Thursday, December 22, 2016

History of Central Banks Tutorial - Before Central Banks

Central banks can be seen as the culmination of the long process of financial development in Western Europe. Starting with the Italian City States, in particular in Genoa, Venice, and Florence, followed by the Dutch Republic and finally reaching its apex with the Financial Revolution in England, to use Dickson famous expression.  Many of the financial innovations pioneered in the early stages were central for the latter development of modern central banks. But, the relatively small scale of the pioneering economies limited the effects their inventions on the global economy.

Most accounts of the emergence of banking suggest that merchants dealing in foreign exchange and metallic currencies started to discount bills of exchange, accept deposits and make loans as a side development of their commercial activities. In this view, it was the advantages of reducing transaction costs that the practice of safekeeping metallic currency as deposits that allowed goldsmiths to lend money beyond their reserves.  This in fact would suggest that the emergence of banking is very similar to the development of money, which is often also seen as a means of reducing the transactions costs associated to barter.

However, what is often neglected about the rise of modern banking is the role played by public debt. Lending to the state was initially compulsory, in the Italian City States, and the elites were compelled to lend to the state in lieu of taxes, which were essentially a burden on the poor (Vernengo, 2004). Public debt was secured by setting aside the revenues of specific taxes, in general excise or trade taxes, for that purpose. Banks were often a source of short-term finance for the state, necessary in order to deal with the uncertainties of the tax system.

Further, a symbiotic relation between the banking and merchant elites and the state emerged, since bankers and merchants and other wealthy individuals that participated actively in the administration of their cities were holders of public debt. Active trading in public debt and the shares of banks and other corporations developed. Even though there were recurrent interruptions in debt service, and consolidations of public debt, in general public debt provided the most secure financial asset. It was the security provided by public debt that allowed the expansion of banking and other financial transactions.

But the iconic banking institutions of the mercantile period, the Bank of San George in Genoa, the Bank of Rialto in Venice, and the Bank of Amsterdam fell short of becoming what we would call central banks by most accounts. These were all public institutions, that provided, centralized clearing accounts (giro accounts), banknotes and, even more importantly, legal tender in exchange for lending money to the state. Before discussing the precursors of central banks, it would make sense to take a critical look at the conventional definition of central banks.

Capie, Goodhart and Schnadt (1994), in their review of the development of central banking, fix the beginning of central banking in various countries by two indicators: the legal monopoly of note issue, and the de facto assumption of the responsibilities of the lender of last resort. In other words, central banks control the money supply, and they guarantee the stability of the banking and financial sector.

Interestingly enough this definition of central banking presupposes both the existence of money and of an organized banking and financial system. Central banks then become the external instrument that evolves organically from the functioning of the market or is imposed from above to organize and provide stability to the market. This account, also, assumes that the monetary and financial markets arose more or less spontaneously from the rational behavior of economic agents.

In other words, banks results from the perception of goldsmiths that they could lend beyond the amounts of metallic deposits that they held, since it was unlikely that all depositors would withdraw their deposits simultaneously, while the public benefited from the security provided by the deposit institutions, and the reduction of transaction costs associated with the use of banknotes instead of metallic coin. In doing so banks intermediate between savers that deposit in the bank, and investors, that take loans, functioning as intermediaries.

However, since banks provide a bridge between short-term deposits, that can be withdrawn at any time, and long-term loans, that cannot be called in immediately, bank runs are a likely possibility. Further, bank runs might lead to what is often referred to as systemic risk, if the depository institution under attack is interconnected with several others in the banking system, that is, if other banks have deposits in the problematic institution. Central banks develop as the natural outcome of the need to provide banknotes and guarantee the stability of the system, eliminating systemic risk, in a world with asymmetric information between depositors and banks (Goodhart, 1988, p. 85).

So it is the possibility of bank runs, and systemic risk that requires the need for supervision. Goodhart notes that there is no need for a public bank, and that a club of banks could play that role. Evidently the notion is that the central bank could evolve from a private bank, that given its preeminence in the market, its primus inter pares position, allows it to act as the independent arbiter of such a club of banks, and that the evolution of Bank of England represents a reasonable illustration of such a process.

In this view, it is only with the Bank Act of 1844, with the separation of issue and the banking departments of the bank and with the monopoly of issuing that the Bank of England (BoE) could be considered a modern central bank. Further, it is the effective development of the Lender of Last Resort (LOLR) function in the second half of the 19th century that consolidates the modern central bank as an institution necessary for the management of an advanced market economy. More importantly, it seems that the separation between the issuing and loan departments of the BoE and the indication that the central bank is independent from the treasury is what really makes it a modern central bank, according to the conventional economic analysis.

Essential in the evolution of central banks, not only the BoE but also some of its predecessors, was the role of fiscal agent of the state. Public banks, of which the Casa di San Giorgio founded in Genoa in 1407 is a chief example, that managed the public debt of the state, were an essential feature of the development of central banks. There are many issues with the conventional view of the origins and functions of central banks, including the ideas regarding the origins of money and banks. In the next installment I will deal with them, and provide an alternative interpretation of why the BoE is often seen as the first central bank, and why that definition is a bit arbitrary.

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