Long-Term Perspectives on Central Banking

1. Long-Term Perspectives on Central Banking Michael D. Bordo, Rutgers University and NBER Paper prepared for the Norges Bank Symposium “What is a Useful Central Bank?”; Oslo, Norway; November 18, 2010

2. Introduction • The recent global financial crisis has led for calls by some to remake the model of central banking to focus much more on financial stability • Others argue that central banks should stick to the successful model that led to the Great Moderation and should continue to attach ultimate importance to maintaining credibility for low inflation

3. Introduction (cont.) • Financial stability concerns should be treated separately by a Financial Stability authority or if based within the central bank by statute, should be managed by tools other than the policy rate • This essay takes an historical perspective to consider whether we need to rewrite the central banking rule book

4. Introduction (cont.) • I argue that central banking evolved into a golden age of following credible rules to maintain price stability and serve as a LLR during the classical gold standard from 1870-1914 • The Great Depression threw central banks into the dark ages, a fate created largely by their adherence to bad doctrine and the flawed interwar gold exchange standard • central banks lost their independence and became adjuncts of the fiscal authorities

5. Introduction (cont.) • Central banks regained their independence starting in the 1950s, but lost it again with the Great Inflation • The renaissance of central banking followed the Volcker/Thatcher shocks of 1979-1981 led to new regime of a credible nominal anchor in a fiat money regime based on rules similar to the gold standard convertibility rule • This led to the Great Moderation from the 1980s to 2007

6. Introduction (cont.) • The recent global crisis stemmed from policy failures in the US • Despite the crisis, central banks should stick to the tried and true rules for central banking that have evolved through history

7. The Origins of Central Banking • The story of central banking goes back to the Swedish Riksbank (1668) and the Bank of England (1694) • Both were chartered as note issuing joint stock banks to lend to the government • Early central banks became bankers banks which ultimately allowed them to become LLR

8. The Origins of Central Banking (cont.) • Monetary policy began by central banks discounting the paper of other financial institutions. The discount rate could influence credit conditions in the economy • Central banking achieved its maturity during the classical gold standard • The key rule for a central bank under the gold standard was to adhere to convertibility of its notes in terms of gold at the official fixed parity (except in wartime or serious financial crises)

9. The Origins of Central Banking (cont.) • The classical gold standard had automatic mechanisms to ensure long-run price stability • Hence adhering to gold convertibility ensured price stability • The gold standard was a commitment mechanism to prevent monetary authorities from following time-inconsistent policies

10. The Origins of Central Banking (cont.) • Under the gold standard, central banks were supposed to follow the “rules of the game” • To use their discount rates to speed up the adjustment to external shocks to the balance of payments • Central banks learned to became LLR during this period • According to Bagehot’s (1873) responsibility doctrine, the Bank of England (which was private) was urged to place primary importance on its role as LLR

11. The Origins of Central Banking (cont.) • The Bank of England learned to follow Bagehot’s rule - in the face of an internal drain to lend freely on the basis of sound collateral, in the face of an external drain to raise bank rate, and in the face of both to lend freely at a high rate • The Bank of England learned to lend anonymously to the money market • No banking panics occurred in England after 1866

12. The Origins of Central Banking (cont.) • Other European central banks followed suit in becoming effective LLRs • Successful LLR policy and credible gold standard adherence were intertwined • Central banks under the gold standard attached little weight to real economic stability and unemployment, because of wage flexibility, labor mobility and the absence of labor unions and Labor parties • However credibility granted a modicum of policy independence

13. In the Dark Ages • The classical gold standard ended with WWI. It was reinstated as a gold exchange standard in which central banks substituted foreign exchange for gold reserves and discouraged gold holdings by the private sector • The central banks of Britain, France and Germany joined with the Federal Reserve to coordinate monetary policies • The gold exchange standard only lasted until 1931. It failed because of fatal flaws and because it did not embody a credible commitment mechanism

14. In the Dark Ages (cont.) • The fatal flaws • asymmetric adjustment between deficit countries such as Britain and surplus countries such as France and the US • the failure of countries to follow the rules of the game • inadequate gold supplies and the substitution of key currencies for gold as international reserves, leading to a convertibility crisis • the confidence problem leading to shifts among key currencies and between key currencies and gold

15. In the Dark Ages (cont.) • The commitment mechanism was weaker than under the gold standard, because with the advent of organized labor preserving jobs became more important • This meant that preserving convertibility was no longer paramount • The GE standard collapsed with the Great Depression

16. In the Dark Ages (cont.) • The Great Depression reflected the failure of the Fed to serve as LLR in the face of 4 banking panics from 1930-33 • Fed tightening in 1928 to stem stock market speculation based on the CB’s adherence to the real bills doctrine led to the downturn in August 1928, followed by the crash in October

17. In the Dark Ages (cont.) • The Fed’s failure reflected: • adherence to the flawed real bills doctrine ( Meltzer 2003) • flaws in the Fed’s structure (Friedman and Schwartz 1963) • inability of the architects of the Fed to adapt the successful European LLR model to the U.S. institutional environment (Bordo and Wheelock 2010) • The Great Depression was spread abroad by the fixed exchange rate gold standard

18. In the Dark Ages (cont.) • Golden Fetters prevented central banks from acting as LLR • Countries only escaped the depression by exiting the gold standard • The Great Depression was blamed on commercial banks for taking undue risks and central banks for restoring and maintaining a flawed gold standard • This led in every country to massive regulation of the financial system

19. In the Dark Ages (cont.) • And the subservience of central banks to the Treasury • In the 30s and 40s, central banks followed low interest pegs to stimulate the economy and aid the Treasury in fueling its debt • This policies fueled inflation during and after WWII • Monetary policy independence was restored to the CB’s beginning in the 1950s, e.g. the Federal Reserve Treasury Accord of 1951

20. In the Dark Ages (cont.) • 1950s and 60s, the CB’s followed successfully countercyclical policy and low inflation within the context of the Bretton Woods system • Bretton Woods indirect link to gold helped maintain price stability • However Bretton Woods had similar flaws to the GE standard

21. In the Dark Ages (cont.) • It collapsed in the 1960s largely because the U.S. as the key provider of international reserves, broke the rules of gold standard and began following expansionary monetary policy to fund fiscal deficits • It collapsed because the rest of the world was unwilling to absorb additional dollars that would lead to inflation • The advent of generalized floating in 1973 allowed each country more flexibility to conduct independent monetary policies

22. In the Dark Ages (cont.) • In the 1970s inflation accelerated as many countries attempted to use monetary policy to maintain full employment and to accommodate oil price shocks in 1973 and 1979 • Finally in the face of heavy regulation of the financial sector and the institution of a financial safety net there were no banking crises from the 1940s to the 1970s • The LLR function of CB’s was in abeyance

23. A Renewed Golden Age • the Great Inflation ended with the Volcker shock of 1979-81 in the U.S. and U.K. and similar policies in other countries • Tight money broke the back of inflation and inflationary expectations at the expense of a severe recession • The 1980s witnessed renewed emphasis by CB’s on low inflation as their primary objective

24. A Renewed Golden Age (cont.) • Many countries granted their central bank independence from the fiscal authority and instituted mandates for low inflation • Inflation targeting first instituted in New Zealand in 1990 • Subsequent two decades referred to as the Great Moderation with low inflation and stable growth • Some similarity to the gold standard convertibility principle

25. A Renewed Golden Age (cont.) • Financial instability became a problem again in the 1970s in the face of inflation which led to financial innovation and deregulation • Banking crises again erupted in advanced countries, but CB’s no longer followed Bagehot’s rules and adopted the “Too big to fail” doctrine • Asset booms and busts reappeared but the experience of the 1929 crash and Japan’s bursting bubble in 1990 led the Fed and other CB’s to become unwilling to use monetary policy to deflate bubbles

26. The Crisis of 2007-2008: A Game Changer? • The subprime mortgage crisis of 2007-2008 originated in the U.S. and spread to the RoW • It was precipitated by the collapse of a major housing boom in 2006 which severely impacted the financial system • Its causes include: U.S. government policies since the 1930s to extend homeownership, major changes in regulation, lax regulatory oversight, a relaxation of normal standards of prudent lending, and a period of abnormally low interest rates

27. The Crisis of 2007-2008: A Game Changer? (cont.) • The story is very familiar: • the subprime crisis led to spillover effects around the world via securitized mortgage • uncertainty over the value of MBS led to the freezing of the interbank lending market in fall 2007 • this led to extensive CB liquidity injections and credit policies • the crisis worsened with the failure of Lehman Brothers in September 2008 • this led to bailouts of major financial firms • the US Treasury TARP • Bailouts in Europe • Quantitative Easing in December 2008 after ZLB reached

28. The Crisis of 2007-2008: A Game Changer? (cont.) • Unlike the liquidity panics of the 1930s, the deepest problem facing the financial system was insolvency based on the difficulty of pricing securities backed by a pool of assets • Another hallmark of the recent crisis was that the Fed and other MAs engaged in bailouts of firms deemed too systemically connected to fail

29. The Crisis of 2007-2008: A Game Changer? (cont.) • The Fed and other CBs were criticized for not preventing the crisis: • the Fed fuelled the housing boom with low interest rates 2002-2001 • credit policy picked favorites • CBs lost independence • the Fed created panic by first rescuing Bear Stearns in March 2008 and then letting Lehman fail in September • bailout based on “too interconnected to fail” • CB’s did not follow Bagehot’s strictures

30. The Crisis of 2007-2008: A Game Changer? (cont.) • These criticisms and more led to calls for changes in the basic CB model based on rules prescribing credibility for low inflation and CB independence • Reforms suggested include: • greatly increasing the CB’s role in financial stability • using monetary policies to lean against the wind of asset booms • administer macro prudential rules for commercial and investment banks • work more closely with the fiscal authorities • stick to transparent rules

31. Sticking to the Rules • History of CB teaches that first responsibility is to maintain price stability. If the CB is successful in maintaining a stable and credible nominal anchor then real macro stability should obtain • But, in face of shocks CB’s need to follow short-run stabilization policies consistent with long-run price stability

32. Sticking to the Rules (cont.) • History teaches the importance of CB’s to act as LLR to the money market • LLR involves temporarily expanding liquidity • should be done by OMO rather than DWL • if DWL is used then loans should only be made to solvent but illiquid banks • no bailouts

33. Sticking to the Rules (cont.) • Lessons of 1929 suggest tools of monetary policy should not be used to head off asset price booms • in the event of a bubble whose bursting would adversely affect the real economy, should use non monetary tools to deflate it • Comparative advantage of monetary policy tools is to influence the money market and not asset prices • History suggests CBs should protect the payments system and provide liquidity only to FI’s that provide means of payment

34. Sticking to the Rules (cont.) • History of past inflations and recent crisis teaches us that CBs should be independent of the fiscal authorities • In sum the events of the recent crisis leads to the conclusion that CBs should stick to tried and true rules to maintain price stability • Flexible inflation targeting as practiced by the Norges Bank and the Riksbank seems to be a reasonable way to go forward

35. Sticking to the Rules (cont.) • Flexible inflation targeting allows the CB to both accommodate real shocks and financial shocks into its forecasts • Finally, a lesson from the recent crisis is that financial regulation (by agencies other than the CB) should be based on providing incentives for private financial agents to take prudential actions --to have “skin in the game”