central bank—certainly when trying to locate their origins and early activity. But even here care must be taken over what the lender of last resort is. There is mixed use of the term. But the most satisfactory definition of the lender of last resort is: the institution that comes to the aid of the market (and not any single institution) in times of liquidity shortage. The basics involve the role of banker to the banks and the concern with banking stability. It was surely that that led to the lender of last resort, and that that properly defines the origins.³ That would rule out many institutions at least in their early years when they were the only bank in the country. There were occasions when nascent central banks came to the rescue of one of their customers (a bank) in much the same way as a commercial bank may extend additional loans to one of their customers who is temporarily illiquid, or conceivably by some standards insolvent. They did so when the present expected return from the new loan was itself zero or negative if the wider effects should warrant it. But that is not a lender of last resort. The LLR can be dated from the time when the bank accepted its responsibility for the stability of the banking system as a whole, which overrides any residual concern with its own profitability. So it is the intellectual basis and reasoning that matters rather than any example of rescue action. But shifts in mental perceptions are difficult to identify and date.⁴

Origins and evolution

Equipped with that definition we would conclude that the earlier central banks were essentially late-nineteenth/early-twentieth-century creatures. There are some examples from the nineteenth century, notably the Bank of England, but mostly not. Interestingly, Palgrave’s 1896 dictionary has no entry for central banking. And Sayers, the distinguished historian of central banking, notes that central banks in the main began to appear around 1900.⁵ Where evolution took place, it took a very long time—in the Bank of England’s case close to 200 years. There is a good case to be made for evolution, at least for those central banks that made their appearance in the nineteenth century, even if these were few.

The birth of the institutions that became central banks was frequently as banker to their government with a principal task being managing the government’s debt. That was the case for the Bank of England, the story of whose origins and development is well enough known not to need repeating here. But there are some elements that can be set down briefly that remind how it evolved as a lender of last resort. In its early years the Bank was a normal commercial bank, though with monopoly joint-stock status; and it was the government’s bank. While commercial banks were developing in England in the eighteenth century they were for a long time closer to cloakrooms than modern fractional reserve banks. Although the principles of fractional reserve banking were not only grasped but being acted upon from the seventeenth century, extreme caution prevailed and the money multiplier remained very low.

However, by the time of the Napoleonic Wars or soon after, the banking system had developed to the point where runs on banks became possible, even likely. When the first real crisis struck in England in 1825 it was huge—genuine panic. The Bank had by that time emerged as the centre or pinnacle of the system. It alone was in a position to help but it was handicapped by regulation since the Usury Laws were still in place. These were thereafter relaxed so that when the next crisis struck in 1836/1837 the Bank was in a better position to perform its role of lender of last resort. It was a step forward.

In 1844 legislation further strengthened the Bank’s position and gave it a phased-in monopoly of the note issue. And the gold standard was more strictly defined. This latter, however, presented problems when the next crisis broke in 1847 for while it was clear what the Bank should do, it could not do it without breaking the law. The solution was for the Chancellor to permit the Bank temporarily to suspend convertibility.

There are those who would argue that if free banking had been allowed—no regulation at all—as it had been in Scotland for almost 150 years up to 1844, there would have been no need for a central bank, and there would have been greater stability. But that opens up too much territory of a different and wide-ranging kind. The facts were that by the middle of the nineteenth century a system had developed to cope with the conditions such as they were. Discount houses had emerged as intermediaries between the banks and the Bank of England where long-running antagonisms had brought distance. This particular institutional arrangement was to provide a useful additional element in the system since it meant that when banks needed to borrow they would do it through the discount market and not directly from the Bank. What that meant was that if any one was in difficulty, the danger of individual treatment was greatly reduced since the Bank need not know whose paper it was discounting, coming as it did from the discount house—the temporary home of the paper— paying attention only to the quality of the paper.⁶

Two further crises in 1857 and 1866 brought other experiences, and better appreciation of the required behaviour. They showed that the letter from the Chancellor would always be available in these circumstances. The crisis in 1866 brought home the fact that no bank was too big to fail.⁷ The Bank could therefore do what was needed. But would it? Bagehot was still critical of the Bank in 1866 for not acting sooner than it did—lending, ‘hesitatingly, reluctantly, and with misgiving. In fact to make large advances in this faltering way is to incur the evil of making them without the advantage’.⁸ In fact Bagehot went further by suggesting that not only should the Bank act promptly but that it should announce in advance that it would so act. By the 1870s it had not quite done that but to all intents and purposes it was behaving like a mature lender of last resort.⁹ Bagehot’s advocacy of a clear announcement of what they would do in advance was somewhat in advance of Kydland and Prescott. In the late twentieth century pre-commitment provided a case for the independence of central banks. In the 1870s the Bank of England made no explicit statement to that effect but its behaviour made it implicit.

There were other developments in the system in England and notable among them were changes in the banking system. That became a concentrated structure heavily branched and diversified geographically and industrially or by activity. It had also found its way by learning an appropriate balance sheet structure with sufficient in the way of liquid assets. It is surely no coincidence that for the next 100 years there were no banking/financial crises. All the important lessons had been learned and practices adopted either explicitly or implicitly. So there was a readiness and ability by the Bank to lend to whatever extent was needed. The lending was done anonymously and so greatly reduced or even eliminated moral hazard. So well understood were the arrangements and so great the trust developed among the participants that in themselves these promoted stability.

There would of course still be mishaps or extraordinary or unforeseeable events. In 1890 there was an example of the first when Barings failed. There was no need for the Chancellor’s letter for there was no panic. The Bank nevertheless took on another role, that of crisis manager and organised a rescue operation. In 1914 there was an example of the second, when war broke out. Although the years 1890 to 1913 are sometimes characterised as years of growing international tension, there was not much evidence of that in financial market data; the war came as a bolt from the blue to investors. There was no preparation for war in t...

Table of contents

• Routledge international studies in money and banking
• Contents
• Contributors
• Foreword
• Acknowledgement
• Introduction
• 1 Some scattered thoughts from history on evolution and design in central banking
• 2 The north European model of early central banking
• 3 Central bank independence and monetary policy-making institutions
• 4 How should central banks define price stability?
• 5 A proposal for extracting policy information from the ECB’s second pillar
• 6 Forward guidance for monetary policy
• 7 Designing a central bank communication strategy
• 8 Achieving financial stability with cross-border banking in an EU perspective
• 9 What kinds of research in central banks?
• Index