RG3: Micro-Management Responsibility of Central Banks

[bit.ly/we0rg3] This continues from previous post RG2: Goodhart on Central Banks of our online READING Course on the Evolution of Central Banks by Charles Goodhart. This post (Readers Guide 3) covers  pages 6-11, or the last half of Chapter 1. Writeup is given following the 10m video lecture.

Central Banks were not designed for macro and micro management roles. Rather, as they acquired power and strength, they came to the recognition of responsibility that this status gave them.

As Central Banks became big and powerful, they realized that they could not act competitively, just like other banks. They needed to support other banks in times of crisis. Also, they needed to pay attention to macro responsibilities. These responsibilities were in conflict with the role of a private sector competitive profit maximizer

Two Types of Monetary Management responsibilities emerged naturally from the institutional structure:

  • Macro Management: State of Economy, Employment, Exchange Rates, Stability of Currency.
  • Micro Management: Regulation and Supervision of the Banking System

Over time, the macro management responsibilities changed greatly, but the micro management responsibilities remained constant. This suggests that the primary role of Central Banks is the micro management of the financial system.

Evolving Nature of (Macro) Responsibilities

Gold Standard until 1914 (World War 1):  Ensure stability of money by keeping adequate gold reserves for stability and convertibility of currency.

Post WW1 (inter-war chaos): Gold Standard broke down due to excessive war expenditures by Central Banks, chaotic change of system. Post-war, complete ruin of the economy led to prioritization of the needs of domestic economy over the stability of currency for international trade. For detailed discussion of this, see  International Financial Architecture, Part II.

Post WW2: Bretton-Woods: created Gold-Exchange Standard based on dollars. CB Responsibility shifted to defending exchange rates and keeping domestic economy healthy.

Post Nixon Shock in 1971: New regime of floating exchange rates – major change in conceptualization of CB responsibilities.

Throughout these major changes in macro management responsibilities, Central Bank responsibility for smooth operation of Financial System remained constant. This suggests that the main function of Central Banks is to ensure that people can pay for goods produces, deposit money, transfer money from reliably. It is only SECONDARILY, the macro management functions emerge.

This is opposite of textbook picture, according to which the main function of Central Banks is the conduct of monetary policy. As Goodhart writes, micro functions – supervision and regulation of banks and financial system are main reason for Central Banks. This is not taken into account by current theoretical debate about functions of Central Banks which looks only at macro management, and not at the micro management functions.

An important issue that emerges from this analysis is the role of Interactions between Micro and Macro Management functions. In fact, there is a close connection between the two aspects, but this is not dealt with adequately in theoretical or empirical literature. The reason for the connection is explained below:

Central Banks act as lender of last resort; this provides some level of insurance to private banks. Insurance creates Moral Hazard: a tendency for risky behavior, because insurance protects against big losses. High levels of insurance will generate Macro financial crisis because banks will gamble with depositors money. If they win, they increase profits, if they lose, the Central Bank picks up the losses. Because of this connection between regulation and financial crises, there is need to connect the two functions – Supervision and Regulation of Commercial Banks, and Macroeconomic Management. It is worth noting that post Global Financial Crisis, “Macro Prudential Regulation” became a hot topic; see my talk on “Regulation of Financial Markets: An Islamic Perspective”.

How did Experience lead to abandonment of commercial and competitive role, and transition to a  supervision and regulatory role for Central Banks?

The 1844 Bank of England Act was actually a step backwards. It divides BoE into two parts – One is responsible for issue of currency, maintaining Gold Standard. Other is a private commercial bank. It was not clear at that time that Central Banks cannot act as private commercial banks. This is simply becausea bank which is lender of last resort CANNOT be a competitor; it must cooperate with banks in distress. There is a conflict of interest between the supervision and regulation role and the private commercial bank role.

Goodhart goes through an analysis of historical experience to establish how this conflict was realized in several European countries, and how this led to change in the role of Central Banks. Central Banks often started out as just one big bank, like others, in competition with other private commercial banks. This led to unpleasant outcomes, when financial systems collapsed because the Central Banks refused bailouts to competitors. This led to the realization that CBs cannot act as a competitive profit maximizing private entity. This led to re-organization where CBs abandoned private banking and became solely a banker’s bank.

European history shows a large number of different trajectories and also a large number of different structures regarding the supervisory and regulatory responsibilities of CBs in European experience. There is no single best institutional structure, and many different ways to arrange management of macro and micro responsibilities.

The questions of interest which emerge from this preliminary discussion are the following:

Should we separate Supervision & Regulation (Micro Management) from Monetary (Macro) Management? If so how? If not, how best to merge them? This is NOT explored in the book.

Rather, the book focuses on the theoretical & empirical reasons for existence of Central Banks. The 19th Century discussion of this issue concerned the question that: “Would a Central Clearinghouse be sufficient to create a stable monetary system?” A central clearinghouse is one of the important functions of Central Banks where daily clearing of all checks written on the entire banking system takes place. History provides a clear answer to this question. A system of private banks without any supervision and regulation leads to wild and chaotic system with regular and frequent crises. This is why the 20th Century Discussion of this question has moved on to: the Role of Asymmetric Information, Risk, Moral Hazard, and how Central Banks can reduce these market failures.

The next two posts provide a general methodological discussion of how historical context of economic theories matters, and what we can learn by studying history. These posts are: RG4: History, Methodology, & Economic Theory, and RG5 Evolution of Economic Systems

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