In previous post on the founding of the Bank of England, we have explained that Central Banks were created to provide financing for wars. In fulfilling this role, they had several advantages over the state, enabling them to get credit, and get it at low interest rates. For a number of reasons, this was not possible for sovereign states. See Origins of Central Banking for historical details about the creation of the Bank of England. Accompanying post on Monetization, Maturity Transformation, and MMT explains the dramatic differences between appearances and reality about exactly how banks function. That the main function of Central Banks was financing of wars, and that they succeeded at this function very well, is empirically established by Paul Poast in “ Central Banks at War ”. One of the unique features of this virtually constant fighting between the “great powers” of Europe was that no one party could dominate the others, although many attempts were made. This was due to the Balance of Power mechanism, whereby when any one power seemed to be acquiring too much control, the others would combine against it, to prevent this from happening. A consequence of this continuous fighting with no single victor was a “Military Revolution”, which was not just in weapons and battle tactics, but in finding ways of financing the enormously expensive methods of modern warfare that were invented in the process. For a detailed historical discussion, see Paul Kennedy “ Rise and Fall of Great Powers ”. Central Banks are an important part of this story, in terms of creation of modern methods of financing warfare. This post provides a detailed explanation of concepts covered briefly in the 15m video lecture:
The last of the major wars between the Great Powers ended in 1814 with the defeat of Napolean at Waterloo. After this, a century of peace between the Great Powers ensued, until the outbreak of the first World War in 1914. See Hundred Years’ Peace . Karl Polanyi writes that this was due to the emergence of a peace interest – haute finance. The Central Banks, established to give loans to states to fund wars, were globally connected. They found it more profitable to maintain peace, and benefit from global trade and investment, rather than provide funding for wars. In particular, avoidance of direct conflicts, and investments in the colonies became a larger priority. Over the hundred years of peace, the functions of Central Banks evolved and changed. As this happened, the theory of Central Banking was also developed in the light of accumulating experience.
Central Banks were private organization of the super-rich, designed to provide funding to governments for profit. They were not designed to provide public service of any type. As the function of funding for wars became less important, the function of private banking became more important. Here, the Central banks were far larger than other banks, because they were designed to provide huge amounts to states. This created a major imbalance and asymmetry, between other, smaller private banks, and the one big bank. Free market theorists, like Bagehot, preferred a system of private banks with multiple banks on equal footing. They theorized that competition would create better outcomes than the monopolistic outcomes created by the presence of one large bank. See Chapter 2 of Charles Goodheart, The Evolution of Central Banks , for a detailed discussion of this free banking debate, which continues to this day. Free market theorists thought that competitive pressures would be sufficient to regulate banks and make them behave responsibly. However, the empirical evidence on this matter is very clear. The incentives to cheat, and to make profits and run, are enormous for private, unregulated free banks, and this leads to enormous losses for the public, time and again. The free banking debate is useful as evidence for the extremes of blindness to empirical evidence created by ideological commitments.
Bagehot, and other free market theorists, agreed that even though free market private banks may be a theoretical ideal, this was not achievable in view of the historical context, and the available political configurations. Therefore, theoretical analysis of this era of banking concerned the ways that Central Banks functioned, their relationships with other banks, and how these should be managed in the public interest. The functions of price stability and growth currently assigned to Central Banks were more or less absent in that era. Rather, the main concern was with the stability of the financial system, both domestic and international. The nature of private banking was such that it was guaranteed to create crises from time to time. The business of banks is to create credit – they extend loans on gold they do not have, and cover calls by temporarily borrowing from others – this is called “maturity transformation” to hide the nature of the business. The public is told the myth of “financial intermediation” to further hide the real business of banks. Since banks never have enough current assets to cover all liabilities, and their profits are tied to increasing credit, and thereby increasing the risk of being caught short, the financial system is built for crises. Furthermore, as Minsky showed, stability breeds instability. In good times, banks have every incentive to aggressively expand credit, which creates increasing risk of collapse. Concepts of Central Banking were shaped by the historical experience of the nineteenth century, which we briefly review below.
The Bullionist controversy sprung during early 1797 when rumors of French soldiers landing on English soils spread. There were runs on banks and several of the banks failed to respond to this situation. On Saturday February 25, 1797 the Bank of England reported to have left with only 1.1 Million in gold, and on the Monday February 27, 1797 if the situation prevailed, the bank would collapse while facing a bank run. Keeping in view the situation, the Pitt government issued order the very next day to suspend the convertibility of paper money into cash. After deliberation, in May 1797, Bank Restriction Act (37 Geo III, c.45) was implemented and the Pitt’s restriction was extended until further six months. It was then that there emerged two schools of thoughts: Bullionists and Anti-Bullionists. The Bullionists proponents such as David Ricardo, John Wheatley, Francis Horner and Sir Henry Parnell supported that the paper notes be backed by the gold reserves and be convertible into gold as per demand. They based their argument on the ground that if the paper notes are not fully backed by the gold, the banks would be tempted to print too much money, making it less valued and hence causing inflation. Contrary to Bullionists, the Anti-Bullionists adhered to some form of the old Real Bills Doctrine of John Law (1705), Sir James Steuart (1767) and Adam Smith (1776). Supporters of Anti-Bullionists doctrine in the early 1800s, included Nicholas Vanisttart, Robert Torrens, Charles Bosanquet, Henry Boase and James Mill (who later embraced the Bullionist point of view after interacting David Ricardo).
The issue between the two parties was: can banks create credit backed only by gold, or can they use as backing collateral offered by merchants (real bills). The concern was that too free issuance of credit would lead to inflation. Theories of both parties were faulty, but in accordance with the mainstream thought about money at that time. Historical experience led to the dim and partial realization that gold backing could create deflation – money supply may not be expanded sufficiently fast to keep up with the needs of a growing economy. Deflation serves as a brake on business expansion and leads to different types of economic hardships. In this situation, the real bills doctrine is helpful, because it allows credit to expand with growing needs of business. Business can offer prospects of future sales as collateral for loans. However this does lead to the creation of possibilities for wild speculations and bubbles. Multiple banking crises occurred in the nineteenth century, leading to widespread economic distress, and a gradual realization of the roles and responsibilities of Central Banks in such situations.
One of the apparent and obvious causes of crises was that banks did not have gold to pay back creditors if too many of them made the demand at the same time. The Bullionist position carried the day when the gold standard was re-introduced in 1821. However, the “Bullionist” solution of requiring gold backing (implicitly 100%) did not work because it contracted the money supply too much, creating recessions and deflations. A compromise was introduced, during later years 1827-1832, Palmer Rule for managing liquidity . It required that that the banks maintain one third of their total liabilities (Deposits and notes issued) in the form of currency and specie. And the remaining two thirds in the form of government securities and interest yielding assets. Note that this allows for one third backing by gold, and two thirds by real bills, creating a practical compromise between the two positions. This continues to be the practice in Central Banks to this day.
A second important cause of crises was competitive behavior by banks. In times of bank runs, all banks wanted to guard their own interests. The Central Bank would refuse to lend to banks in distress, allowing them to collapse. Indeed, big banks would sometimes attempt to drive out competitors by deliberately withholding presenting checks drawn on them, until they were collected in a sufficiently large amount to create a crisis. However, with experience, banks learned that they were inter-linked and panics in one bank would inevitably spread to the system. Finally, the Bagehot rule was popularized during 1860s when Walter Bagehot advised the Central banks to act as a lender of last resort . His idea is summarized as “ Lend without limit, to solvent firms, against good collateral, at high rates ”. This was tremendously successful in preventing banking crises in England. At the same time, the USA continued to suffer frequent banking crises due to lack of a Central Bank. To understand the Bagehot rule, we need to understand the difference between liquidity and solvency.
Liquidity is have enough cash to meet current demands. Solvency is having enough assets so that all credit demands can be met, given enough time. These two are very different and it is essential to understand the difference. This difference was NOT respected in the recent Global Financial Crisis, where both solvent and insolvent financial institutions were bailed out, contrary to the Bagehot rule. This point is explained further below.
Liquidity without Solvency: A Ponzi scheme occurs when a bank offers attractive higher interest rates than competing institutions, without actually having any way of earning money to make the interest payments. Depositors are attracted by high interest rates, and false painted pictures of some mythical enterprise which is churning out money. As deposits accumulate, the bank is highly liquid, and can easily make initial monthly payments of high interests. Seeing that payments are being made attracts even a larger number of depositors, who do not realize that the bank is making them payments of interests out of their own principal. This means that eventually nothing will be left of the principal, and the bank will collapse. This bank is INSOLVENT but LIQUID. It has enough cash to meet current demands, but in the long run, it cannot pay back what it owes the creditors.
Solvency without Liquidity: Now suppose a bank issues sound fifteen year mortgage loans, by lending $1 Million to different homeowners. In return, it will receive payments of $10,000 per month for the duration of the loan. The bank created credit of $1M for this purpose, but it has the capability of paying back the full amount, with much leftover profits, from its future income streams – this means the bank is solvent. However, the bank may not have instant cash to cover a large demand today, and this means the bank is not liquid. Here the Bagehot rule says that the Central Bank should lend freely, however much is needed, to this type of bank.
Note that banks which are not solvent should be liquidated in an orderly way; only solvent banks should be rescued. Following this rule eliminated banking crises from England for more than a century, until the global financial crisis. However, the Bagehot rule was not followed during the global financial crisis. Instead of rescuing solvent banks, all banks were rescued, regardless of solvency. Furthermore, the “high rate” penalizes banks, but the bailout gave banks virtually zero interest loans, rewarding instead of penalizing cheating and gambling. This creates a very bad precedent, as it encourages more irresponsible behavior, because the government is always there to catch the risk of bad gambles at high stakes.
POSTSCRIPT: This writeup cover the second portion of my lecture on the history of Central Banks, which is based on the paper by Goodhart, Charles A.E., The Changing Role of Central Banks. A very important part of the story, regarding the colonization and conquest of the globe over this period, and the emergence of the gold standard in this process, has been completely left out of the above account, because it deals only with the role of Central Banks. Actually, Central Banks also played a very important role in this process, but above summary deals with Goodhart’s paper, which does not pay any attention to this aspect. For more detailed discussion about the emergence of the Gold Standard, see my lecture on The Vital Importance of Understanding International Financial Architecture.