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

1. What Do WeReally Knowabout the Long-Term Evolutionof Central Banking? Evidence from the past, Insights for the present Stefano ugolini Paolo Baffi Seminar – Bocconi University, May 4, 2012

2. 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

3. Motivation Is this really how things went? Motivation

4. 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

5. Motivation Motivation

6. 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

7. Novelty of This Survey • I adopt a functional, instead of an institutional approach to central banking • 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) • 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

8. Problems with an Institutional Approach What is a central bank? Approach

9. Problems with an Institutional 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

10. Problems with an Institutional 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

11. Problems with an Institutional 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

12. Problems with an Institutional Approach Mistaking Organizational for 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

13. Problems with an Institutional Approach Mistaking Organizational for Functional Differences Giro Bank Bank of Issue Deposits Reserves Capital Reserves Deposits & Banknotes Securities & Loans Securities & Loans Approach

14. Problems with an Institutional Approach Mistaking Organizational for Functional Differences Giro Bank Bank of Issue Provision of a Means of Payment Deposits Reserves Capital Reserves Deposits & Banknotes Securities & Loans Securities & Loans Debt Monetization Approach

15. Towards a Functional Approach What are central banking functions? Approach

16. Towards a Functional Approach What are central banking functions? According to central bankers (e.g. Issing 2003), • Financial Stability • Monetary Stability Approach

17. Central Banking Functions (CBFs) MICROECONOMIC (Financial Stability) MACROECONOMIC (Monetary Stability) • Payments System • LLR • Banking Supervision and Regulation • Issuing Money • Monetary Policy and Its Implementation Cfr. e.g. Aldrich (1910, pp. 17-21) Approach

18. Sampling Institutional Approach: Approach

19. Sampling Functional Approach: Approach

20. MICROECONOMIC (Financial Stability) MACROECONOMIC (Monetary Stability) • Payments System • LLR • Banking Supervision and Regulation • Issuing Money • Monetary Policy and Its Implementation Financial Stability: Payments System

21. 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) Financial Stability: Payments System

22. 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) Financial Stability: Payments System

23. 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 Financial Stability: Payments System

24. 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? Financial Stability: Payments System

25. Solutions for Centralizing Payments • 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) Financial Stability: Payments System

26. Solutions for Centralizing Payments • 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) • 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) Financial Stability: Payments System

27. Solutions for Centralizing Payments • 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) • 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) • 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) Financial Stability: Payments System

28. MICROECONOMIC (Financial Stability) MACROECONOMIC (Monetary Stability) • Payments System • LLR • Banking Supervision and Regulation • Issuing Money • Monetary Policy and Its Implementation Financial Stability: LLR

29. What is (Bagehot-Style) LLR? • Lending to Crisis-Stricken Banks: Hence, LLR appeared when CB-led bailouts occurred (in 1890?) Financial Stability: LLR

30. What is (Bagehot-Style) LLR? • Lending to Crisis-Stricken Banks: Hence, LLR appeared when CB-led bailouts occurred (in 1890?) • Lending Countercyclically: Hence, LLR appeared when CBs started to lend more during crises (in 1763?) Financial Stability: LLR

31. What is (Bagehot-Style) LLR? • Lending to Crisis-Stricken Banks: Hence, LLR appeared when CB-led bailouts occurred (in 1890?) • Lending Countercyclically: Hence, LLR appeared when CBs started to lend more during crises (in 1763?) • Lending as Much as the Market Demands on Given Eligible Assets: Hence, LLR appeared when CBs completely ceased credit rationing (in 1857?) Financial Stability: LLR

32. Preconditions for LLR • 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 • The repeal of usury laws – i.e., the possibility to increase the commercial banks’ opportunity cost of hoarding cash Financial Stability: LLR

33. Preconditions for LLR • 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 • 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) Financial Stability: LLR

34. MICROECONOMIC (Financial Stability) MACROECONOMIC (Monetary Stability) • Payments System • LLR • Banking Supervision and Regulation • Issuing Money • Monetary Policy and Its Implementation Financial Stability: Supervision & Regulation

35. 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) Financial Stability: Supervision & Regulation

36. 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 • monitor the expansion of interbank lending (Goodhart 1988), and • bear the monopoly of crisis lending, and can threat exclusion from it (Flandreau & Ugolini 2011) Financial Stability: Supervision & Regulation

37. 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) Financial Stability: Supervision & Regulation

38. MICROECONOMIC (Financial Stability) MACROECONOMIC (Monetary Stability) • Payments System • LLR • Banking Supervision and Regulation • Issuing Money • Monetary Policy and Its Implementation MonetaryStability: Issuing Money

39. 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 MonetaryStability: Issuing Money

40. CB Money in History • Properly speaking, CB money is issued when the ‘central’ institution undergoes fractional reserve banking. What for? MonetaryStability: Issuing Money

41. 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) MonetaryStability: Issuing Money

42. 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 MonetaryStability: Issuing Money

43. 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 MonetaryStability: Issuing Money

44. MICROECONOMIC (Financial Stability) MACROECONOMIC (Monetary Stability) • Payments System • LLR • Banking Supervision and Regulation • Issuing Money • Monetary Policy and Its Implementation MonetaryStability: Monetary Policy

45. 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: • Internal inconvertibility • External convertibility • Inflation targeting MonetaryStability: Monetary Policy

46. 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 Money Domestic High-Powered Money ‘International High-Powered Money’ MonetaryStability: Monetary Policy

47. 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 Money Domestic High-Powered Money ‘International High-Powered Money’ MonetaryStability: Monetary Policy

48. 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 High-Powered Money’ MonetaryStability: Monetary Policy

49. 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 = Domestic High-Powered Money ‘International High-Powered Money’ MonetaryStability: Monetary Policy

50. 3) Inflation Targeting • As a result, inflation targeting developed as a strategy for defending the international purchasing power parity of CB money CB Money = Domestic High-Powered Money International Purchasing Power Parity MonetaryStability: Monetary Policy