Classical Political Economics and the History of Central Banks

As promised not long ago, here a short paper on the history of central banks presented at ASSA meeting in Philadelphia. The paper is short, given the submission policy. It discusses the growing literature on the origins of central banks, and essentially disagrees with Charles Goodhart, who is the authority on the topic.

The conventional argument is that central banks only become effectively central banks in the late 19th century when a concern with financial stability was developed and the function of Lender of Last Resort (LOLR) was more formally established. The notion is that up to that point central banks were essentially concerned with profit making, as private institutions, and that only when a concern with financial stability as a public good was developed is that they can be seen truly as public institutions (even if they remained private).

Implicit in this view is also the notion that central banks would have a tendency to overissue paper money, in times of booms, which would help their profitability, and that constraining that ability, but at the same time allowing them to act as LOLR was central for financial stability. The first part of the argument, the notion that inflation is caused by the overissue of paper money, derives from the Bullionist controversies and the Bank Charter Act of 1844.

The point of the paper is that early public banks (essentially Italian and Dutch banks that preceded the the Swedish and English central banks) were central banks because they did have a public concern considerably before than their LOLR function was developed. They were fiscal agents of the state concerned with providing a stable unit of account and a secondary market for public debt allowing the expansion of the State.

The paper tries, in that sense, to connect the discussion of the origins of central banks with the extensive literature on the Fiscal-Military State and its relevance for the process of capitalist development.

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.

Kicking away the ladder too

The table below comes from Broadberry and O’Rourke's The Cambridge Economic History of Modern Europe. It shows that national control of the money supply, the monopoly of emission, is a 19th century phenomena, something we discussed with L-P. Rochon in this paper back in 2003.

Note that before the mid-19th century period, which Charles Goodhart aptly calls the Victorian era, central banks had been created for supporting the State’s financing needs. Also, the role of lender-of-last resort (LOLR) in the late 19th century, associated to Bagehot, did not lead to a significant change in the Victorian preoccupation with price stability.

It is only with the Great Depression that the Victorian dreams of a self-adjusting economy with a tendency to full employment and an orderly division of labor, where the periphery only produced commodities and imported manufactured goods, were utterly shattered. In my view, an contrary to Goodhart, the crucial element on the rise of Keynesian Central Banks was the abandonment of Say's law, not of the Real Bills Doctrine, as we discuss here with Esteban Pérez.

I wrote a paper (in Spanish), when I was at the Central Bank of Argentina, that has not been published on these topics, titled 'Kicking Away the Ladder Too,' in obvious allusion to Ha-Joon Chang's use of List's expression. The point is that central banks were used as tools of economic development (the Bank of England for sure), but once central economies went up the ladder they kicked it, suggesting that central banks should only be concerned with inflation. Now that the Keynesian moment has passed, the mainstream has gone back to the inflation obsession.

More on David Graeber’s Debt

Indebted? No problem we have a (minimum wage) job!

David (Fields) posted a link to Geoff Ingham’s review of Graeber’s book. Graeber is an anthropologist, recently hired by the London School of Economics, and that has often been associated with the Occupy Wall Street movement. Note that several mainstream economists have posted recently on the topic, and have been, as is often the case, barking at the wrong tree. Two mainstream takes on Graeber that are typical are from Noah Smith and Brad DeLong.

Noah wrote a post, a while ago, on David Graeber's views on debt. According to him Graeber is "a sort-of-leftish guy with a tendency to fight with other people on the left." Noah would be, by the same token, a sort of neoclassical-liberalish (in the American sense of progressive) economist fighting other people within neoclassical economics. And here lies the problem, because mainstream (neoclassical) notions about debt are really problematic, and there is quite a bit that could be learned by the profession from anthropologists like Graeber (or sociologists like Ingham; see for example this book).

Noah's complaint seems to be that David is confusing or confused or both. In his words: “his [Graber’s] pronouncements on the subject are vague or seemingly contradictory on all of the questions listed above.” In all fairness, Debt is a very long book, which deals both with one might call a Chartalist view of money, and (in my reading) a vaguely Marxist (certainly non-neoclassical) view of the functioning of the economy, but discussing the evolution of debt and economic development more or less since the beginning of Civilization.

But the basics are not difficult to get. Money does not appear as the efficient mechanism to reduce transaction costs (avoid the double coincidence of wants) in barter economies, but is the result of certain social groups ability in imposing a unit of account. As Keynes put it in his Treatise on Money: “money-of-account, namely that in which debts and price and general purchasing power are expressed is the primary concept of a theory of money.” And what is behind money of account is the power to determine what is the unit to be used, or as Keynes says, the power “to enforce the dictionary but also to write the dictionary.” Further, the classical political economy (and Marxist) approach, is not about market efficiency (not even for Adam Smith by the way, but that’s for another post) of individuals making uncoordinated decisions, but about capital accumulation in particular historical conditions, which involve class relations.

So debt is not bad per se, or good (Noah thinks that David’s point is that debt is bad, or something, as he says). Debt is an instrument that can be used by a social group to extract surplus from other social groups, from the elites in early civilizations that could command work from peasants and determine the means by which they were going to be compensated for their work, to countries that need to pay their debts in a foreign currency (normally dollars, which became the dominant currency after the victory in World War-II). Debt is then a way to force social groups and countries into situations of dependency (Noah himself is probably still paying student loans, with interests that he does not control, since he was told this is the respectable path to a happy life; yes he had a choice, but what are the choices for middle class kids with no money for college? Working for Taco Bell?).

Mind you, not all debt is bad. For example, the increase in debt to pay for unemployment insurance during this crisis is good, and in fact, too small to do any good (yes we need more spending and more debt). But not the kind of private, unsustainable debt that shackles workers to badly paid, unrewarding jobs, or that forces countries into economic arrangements that are contrary to their national interests (it was the debt crisis of the 1980s that forced most Latin American countries to accept the Washington Consensus policies).

Brad's complaint is more complicated to describe, and he is angrier it seems, but it appears to be associated to the fact that he believes David is not open to criticism, while his book contains too many factual mistakes. And yes there are some controversial points in David’s book, unavoidable in a book that is this ambitious and inter-disciplinary on top, including in chapter 12 (not sure why Brad was specially picky with that chapter). I do have also some disagreements on minor issues, but overall the framework of analysis seems to correctly point out the relevant social conflicts that arise from debtor/creditor relations, which have been absent in the mainstream analysis. At any rate, my two cents on the issue.

PS: The idea of Chartal or Cartal money is defended by 'serious' mainstream authors, and central bankers like Charles Goodhart, by the way (here). Not that it makes it more relevant. Authority has (or should have) little relevance when it comes to scientific evidence.

Heterodox Central Bankers

"Virtually every monetary economist believes that the CB [Central Bank] can control the monetary base and…the broader monetary aggregates as well. Almost all of those who have worked in a CB believe that this view is totally mistaken…"

Charles Goodhart (1994, p.1424).

Goodhart, C. A. E. (1994) "What should central banks do? What should be their macroeconomic objectives and operations," Economic Journal, 104, November, pp. 1424-36.

The Economist is Cartalist

Well not really, but they do cite the Cartalist approach of Charles Goodhart and wonder about it and the meaning for US dollar hegemony. They contrast Cartalism (or Chartalism) with the marginalist approach of Menger, but do not cite Georg Knapp or Abba Lerner or Keynes (of the Treatise on Money) as precursors of Goodhart, or any MMT author for that matter, following the tradition that the acceptable critiques of the mainstream have to come from within. Interestingly the specific take of the piece, the relation of Cartalism and dollar hegemony, has been the theme of our posts (here, here and here), and at least one paper. What are these guys reading?

PS: The classic book by Knapp on Chartalism is available here.