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Central Banking in the Twentieth Century
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The requirement on banks to prepare living wills would address any exceptional cases of failure. Implementing regulatory restrictions is inevitably complex and vulnerable to evasion through innovation by financial firms. But this is an argument for hands-on engagement by policymakers with those they are regulating in order to make regulations as effective as possible, and dynamic in the face of changes in practices.
From a Post Keynesian perspective, this relationship with retail banks would be all the more effective if the traditional quid pro quo were restored of balancing regulatory restrictions with provision of the lender-of-last-resort facility. Rather than downplaying this facility, restoring it to prominence would serve to restore trust in banks and central banks and money, reducing the risk of crisis and thus of the need for the facility to be used. Thus, while central banks responded to the crisis by extending the use of traditional monetary policy tools, they did so with an increasing market orientation which ignores the complex interdependencies involved at the social, institutional and technical levels.
Only the attempts to reintroduce some segmentation in banking represent a recognition of the special nature of retail banks in the provision of money and credit, but even there the emphasis has been on limiting the need for central bank support rather than on the rebuilding of trust in institutions. In the meantime the implications of quantitative easing for government finances and the implications of these finances for the relative safety of sovereign debt as collateral, together with the undue burden placed on monetary policy by continuing fiscal austerity, all await resolution.
Consideration of banking structure is relevant to the role of central banks since that structure is central to the conduct and effects of monetary and prudential policies in relation to broader government policy. In the following section, we therefore consider ideas for reform of money and banking alongside other ideas closer to what is more conventionally regarded as the business of central banks.
Several proposals address the nature of the money asset itself, drawing on old proposals for monetary reform. At one end of the spectrum, free bankers propose that central banks cease to exist, such that all money is provided by the private banking system drawing e. Without central bank intervention with associated fiscal costs , it is anticipated that depositors themselves would discipline banks to be prudent in their asset allocations; imprudent investment behaviour would threaten the value of deposit liabilities and, left uncorrected, would lead to bank failure.
The same argument applies to modern proposals for limited purpose banking, whereby all assets including money would take the form of mutual funds Kotlikoff, But in fact the experience of the crisis which began in was so unnerving that confidence in the banking system to operate successfully without any central bank direction at all has been seriously challenged. Indeed, historical experience tells us that a successful private sector banking system will in any case develop its own central banking system Dow and Smithin, Much more attention has been given recently to proposals for the other end of the spectrum whereby central banks would be given complete control over the supply of money and the government would not be required to bail out banks.
But if demand for money in its various forms is unstable due to shifts in liquidity preference, controlling the supply of money even if it were logistically feasible would not control inflation. They envisage money entering and leaving the system by means of government expenditure and taxation, i. Most full reserve banking proposals envisage all money being a counterpart to fiscal policy, i. But there is no reason why monetary financing of government expenditure more generally should be tied to a central bank monopoly on money, quite apart from the conflict with what is feasible in practice.
A range of different alternatives to the current form of quantitative easing have been put forward, all designed to boost aggregate demand more directly see van Lerven, Starting from a critique of the full-reserve-banking form of state control of money, Kroll proposes instead a Partial Sovereign Money system whereby the central bank stimulates an underemployed economy by means of direct injections of new money to finance expenditure rather than transactions in securities, while commercial banks can continue to operate in a fractional reserve system which is heavily constrained by regulation.
If the seeds of the latest crisis were sown by market and institutional diffusion in banking and doubts about central bank support, the prevention of future crises requires a return to the mutual arrangement between retail banks and central banks whereby the former accept portfolio restrictions in return for the ability to expand portfolios with central bank support. Of course the financial sector has moved on in other ways too, in particular in its capacity for sophisticated evasion of regulatory restrictions. But that is no reason to give up on restrictions—rather, to keep updating them and extending their scope in light of financial innovations.
For the financial system as a whole, financial transactions taxation would take some of the heat out of credit creation to finance speculative financial transactions and divert credit creation to real economic activity. The Vickers proposals and the efforts to bring financial stability oversight back more firmly into the Bank of England are welcome moves in that direction. Further, since reliance on macroprudential policy alone carries the risk of officials lacking the knowledge necessary to revise policy in light of developments, the fact that microprudential regulation by the FPA is back within the Bank is very welcome.
There is attention now to the warning signs of systemic risk. Bank portfolios are now being monitored periodically by means of stress tests which have some chance of picking up systemic tendencies. Coordination between macroprudential regulators and microprudential regulators is thus crucial.
Such knowledge is also crucial for the ability of central banks to keep up with the evolving products, practices and environment of retail banking; a return to the principles of traditional retail banking allows for the possibility that its appropriate form would evolve, e.
Central Banking in the Twentieth Century
But there has been an undue emphasis on bank failure which reflects a continuing market orientation among central banks as well as mainstream theory. The mind-set has been to anticipate bank failure in the future and indeed, for some, to welcome it as a sign that market discipline is working to counteract moral hazard King, This runs counter to the core principle which has guided Post Keynesian analysis of money and banking, which is that society needs money, this money is provided mainly by banks and the duty of the central bank is to ensure that that money is sound, i.
While some bank failures might occur in isolated instances, requiring careful management, these should be exceptional, in contrast to the prevailing mainstream discourse which focuses on bank failure as a routine exercise in market discipline. Central banks need to engage directly with the banks whose liabilities are money.
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Not only does such engagement keep the central bank apprised of new products and practices, and new sources of systemic risk, but it would also allow it to engage more effectively on matters of bank culture. Much has been made, in analyses of the crisis, of the encroachment of an inappropriate investment banking culture into retail banking. Bank culture is highly complex, embedded in particular environments, so restoring an appropriate culture is not an easy matter.
But efforts can be made in that direction within the monitoring and supervision functions; it is a great pity that the UK government did not use the opportunity of public ownership of failed banks to establish exemplars of good culture for the rest of the banking system. New Economics Foundation, Market-driven credit allocation is inefficient with respect to economic performance, given that it is governed by the distorted knowledge base of a concentrated commercial banking system objective quantitative risk measures not being available, given uncertainty.
But for the state, efficiency is relative to goals which extend beyond economic performance.
Thus policy can reasonably be directed to encourage private sector banks to promote social justice, e. Inevitably there would be some unintended consequences, but that is the case with all government intervention and is not per se a reason to abandon it. In addition, public sector initiatives can aim to direct credit in pursuit of public goals, such as the Green Investment Bank set up in the UK in , and financial help for small businesses.
Further support could be given to those institutions already pursuing social goals. Since banks with a stakeholder business model were less vulnerable during the crisis, such a policy would also contribute to financial stability. The UK is unusual relative e. The Bank of England could take a lead in examining the scope for supporting and fostering the growth of cooperative institutions, such as credit unions and not-for-profit local savings banks.
The regional finance literature supports the idea that local banks have a comparative advantage in assessing loan applications, but face liquidity challenges relative to national banks see e. Thus Bone , e. The interpretation of evidence on the effects on inflation of central bank independence is still a matter for debate, the relationship being sensitive to definitions of independence and the sample from which evidence is drawn see e.
But in any case, because of the crisis, central banks perforce had to engage actively in government debt markets and to coordinate with governments. Monetary policy ostensibly was still addressed to the inflation target but in fact was addressed to economic and financial stability. The interconnectedness of monetary stability and financial stability with fiscal policy and other government goals, e. Indeed, the broader even if sometimes conflicting goals of central banks should no longer be treated as subsidiary, but brought into clearer focus.
Just as central banks and commercial banks need to recover a more explicitly cooperative relationship with each other, so do central banks and governments. There are many possible institutional and procedural forms of central bank independence, including a central bank mandate which set out areas for cooperation with government, a joint-committee structure to manage that cooperation and an appropriate set of incentives for central bankers see further Bibow, It would thus still be possible for central banks to have some degree of independence which would still address in a constructive way the interdependencies between the goals and policy tools of government and central bank.
But it does need a new framework. We have addressed the question of how central banking should now develop by going back to the principle that central banks should ensure that a safe money asset is provided. Rather than interpreting this principle in terms of a monetary theory of inflation over which the central bank has oversight, the Post Keynesian perspective interprets it as the core element of a stable financial system which generates credit to finance real economic activity in such a way as to support government policies with respect to its socio-economic goals such as reducing income inequality and conserving natural resources.
Central bank support for retail bank deposits as next to cash in the hierarchy of money assets is crucial, as a quid pro quo for regulation to ensure a prudent bank asset structure. It is very difficult to enforce constraints on bank profit-seeking, given the capacity of the banks to innovate. Yet the analysis here suggests that the alternative of central banks wresting all power over creating money from the banks is not the answer. In particular, shadow banking has demonstrated the capacity for the financial system to develop its own credit mechanisms and money assets.
The fractional reserve banking system rather can be harnessed by ensuring its viability, returning to a separation between retail banking from investment banking, with macroprudential regulation, close supervisions at the bank level and a guarantee of central bank support for retail banking. Financial innovation inevitably requires central banks to be sensitive to the evolution of retail banking. It also requires central banks to oversee the asset structures of an ever-widening range of types of institution developing new products and practices, and to supply the financial system more widely with adequate liquidity.
At the same time the pretence of independence between fiscal and monetary policy needs to be dropped and a more sensible mechanism restored for monetary financing of deficits when required. Too much responsibility has been placed on central banks for macroeconomic policy when in fact fiscal policy is the more appropriate way of dealing with recession—supported by the central bank.
It can also join with government in changing the structure of banking, e. None of this is at all easy; central banking inevitably involves handling tensions with and within the private sector as well as cooperating with it. But what the last few decades demonstrate is the importance of having a strong political will to counter the vested interests in finance.
We need a new framework for central banking for the twenty-first century. Oxford University Press is a department of the University of Oxford. It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide. Sign In or Create an Account. Close mobile search navigation Article navigation. Central banking theory and practice. Central banking after the crisis. Some ideas for reform of central banking. The need for a new framework for central banking.
Central banking in the twenty-first century Sheila Dow. Abstract The recent banking crisis has opened up the discourse about central banking. Goodhart , Singleton , White and Dow Historically, central bank functions have included some or all of: These ranged from the Banking and Currency Schools in the nineteenth century see Arnon, ; Goodhart and Jensen, to the Keynesian Radcliffe approach Committee on the Working of the Monetary System, and free banking theory see e.
Hayek, in the twentieth century, depending on how banking and the economy were variously understood. The unidirectional causal framework was expressed in terms of targets and instruments. The secondary role of central banks was reinforced by the institutional arrangements and the pegged exchange rate regime of the Bretton Woods era, surveyed in Chapter 9.
It was also around this time that central banking came into its own in many other parts of the world, and Singleton usefully reviews the experience of central banking in the developing world, and the extent to which central banks in the industrial world served as role models for the monetary authorities in the developing world.
It is quite clear, as discussed in Chapter 10, that central banks in the developing world were generally subservient to the objectives of government. The failure of Bretton Woods led to the Great Inflation of the s and early s, and the volume devotes an entire chapter to theories and policies developed to cope with the problem. This sets up the second revolution in central banking Chapter 12 wherein governments around the world began legislating central bank independence to guarantee the maintenance of low and stable inflation. The return to prominence of central banks in economic policy making meant that the role of the monetary authority expanded as academics and policy makers debated whether central banks should also supervise the financial system Chapter Success in controlling inflation led to the spread of inflation targeting around the world and Singleton ably summarizes the background and evolution of inflation control regimes since their introduction in New Zealand in the later s Chapter Central banking history in the last century is then rounded out, in Chapter 15, by a description of the great experiment at monetary integration that led to the creation of the eurozone.
The volume concludes by providing a link between central banking in the twentieth century and the travails since the global financial crisis of began to suggest that the twenty-first may bring significant new changes to central banking. Other than a few quibbles, readers interested in the history and evolution of monetary policy will find this a delightful volume. It provides easy to understand summaries of the dominant policy regimes in place between and the early s.
It is careful to avoid drawing too strong conclusions about the current state of central banking. However, many readers will clearly see that how the seeds of the current crisis were sown over the years as monetary policy makers, with more than a little hubris, believed that business cycles were a thing of the past. The volume might have spent a little more time on the conquest of the inflation of the s, and why earlier monetary regime strategies i.
At the institutional level the book underemphasizes the critical role played by attempts to codify how government and central banks would respond in the event of a serious disagreement or crisis and where ultimate responsibility for the performance of monetary policy lies. Other than that, students of monetary policy will find this volume to be an essential starting point for delving further into the history and practice of central banking. Copyright c by EH.