July 6, 2012 Reading Time: 5 minutes

vaultofbank

“In theory, there is no difference between theory and practice. In practice, there is.” –Yogi Berra

In theory, central banks exist to do things like “promote economic stability” and “uphold the value of the currency.” If you consult any Federal Reserve official (or any mainstream economics textbook), the stated purposes of the US central bank are to conduct monetary policy aimed at “full employment” and “long term price stability.” This is done through boring and mundane vehicles like open market operations and involves utterly non-sexy technical stuff like inflation targets and adjusting the policy rate. Central bankers’ reports to the public and to legislators are famously calculated to be sensation-less and inscrutable: “nothing to see here folks, just doing our boring technocrat job of managing the economy for you.”

History, however, is another matter. Sure, central banks do the official, boring monetary policy functions—what central bankers want you to think is ALL they do. But the briefest overview of central bank history reveals a far simpler (and more nefarious) essential function: Central banks exist primarily to loan money to the biggest, most troubled debtors in the economy. In other words, central banks exist to bail out governments and big banks. The main way they do it is through their monopoly on the note issue, or in layman’s terms: “printing money.” Monetary policy functions—i.e. trying to manipulate the money supply and interest rates to achieve desired employment and inflation levels—has typically been a secondary purpose, grafted on to central banks by politicians eager to operationalize Keynesian-style macroeconomic policies.

The history of central banking makes this fact—that central banks’ main purpose in life is to bail out large debtors—as plain as the beard on Ben Bernanke’s chin. Perhaps this is why history is mostly avoided in the textbooks and policy debates on monetary policy. A thoroughgoing historical knowledge might prejudice the public against the very notion of central banking and sweep all the technocratic minutiae of interest rate policy, inflation targets, whether to “twist” or “ease,” to the sidelines. Once citizens begin in large numbers to see central banking for what it is deep down at its historical roots, they may not like it, and may start a movement to get rid of it in favor of sound money institutions.

So here’s a brief history lesson aimed at exposing the roots of central banking. The classical central banks of Europe’s financial centers mostly began as quasi-private banks that were given by their governments some degree of legal privilege in issuing banknotes. In return for such monopoly powers the banks rewarded their government patrons with easy access to credit, whether through direct lending or financial market interventions aimed at holding down interest rates on government securities (sound familiar?).

The classic example of this quid pro quo is the origins of the Bank of England (BOE). The world’s most prominent and influential central bank from its founding in 1694 until well into the 20th century, the bank got its royal charter in exchange for an immediate loan of £1,200,000 to the Crown. In the words of economist Vera Smith, “The early history of the Bank was a series of exchanges of favours between a needy Government and an accommodating corporation.” The bank was also given a monopoly of currency issue in England and made exclusive banker to the British government. Every renewal of its exclusive royal charter for the next 100 years was secured by a further extension of credit to the government. The BOE did not begin what we would now label “monetary policy” operations until the mid 19th century—and only in response to financial crises—and this did not assume the form of modern, paper-money-only, Keynesian “demand management” style monetary policy until the mid 20th century.

Other European nations followed the same pattern. The Bank of France, for instance, was founded by Napoleon in 1800—part new government-sponsored bank, part forced merger of failed revolutionary-era financial institutions. Soon enough the bank was given monopolies on banknotes and lending operations, and soon enough it was called on to support government debt by direct new loans and “discounting” government bonds (i.e. keeping the price of government debt high/yields low in the secondary market). Again, official monetary policy actions came much later.

Central banking developed in the US along similar lines—support of government credit was the first priority from the beginning with the establishment of the 1st Bank of the United States (BUS) in 1791. Although not a central bank proper, the BUS had some central bank-like elements, such as being the government’s bank and enjoying legal privileges in its note issue which enabled it to over-expand credit and launch the US on its first full-blown monetary business cycle (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1828282). Most importantly, however—and this would be repeated with later US central banking institutions—was the bank’s symbiotic relationship with the cash-strapped (and credit-starved) new US government. While Congress blessed the BUS with legal privileges, the Bank reciprocated by lending generously to the government and moving to boost the market for government bonds. Whether the net effects of 20 years of a privileged banking powerhouse were good or bad, it cannot be avoided that the bank’s initial actions—much like the Bank of England—reeked of quid pro quo dealings with the government.

America was late to the game of establishing a central bank proper, although banking regulations throughout the 19th century, at both state and federal levels, had already generally treated banks as errand-boys for government debt. When we finally did get our Federal Reserve System (Fed) in 1913, it initially actually broke the European/early American mold: it was set up neither to lend to the government nor dabble in government debt markets. Instead, the Fed was set up as a decentralized, regional clearinghouse and “lender of last resort” for US commercial banks in times of financial crisis. But this quickly changed (as we’ve noted here); during WWI, the Fed adapted to—you guessed it—support government debt.

With its expanded powers from the WWI episode, the Fed began flexing its monetary policy muscles in the 1920s in the form of fledgling open market operations. Its primary objective was price stability, by which it was thought the Fed could help avoid wild swings in economic activity either up or down. Ironically, it was not too much later that the Fed faced its first major crisis: the banking panics of 1930-1933. Perhaps the best-known fact in economic history is the Fed’s miserable failure here in its primary mission of lending freely to sound-but-illiquid banks in a crisis. At any rate, the Fed’s power was only strengthened after this debacle, and further centralized, It went on to take on the role of a full-fledged modern central bank, complete with a total paper money monopoly and all the requisite tools to engage in monetary policy operations. Eventually Congress acceded to the new reality that had developed through accident, whim, and accumulated law changes by officially laying upon the Fed the official economic policy goals of “price stability” and “full employment.”

Thus we have in the US—like everywhere else—a bona-fide central bank, the official function of which is to manage economic outcomes by doing its monetary policy thing. But theses official economic policy functions of central banks should be taken with a grain of salt. Central banks began life as privileged lenders to the economic elites. The fact that they now also do monetary policy—allegedly to help the economy—should not obscure this historical legacy. Nor should we be surprised to find central banks doing, in the name of monetary policy, their ancient trick of bailing out the biggest debtors in society: governments and large banks. It was true in 1694, it was true in 1917, it was true in 2008, and it will be true as long as citizens tolerate the existence of central banks.

[If you seek an alternative, stay tuned! (If Not Central Banks, then what?)]

By Tyler Watts

Tyler Watts is an assistant professor of economics at Ball State University.

image: flickr.com/JonGozier

AIER Staff

Founded in 1933, The American Institute for Economic Research (AIER) educates people on the value of personal freedom, free enterprise, property rights, limited government, and sound money. AIER’s ongoing scientific research demonstrates the importance of these principles in advancing peace, prosperity, and human progress.

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