What is A Useful Central Bank?
Lessons from the Interwar Years
Gianni Toniolo
Duke University
Symposium What is a useful central bank?
in honor
of Governor Svein Gjedrem
Norges Bank, Oslo, 18 November 2010
Outline of the paper
1. “Useful” central banks in transition
2. The 1920s: “useful” central banks, monetary
policy, and macro imbalances
3. The monetary response to the great
depression
4. Central bank cooperation
5. Unorthodox lending of last resort
6. Central bank independence
7. Interwar lessons for a “useful” central bank.
The long transition of central banking from
gold standard to fiat money (1914-1971)
1914
‘Classical’ gold standard ends
1919-24 Fiat money, inflations
1924-31 Gold exchange standard
1931-36 Long exit from gold standard
1936-39 Attempts at peg (failed)
The transformation of central banks
Central banks were transformed by the process. At the
end of 19th century they were private banks of issue
entrusted by governments with the public function of
maintaining currency convertibility.
By the 1950s most CBs were, de facto or de jure, public
institutions with a wide range of responsibilities, often
including bank supervision, and close relations, often
subordination, with the national governments.
In the interwar years CBs were not always as “useful” as
they might have been.
Nevertheless, the number of central banks in the world
increased from 18 in 1900 to 59 in 1950.
Monetary policy in the 1920s
Europe: monetary policy was dictated by the
decision to reintroduce convertibility. NO parallel
with and NO lessons for today.
US: similarities 1920s & 1995-2007
- Real economy growth pushed by
innovations
- Stock market boom
- Financial innovation
- High leverage
- Accommodating monetary policy until 1928
Should central banks target asset
prices?
R.G. Hawtrey (1933):
“Much controversy has been
aroused as to the proper
functions of a central bank
when faced with an inordinate
Stock Exchange speculation.
Apart from the condemnation of
gambling as a vice (a matter
which hardly concerns a central
bank) the central bank is only
concerned with speculation as
a possible cause of inflation”
After 2007-09: do we still agree
with Hawtrey? Or should CBs
also target asset prices?
The intellectual lesson of the 1920s:
this time is NOT different
US monetary policy of the 1920s, “was supposed to achieve three ends: mitigate
business fluctuations, prevent inflation and restore the international gold standard […]
The apparent success of postwar policies in achieving the three main objectives and
preventing financial panics increased the credibility of policies and the belief that a
new and more stable era had begun” (Meltzer (2003: 261)
A similar belief that a new era of great moderation had dawned was widespread among
the public, economists and even central bankers in the decade or so prior to 2007
The lesson for both economists and ‘useful’ central banks is unequivocal: in the future a
larger dose of humility will create the appropriate intellectual environment for policy
making.
A minor lesson: ‘useful’ central banks should consider employing more economic
historians
The monetary tale of 2 Depressions
(Eichengreen & O’Rourke)
2007-09 was potentially more disruptive than
1929-33
Policy response was different and, so far, also the
outcome
Monetary policy in the second half of the
1930s
After 1935 “Eccles and the Board became convinced after
1935 that the growing volume of (free) reserves at the
member banks posed threat of future inflation. The
Board’s principal policy action in these years increased
reserve requirement ratios as a preemptive act against
inflation… thereby contributing to a steep recession
in 1937-38” (Meltzer 2003: 416).
France deflated to stay on gold after a relatively mild
Depression: growth was sluggish
The UK, off gold, expanded and revived the real economy
Germany and Italy expanded (for the wrong reasons) in
1934-35: output and employment rose
Central bank cooperation
International relations were strained in the interwar years:
CBs allowed to cooperate only when consistent with their
governments’ foreign policy. They resorted to low-key
cooperation in technical matters
Unlike in the 1930s CB cooperation in 2008 was intense
and unrestrained. The lesson was learned (international
relations allowed strict CB cooperation)
In the last year or so, international relations have shown
some distressing similarities with the interwar
Lessons: a) Coordination of domestic monetary policy is
only possible when international relations are favorable;
b) technical cooperation is useful even at times of
“currency wars”
Unorthodox lending of last resort (LLR)
• Bagehot’s model of LLR (“Lend freely at high rates”)
approximates the Bank of England’s operations in most
of the 19th century.
• The game changed with the banking crises of the early
1920s. It entailed accepting collateral of every kind to
“bail out” both financial and non-financial firms
• To do so, CBs had to adjust their practices often by
creating their own “off-balance-sheet vehicles” allowed to
lend on securities not admissible for discount at the CB
The most orthodox of them all..
• The Bank of England undertook to bail out Banks and support
industrial companies in distress, no longer eligible for loans from
private sources.
• Norman’s preferred the indirect ways of moral suasion (“privacy,
speed, determination, and reliance on a few good men”). But
sometimes direct financial intervention was needed (e.g. for the
Williams Deacon’s Bank, the Banca Italo-Britannica and the AngloSouth Bank). The Bank of England ended up with indirect holding of
bank equity and direct involvement in bank management.
• In 1928, the BoE rescued Vickers-Armstrong an armament
manufacturing firm. Besides holding equity in the company, the
Bank got involved with its restructuring and management.
• In 1929, the BoE created a Securities Management Trust, as “the
channel through which the Bank would provide funds for schemes
supported by the Bank”. Norman explained the SMT to the
Macmillan Committee saying that “he was a public servant who
believed that the Bank should be the catalyst in bringing together the
needs for industrial reconstruction and the financial resources the
City would mobilize”. It turned out that the resources cam only from
the central bank.
The Reichsbank
Hjalmar Schacht
The Reichsbank “became
practically a dictator over the
credit life of the nation. The
increased importance of the
Reichsbank came not only
through its position of court of
last resort for foreign exchange,
money, and credit but also
through actual ownership
participation in the control of
the Joint Stock banks and the
central banking institutions”
(Northorp 1938).
The Banca d’Italia
In the late 1920s, the three largest
Italian banks had direct or
indirect control of almost one
half of the companies listed in
the Milan Stock Exchange.
In 1931 the government required
the Bank of Italy to provide a
massive liquidity infusion to the
three banks, the bank took
industrial equity as collateral.
For a time (1931-33) the central
bank found itself indirectly
owing the majority stake in
several of the country’s largest
industrial companies
Alberto Beneduce
The FED
1932 Reconstruction Finance
Corporation (RFC) created to
grant credit to banks that could
not get it from the market.
1933 Emergency Banking Act
calls upon RFC to reorganize
and support solvent banks.
1934, the RFC and Federal
Reserve began lending directly
to business and in due time the
former came to have direct or
indirect control of banks, in
which it was invested. It often
used this position to “replace
officers and significantly alter
the business practices of the
institution” involved
• FDR & Marriner S. Eccles
Lessons from RFC?
Analogy RFC - TARP (2008), in both cases:
1. close cooperation between the Treasury and the central bank,
2. impact on the asset side of the Fed’s balance sheet
3. costs turned out to be a small fraction of what was originally
planned or feared.
The ‘lessons’:
a) governments (and central banks) should not be unduly deterred
from support programs for ailing financial institutions by fears about
their long-term fiscal impact: in due time, markets recovered and
what in 1933 looked like a heavy burden on the federal budget,
turned out to be of much lesser relevance by 1937.
b) both patience in avoiding a fire sale of assets and the choice of
the appropriate exit timing are of crucial importance.
LLR & bank supervision
• Massive lending of last resort during the Great Depression
convinced legislators that bank supervision was essential to the
pursuit of financial stability. In various countries public enquiries
showed that the balance sheets of the banks were, if not utterly
‘cooked’, inflated by unrealistic valuations of assets and credits
• Until the mid-1920s, only the US Fed was endowed with powers of
bank supervision. The banking crises of the early 1920s, resulted in
supervisory authority being conferred on the Bank of Italy in 1926.
Japan followed suit in 1928.
• During and after the Great Depression, provisions for bank
supervision became a standard item in the legislation to regulate the
banking system (US, Germany, France, Belgium, Switzerland, Italy).
• The main exception was the United Kingdom where the Treasury
and the central bank preferred to issue “recommendations” to the
commercial banks.
• Lesson: the LLR authority (central bank) should also have full
supervisory powers (as learned by the UK)
Central bank independence
• WW I: CBs subordinated to governments
• Transition to peacetime economy: slow recovery
of independence
• Gold Standard: recreates CB independence
• Great Depression: mismanagement lowers CB
prestige; governments step in
• 1930s: CBs as Government agencies for
managing exchange rates, clearings, even bank
supervision
Norman and Strong apostles of CB
independence…
• Norman
• Strong
Norman and Strong became the self-styled
apostles of central bank independence. They
had the principle of independence proclaimed at
every economic conference and engraved in the
tables of the League of Nations.
…and yet they disagreed on the limits to
CB independence
Norman’s view was radical to the point of
arguing the Bank should have the right to
rebuke the government in public and to be
free to make decisions regardless of any
political consideration.
Strong told Norman that the Fed could never
openly act against the government’s
interest
Keynes on CB and Treasury
“You can have the two
bodies which maintain
their respective spheres
of responsibility and of
power and yet
necessarily always work
together. It is the
fundamental question of
the relation between any
central bank and any
Treasury”
Interwar lessons on CB independence
CB independence depends on (and is ‘useful’
according to) circumstances (as in the ebbs and
flows in the interwar years)
CB independence is idiosyncratic to national
culture and institutions (e.g. BoE vs. Fed,
today’s Asian vs. Western CBs)
CBs may be independent in monetary policy and
yet cooperative and/or subordinate in other
matters (e.g. “bailouts”): great talent is required
in managing independence, cooperation, and
dependence.
The 3 lessons already learned
(i) a major financial cum real shock requires
immediate monetary reaction of adequate
size
(ii) lending of last resort should use all
available tools
(iii) international cooperation is essential
Lessons/questions for the future:
(i) how to manage the upswing
The following questions remain answered from the
1920s and are in need of attention
(i) Should central banks target asset prices, and
if so how?
(ii) Is there a way of knowing the appropriate
moment for raising rates in a real/ stockmarket boom?
(iii) Can/should central banks reconcile their
domestic with their international
responsibilities?
Lessons/questions for the future:
(ii) long-term unemployment & policy
The 1930s show that the legacy of a major
depression is “a substantial increase in
long-term unemployment and economic
inactivity” and, thus, a lower level of
potential output”.
Given this, risk is probably minimized by
erring on the expansionary rather than on
the deflationary side.
Lessons/questions for the future:
(iii) exit from unorthodox lending
It is undesirable for central banks to hold on indefinitely to industrial
equity and illiquid bonds. In the 1930s CB involvement in financing even managing - banks, companies, and ad hoc institutions violated
the principle of allocative neutrality of monetary policy, exposed
them to criticism and contributed to their loss of independence.
Today it is desirable that central banks return as soon as possible to
“the type of lender of last resort transactions that fit within the
Bagehot Standards” (Feldstein 2010:137), and to smaller and more
liquid balance sheets.
Another “lesson” from the 1930s however is to expect difficulties and
delays down the road. “Conditions on the ground” will determine the
timing of the “exit strategy”. Unwinding TARP has already proven to
be a success story even though the initial time table has not been
completely met.
Lessons/questions for the future:
(iv) CB independence
•
In the 1930s central banks lost their independence because:
- they mismanaged the Depression
- governments took over policy making & availed themselves of CBs t their
technical arms
• The Great Recession has been better managed than Great Depression: no
reputational loss awaits central bankers.
• There is no reason to expect a new wave of autarky, exchange controls, and statemanaged credit allocation. The notion that a “useful” central bank must be
independent in setting monetary instruments will not be challenged.
• The definition and practice of independence, however, might evolve:
- Managing the crisis entailed closer cooperation with the Treasuries which will
continue during and beyond the “exit” period.
- Central banks from emerging-market countries will gain international weight
and many of them are assigned, like the Fed, the dual targets of price stability
and some measure of real-economy performance (growth, employment). Each
of them interprets “independence” according to national tradition and
institutions.
The banal but important lesson is that in the future, as in the interwar years, a
simple, one-size-fits-all concept of independence will not apply to every
“useful” central banks.