Forrest Capie, Charles Goodhart and Norbert Schnadt The development of central banking Book section (Published Version) Original citation: Originally published in Capie, F.; Fischer, S., Goodhart, C. and Schnadt, N. (eds), The future of central banking: the tercentenary symposium of the Bank of England. Cambridge, UK : Cambridge University Press, 1994, pp. 1-261. ISBN 9780521496346 © 2012 Cambridge University Press This version available at: http://eprints.lse.ac.uk/39606/ Available in LSE Research Online: March 2012 LSE has developed LSE Research Online so that users may access research output of the School. Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Users may download and/or print one copy of any article(s) in LSE Research Online to facilitate their private study or for non-commercial research. 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Cambridge Books Online http://ebooks.cambridge.org The Future of Central Banking The Tercentenary Symposium of the Bank of England Forrest Capie, Stanley Fischer, Charles Goodhart, Norbert Schnadt Book DOI: http://dx.doi.org/10.1017/CBO9780511983696 Online ISBN: 9780511983696 Hardback ISBN: 9780521496346 Paperback ISBN: 9780521065467 Chapter 1 - The development of central banking pp. 1-261 Chapter DOI: http://dx.doi.org/10.1017/CBO9780511983696.002 Cambridge University Press 1 The development of central banking 1 Forrest Capiey Charles Goodhart, Norbert Schnadt 1.1 Introduction On the occasion of the 300th anniversary of the Bank of England there is a natural tendency to look back at the historical record of central banks, to examine their development to the present time, and, more daringly, to speculate about their future. Although it is hard to depart from a chrono- logically ordered narrative (particularly since two of the authors are economic historians), we have tried to structure our paper by concentrating on the key functions undertaken by the central bank. The main objective of central banks, over the centuries, has been the maintenance of the (internal and external) value of the currency, and we, therefore, turn in section 1.2 to an historical account of central bank macroeconomic policy. While the maintenance of the value of the currency has, historically, almost always been achieved via the same instrument, varying the central bank's discount rate, this objective has not always meant the same thing. Under the classical gold standard the objective was cast in terms of metal convertibility: that is, the value of central bank notes was expressed in terms of their metal (gold) 'content', which central banks attempted to maintain at stated levels over time. The purchasing power of currency relative to goods in general (i.e. to a price index) was thus only indirectly an objective of central banks, with gold acting as the true nominal anchor. With the gradual erosion of the gold standard throughout the first half of the twentieth century, and its replacement everywhere by a pure fiat 1 We should like to thank the Bank of England for the opportunity to prepare this paper, and Mervyn King in particular for encouragement and support. Naturally, the views expressed in this paper are those of the authors and not necessarily those of the Bank of England. We are heavily indebted to the many central bank officials who provided valuable research material and references used in the compilation of the appendices, as well as useful comments. Furthermore, Pablo Martin Acena, Michael Bordo, Kevin Dowd, Milton Friedman, Charles Kindleberger, David Laidler, Dieter Lindenlaub, Morris Perlman, Alain Plessis, Leslie Pressnell, Angela Redish, Jaime Reis, Richard Sylla, Gianni Toniolo, Eugene White, Geoffrey Wood and Dieter Ziegler all provided comments and/or suggestions for which we are very grateful. The authors, however, are responsible for any errors. Finally, research assistance by Devaiah Ballachandra, Olga Christodoulaki and Niral Maru is gratefully acknowledged. 1 Downloaded from Cambridge Books Online by IP 158.143.192.135 on Thu Mar 22 15:45:04 GMT 2012. http://dx.doi.org/10.1017/CBO9780511983696.002 Cambridge Books Online © Cambridge University Press, 2012 2 The future of central banking standard, the objective of central bank policy has now been recast in terms of price stability. The value of central bank notes has come to be under- stood as the inverse of the price level, the price of a particular bundle of goods, and monetary authorities try to achieve (often implicit) price level or inflation targets. To argue, therefore, that price stability has always been the main aim of central banks, is not strictly true. Recent academic interest in a so-called 'new monetary economics' (see Cowen and Kroszner 1994), which empha- sises the regulatory underpinnings of monetary regimes, has uncovered a long line of economists who have criticised the conventional gold standard for failing to stabilise the price level. They include Jevons who favoured supplementing gold with indexation (as did Marshall), and both Marshall and Edgeworth who advocated symetallism. Walras inclined to bimet- allism, while Francis Walker was a convinced bimetallist. Wicksell favoured managed paper money on an international basis. Laidler argues convincingly that all the good monetary economists of the late nineteenth century thought that something better than the gold standard could be achieved, and that the defenders of the gold standard were a lesser breed - such as Price and Giffen (Laidler 1991). Irving Fisher proposed in 1911 to replace the gold standard by a 'compensated dollar' standard under which the gold-currency price would be varied to offset fluctuations in the price level. It is noteworthy that Fisher's proposal was, in part, motivated by developments in 'the calculation of an official index number of prices' (1912, p. 498). Whilst it is not our intention to examine this or any other specific proposal, we mention it here to reinforce the point that the policy objective of the early central banks was not, and was not perceived as, the preservation of price stability in the modern sense. In the absence of fluc- tuations in the value of gold relative to goods, however, the maintenance of a fixed parity between currency and gold clearly amounted to the same thing. Moreover, comparisons between the classical gold standard period (1873-1913) and subsequent monetary regimes (see Bordo 1993) indicate that, whilst none of them actually delivered price stability, the former system clearly outperformed all others in this respect. There has been an inherent tension throughout the history of central banks between their desire for maintaining the value of their currency and their function as banker to the (central) government. Central banks have almost invariably been established by an Act of government (e.g. a govern- ment charter), and have been designated as banker to the government. Governments have a natural preference for cheap finance from their own bank, and, particularly when the existence of the state is threatened, notably by war, they have both the power and the incentive to force the central bank to give priority to their immediate needs. We discuss the shift- Downloaded from Cambridge Books Online by IP 158.143.192.135 on Thu Mar 22 15:45:04 GMT 2012. http://dx.doi.org/10.1017/CBO9780511983696.002 Cambridge Books Online © Cambridge University Press, 2012 The development of central banking 3 ing relationships between the central bank and its government in section 1.3. Besides the government, the other main clients of the central bank have been the commercial banks. As described in section 1.2, prior to the latter part of the nineteenth century, central banks were generally expected to carry out a commercial banking function; in some cases, in the European countries when they were first established, they offered the only sources of commercial banking services in that country (e.g. Scandinavia), and for a longer period they were often the most important and largest commercial bank in their country. Consequently the early relationships between central banks and commercial banks were often ones of business rivalry and com- petition. This adversarial relationship was resolved around the early twenti- eth century in most cases, with a few exceptions (e.g. Australia), by a largely uncodified concordat, whereby, in return for the central bank's withdrawal from commercial banking, the commercial banks voluntarily accepted the central bank's leadership - even by such informal mechanisms as the Governor's eyebrows. We chart the changing pattern of this relationship, including the expanding function of central banks as regulators and super- visors of the banking system in section 1.4. Institutions and their functions do not develop in a vacuum. They are profoundly influenced by the development of ideas, theories and per- ceptions about their proper role. In section 1.5 we look at two of the main intellectual currents which have influenced the path of central banking, with a natural emphasis, given our background, on the analysis and arguments of Anglo-Saxon economists. Indeed, our Anglo-Saxon affinities may have coloured our selection of examples, references and arguments throughout. Fortunately for our purposes, two main themes in these debates occur regularly, although in somewhat different guises, throughout our history. The first of these battles is that between the proponents of rules and the adherents of discretion; this controversy has erupted in two main periods of intellectual ferment, initially in the first half of the nineteenth century, pitting Bullionists against Anti-bullionists and Currency against the Banking Schools, and then later in the second half of the twentieth century, with Monetarists versus Keynesians.