What Do We Really Know about the Long- Term Evolution of Central Banking ?

EVIDENCE FROM THE PAST,INSIGHTS FOR THE PRESENT

STEFANO UGOLINI

What Do We Really Knowabout the Long-Term

Evolutionof Central Banking?

Paolo Baffi Seminar – Bocconi University, May 4, 2012

Motivation

For three decades to 2007, increasing convergence both in the concept (Siklos 2002) and in the practice (Bindseil 2004) of central banking around the world

Literature on central banking assumes English experience as the model – both the classic theoretical (Thornton 1802, Bagehot 1873, Hawtrey 1932…) and the historical one (Goodhart 1988, Capie et al. 1994, Wood 2005…)

As a result, ‘teleological’ accounts of the evolution of central banking do prevail

Motivation

Motivation

Is this really how things went?

Motivation

Motivation

Moreover, is this really useful?

The present crisis has shaken central bankers’ certainties with respect to their own mission (Davies & Green 2010; Borio 2011; Eichengreen et al. 2011…)

Motivation

Motivation

Motivation

Motivation

Moreover, is this really useful?

Any attempt at rethinking central bankers’ mission would greatly benefit from a non-finalistic survey of the long-term evolution of central banking

Motivation

Novelty of This Survey

I adopt a functional, instead of an institutional approach to central banking

1.Institutional approach: Take financial institutions (viz. banks of issue) as given, and look at what they do over time (see e.g. Capie et al. 1994)

2.Functional approach: Take financial (viz. central banking) functions as given, and look at which institutional structures do perform them over time (see Merton 1995 for a related discussion)

Approach

Problems with an Institutional Approach

What is a central bank?

Approach


What is a central bank?

“Defining central banking is problematic. In one sense, we recognize it when

we see it.” (Capie et al. 1994, p. 5)

Approach


What is a central bank?First answer: A central bank is a bank of

issue; then, the first one is Sweden’s Riksbank (est. 1668)

But the Riksbank is neither the first institution to have worked as a bank of issue, nor anything more similar to a modern central bank than preexisting institutions

Approach


What is a central bank?Second answer: A central bank is what theorized

by Bagehot (1873); then, the first one is what the Bank of England evolved into in the late 19th century (Capie et al. 1994, Capie 2002, Grossman 2010…)

But neither is LLR the defining function of modern central banking par excellence, nor did banks of issue wait for Bagehot’s lesson in order to start acting in the way he advocated (Bignon et al. 2012)

Approach


Mistaking Organizationalfor Functional Differences

Banks of Issue (e.g. the Bank of England) and Giro Banks (e.g. Amsterdam’s Wisselbank) differred in their organizational form, not in the functions they performed

Approach



Approach

Deposits

Securities &

Loans

Reserves

Deposits &

Banknotes

Securities &

Loans

ReservesCapital

Giro Bank Bank of Issue



Approach

Deposits

Securities &

Loans

Reserves

Deposits &

Banknotes

Securities &

Loans

ReservesCapital

Giro Bank Bank of IssueProvision of a

Means of Payment

Debt Monetization

Towards a Functional Approach

What are central banking functions?

Approach

Towards a Functional Approach

What are central banking functions?

According to central bankers (e.g. Issing 2003),

1.Financial Stability2.Monetary Stability

Approach

MICROECONOMIC(Financial Stability)


MACROECONOMIC(Monetary Stability)


i. Payments Systemii. LLRiii. Banking

Supervision and Regulation

1. Issuing Money2. Monetary Policy

and Its Implementation

Central Banking Functions (CBFs)

Approach

Cfr. e.g. Aldrich (1910, pp. 17-21)

Sampling

Kinds of InstitutionsProviding

CBFs

Non-Providing

CBFs

Banks evolved into central banks √ √

Banks evolved into pure commercial banks × ×

Banks eventually liquidated × ×

Non-banks (Treasuries, etc.) × ×

Approach

Institutional Approach:

Sampling

Kinds of InstitutionsProviding

CBFs

Non-Providing

CBFs

Banks evolved into central banks √ ×

Banks evolved into pure commercial banks √ ×

Banks eventually liquidated √ ×

Non-banks (Treasuries, etc.) √ ×

Approach

Functional Approach:





i.i. Payments SystemPayments Systemii. LLRiii. Banking




Financial Stability: Payments System

Clearinghouses vs. Central Banks

In any sufficiently advanced banking system, the need for the centralization of interbank transactions naturally arises

According to proponents of free banking, this demand can be adequately met by setting up a clearinghouse (Smith 1936)

According to its opponents, pure clearinghouses systems are fragile: a) they cannot limit the overall growth of banks’ liabilities, and b) scope economies lead to a single bank dominating the clearing process (Goodhart 1988)


Clearinghouses vs. Central Banks

A very old debate indeed!Since at least the 14th century, frequent

banking crises in Venice suggested that the clearinghouse system was inadequate: reform bills were presented to the Senate (in 1356 and 1374) with the aim of centralizing the clearing mechanism at a state-controlled bank (Mueller 1997)

Yet only after a general meltdown of the Venetian banking system did the Senate centralize the payments system at a state-controlled bank (in 1587: Luzzatto 1934)


The Dilemma of Centralization

Entrusting the management of the payments system to a non-profit-maximizing institution may be a remedy to the faults of the private clearinghouse system

A non-profit-maximizing institution can easily fail to play the role of centralized clearinghouse if the incentives structure is not adequately designed within the banking system


The Dilemma of Centralization

Entrusting the management of the payments system to a non-profit-maximizing institution may be a remedy to the faults of the private clearinghouse system

A non-profit-maximizing institution can easily fail to play the role of centralized clearinghouse if the incentives structure is not adequately designed within the banking system


How to get a permanent centralization to a non-profit-

maximizing institution?

Solutions for Centralizing Payments

1) Legal Restrictions: Establish a legal monopoly of some crucial service like deposit collection or the encashment of certain payments (e.g. Amsterdam’s and Hamburg’s giro-banks)




2) Scope Economies: Build on the role of the state as the biggest domestic financial actor (e.g. Florence’s Ricci bank and Venice’s Banco del Giro)




2) Scope Economies: Build on the role of the state as the biggest domestic financial actor (e.g. Florence’s Ricci bank and Venice’s Banco del Giro)

3) A Blend of the Two: Combine some restrictions (like the monopoly of joint-stock banking) with scope economies (like the concentration of the state’s payments) (e.g. the Bank of England)






i. Payments System

ii.ii. LLRLLRiii. Banking




Financial Stability: LLR

What is (Bagehot-Style) LLR?

1) Lending to Crisis-Stricken Banks: Hence, LLR appeared when CB-led bailouts occurred (in 1890?)




2) Lending Countercyclically: Hence, LLR appeared when CBs started to lend more during crises (in 1763?)




2) Lending Countercyclically: Hence, LLR appeared when CBs started to lend more during crises (in 1763?)

3) Lending as Much as the Market Demands on Given Eligible Assets: Hence, LLR appeared when CBs completely ceased credit rationing (in 1857?)


Preconditions for LLR

1) The establishment of the CB at the center of the payments system – i.e., the possibility to meet the contraction of interbank lending with an expansion of CB money

2) The repeal of usury laws – i.e., the possibility to increase the commercial banks’ opportunity cost of hoarding cash


Preconditions for LLR

1) The establishment of the CB at the center of the payments system – i.e., the possibility to meet the contraction of interbank lending with an expansion of CB money

2) The repeal of usury laws – i.e., the possibility to increase the commercial banks’ opportunity cost of hoarding cash


Both preconditions were first met in the 1850s (Bignon et al.

2011)





i. Payments Systemii. LLR

iii.iii. Banking Banking Supervision and Supervision and RegulationRegulation



Financial Stability: Supervision & Regulation

Banking Supervision

Banking supervision less and less entrusted to CBs (Grossman 2010)

Poor performance of unified supervisors has strengthened the idea that supervision is a built-in function of central banking (Goodhart 2009)


Banking Supervision

Banking supervision less and less entrusted to CBs (Grossman 2010)

Poor performance of unified supervisors has strengthened the idea that supervision is a built-in function of central banking (Goodhart 2009)

Historically, this has proven true regardless of the regulatory framework, as CBs

1)monitor the expansion of interbank lending (Goodhart 1988), and

2)bear the monopoly of crisis lending, and can threat exclusion from it (Flandreau & Ugolini 2011)


Banking Regulation

Banking regulation less and less influenced by CBs, as focus shifted from reserve requirements to capital requirements

Traditionally, CBs very much concerned about reserves as a way for reducing leverage (e.g. the BoE’s campaign for the introduction of reserve requirements in the 1890s)

This retrenchment has been tied to the alleged failure of reserve requirements as an instrument for the conduct of monetary policy (from the 1930s to the 1980s: Bindseil 2004)








1.1. Issuing MoneyIssuing Money2. Monetary Policy


Monetary Stability: Issuing Money

CB Money in History

Claims on privileged banks of issue have been stably granted legal-tender status by governments only in the late 19th century

Nonetheless, since sufficiently developed banking systems have emerged (at least in the Middle Ages), claims on the institution at the center of the domestic payments system have acted as money

‘CB money’ is defined here as claims on a ‘central’ institution which do play the role of domestic medium of exchange regardless of their legal status


CB Money in History

Properly speaking, CB money is issued when the ‘central’ institution undergoes fractional reserve banking. What for?


CB Money in History

Properly speaking, CB money is issued when the ‘central’ institution undergoes fractional reserve banking. What for?

Mostly, financing governments: along the centuries, CB money has almost constantly been issued in order to lend against sovereign debt (either directly, or indirectly through eligibility criteria)

This has also been the case with the most conservative institutions (e.g. the Amsterdam Wisselbank: Van Dillen 1934)


The Monetization of Government Deficits

In fact, the expansion of ‘central’ institutions’ lending through the issue of CB money does not necessarily create disarray in the payments system (Hicks 1969)

This contrasts with the effects of monetary debasements, which always impair the whole payments system (Sargent & Velde 2002)

As a result, governments (especially in financial centers) have very early on tried to monetize government deficits by borrowing from ‘central’ institutions


The Monetization of Government Deficits

The creation of ‘central’ institutions for the monetization of deficits has therefore been a crucial task for governments

Like ‘Coaseian’ firms, they have at times externalized, at times internalized this CBF, according to the relative efficiency of each solution

See e.g. the case of the Venetian Republic from medieval to early-modern times (Mueller 1997, Luzzatto 1934), as well as the history of all major Western CBs during the last three centuries








i. Issuing Money

ii.ii. Monetary Policy Monetary Policy and Its and Its ImplementationImplementation

Monetary Stability: Monetary Policy

Monetary Policy in History

Monetary policy up to the interwar period: a no-brainer? (Polanyi 1944, Eichengreen 1996)

However, the defense of the long-term value of CB money has constantly been the target of issuers

Over the centuries, the strategies implemented in order to reach this target have been the following:

1)Internal inconvertibility2)External convertibility3)Inflation targeting


1) Internal Inconvertibility

Internal inconvertibility a device for sheltering the value of CB money from the fluctuations of legal money

CB money typically traded at a premium, not at a discount with respect to domestic legal money (e.g. in Amsterdam or Genoa)


CB MoneyDomestic

High-Powered Money

‘International

High-Powered Money’

2) External Convertibility

External convertibility a device for limiting CB’s discretionary power (Flandreau 2008)

This became expedient as soon as the recurrent instability of metallic money was eliminated by technological improvements in the early 19th century (Redish 2000)


CB MoneyDomestic

High-Powered Money

‘International


2) External Convertibility

External convertibility allowed for the extension of the legal-tender status to CB money – something widely regarded as dangerous until the late 19th century


CB Money=

Domestic High-Powered Money

‘International


3) Inflation Targeting

With the demise of the Bretton Woods system in 1973, something like an ‘international high-powered money’ no longer existed


CB Money=


‘International



As a result, inflation targeting developed as a strategy for defending the international purchasing power parity of CB money


CB Money=


InternationalPurchasing

Power Parity


As a result, inflation targeting developed as a strategy for defending the international purchasing power parity of CB money

…at least in theory…


CB Money=


InternationalPurchasing

Power Parity

Monetary Policy Implementation

The defense of the long-term value of CB money has been implemented in alternated ways:

i. Quantity policies (OMOs) as long as usury laws were in force (until the mid-19th century);

ii.Price policies (British orthodoxy: Hawtrey 1932) during the first wave of globalization;

iii.Quantity policies (stabilization of money supply) in the age of capital controls;

iv.Price policies (stabilization of interest rates) during the second wave of globalization (Bindseil 2004).


TOWARDS A NEW FRAMEWORK

Concluding Remarks

Conclusions

Linear Trends in Microeconomic CBFs

Linear Trends in Microeconomic CBFs

Cyclical Trends in Macroeconomic CBFs

Cyclical Trends in Macroeconomic CBFs

i. towards the Centralization of Payments System

ii. towards the Adoption of LLR Policies

iii. towards the Scrapping of Banking Supervision and Regulation

1. between Internalization and Externalization of Deficit Monetization

2. a) between Discretion and Rules in the Setting of Monetary Policy b) between Quantity and Price Policies in Its Implementation

Long-Term Trends in Central Banking

Conclusions

Concluding Remarks

Macroeconomic and microeconomic concerns almost constantly intertwined in determining the evolution of CBs

Major changes in the provision of CBFs internationally coordinated: this tied to the contemporary propagation of shocks, not to the common adoption of a model

The concepts of ‘modern CB’ and ‘best practice’ hardly operationally valid for historical research

Conclusions

Insights

Organizational models for the provision of CB functions adjust to political and economic shocks: hence, the current form is not the only viable one

Government debt monetization is the ancestor of modern monetary stabilization: periods of direct recourse to markets have alternated with periods of debt monetization (according to the financial market conditions)

The efficiency of any organizational solution depends on the credibility and sustainability of the institutional arrangement which backs it

Conclusions

Insights

Monetary and fiscal authorities are the two sides of the same coin: hence, neither one should not try to free-ride on the other

Conclusions

EVIDENCE FROM THE PAST,INSIGHTS FOR THE PRESENT

STEFANO UGOLINI

What Do We Really Knowabout the Long-Term

Evolutionof Central Banking?

Paolo Baffi Seminar – Bocconi University, May 4, 2012

Documents

What Do We Really Know about the Long- Term Evolution of Central Banking ?