Central banking, the function of central banks, consists essentially of the exercise of the public duty of influencing—by regulation, persuasion, or market operation—the behavior of banks and other financial intermediaries in a country. Although they have antecedents as private institutions in the economic development of a few countries, central banks are now primarily public institutions for implementing economic policies of governments. They are appropriate to the Western-type economies; in the communist countries, where economic activity is more comprehensively organized by governments, there is little scope for central banking, although institutions described as central banks exist. In true central banking the public interest is universally paramount, although for historical and other reasons there is some clinging to vestigial private forms and some insistence on a peculiar independence from the central machinery of government.
The activity of central banking emerged gradually from attempts by bankers to protect themselves by organized action and attempts by governments to ensure that monetary conditions serve the purposes of financial policy (at first) and general economic policy (later); this twofold origin is reflected in the formal organization of central banks as banks and in their ultimate subjection to the sovereign power in the state. Before 1900, the development of central banking was almost entirely empirical. Ideas on the subject sprang largely from the efforts of the Bank of England to deal with practical problems; there were also important experiences in the United States before 1836 and in Europe at times during the nineteenth century. Although some aspects were discussed in official inquiries, in English pamphlet literature (W. Bagehot’s Lombard Street, 1873, being the classic example), and in European controversy on the issue of bank notes, systematic thought on central banking in recognizably modern form can be dated from the United States controversy and public inquiry from which the Federal Reserve System emerged in 1913.
The development of thought received further impetus from the problems of monetary reconstruction in the years immediately following World War i; it was in this phase that the central bank was seen as the independent controller of the supply of money, and therefore as the custodian of its value against the assaults of improvident ministers of finance. Incidental to the rehabilitation of the monetary systems of countries that had passed through extreme inflations, new central banks were established and older institutions were reconstructed and explicitly charged with the function of central banking.
Since 1945 there has been a further spate of new central banks, especially in countries emerging from the breakup of colonial empires. In this latest phase, in these and other underdeveloped economies, central banks have been seen as part of the administrative machinery for speeding economic growth. There has also been a disposition to regard a central bank as a symbol of economic independence in reaction against the tutelage of the colonial period. In the more highly developed economies, the emergence of more positive and more complex economic policies (such as “full employment”) has tended to make the objectives of central banks more complex and their operations more extensive.
Early philosophy. Because central banking grew out of the attempts of practical men to deal with situations arising in the business world, the historical theories of central banking have had little logical relationship with each other, although all have left their mark on the broad body of ideas current among central bankers in various countries. Throughout the earliest phase the “stand-by” theory was predominant: the central bank was a large institution continuously but cautiously engaged in the ordinary business of banking, but having a public duty to prevent, by its occasional aid to other financial operators, the collapse of the structure of credit. In fulfillment of this duty—a duty that served alike the needs of government finance and of the banking community—the central bank emerged as the “lender of last resort.” This function as lender of last resort remains a cardinal feature of central banking; from it much else has developed, including powers of control more continuous than anything envisaged in the pure standby theory.
Emergence of the central bank as lender of last resort and as a curb on the lending practices of commercial bankers was closely associated with, and sometimes preceded by, its emergence as “the bankers’ bank,” in the sense of allowing the commercial banks to keep their own banking accounts with itself. In London, this development arose primarily from the strength of the Bank of Eng-land as the government’s banker, enjoying privileges won in return for its substantial help to a needy government in time of war. The prestige of this privileged body, combined with its business as banker to the government, gave bank notes issued by it a circulation displacing, in London, the notes of other bankers. Both because other banks had continuous business with it as the government’s banker and because its notes were in such demand, other London banks soon found it advantageous, and eventually vital, to keep accounts at the Bank of England. The Bank had become the bankers’ bank. The other banks found it convenient to settle clearing differences by transferring Bank of England debts (at first notes and later deposit balances), and the Bank gained further prestige.
There were analogous developments in some European financial centers, but slower development of the banking habit on the Continent, and particularly the absence of such extreme financial centralization as that of London in the English economy, made the process slower and more dependent on deliberate centralization of the note issue. In the United States and other countries with no effective central bank before 1900, there was no analogous evolutionary process; instead, there has been simple application, by legislative fiat, of the theory that the central bank must be the bankers’ bank and lender of last resort. This twofold relationship with the commercial banks gives the central bank, incidentally, a twofold sanction: a recalcitrant bank would be unable to count upon help in time of trouble, and at any time its business could be drastically inconvenienced by enforced closure of its account at the central bank. This double sanction remains important: its existence, although not often mentioned, is as important as any legislative sanction in giving force to the moral suasion that has become such an important part of the central bank’s practice in England and elsewhere.
Stand-by theory. In its strictest form the standby theory of central banking leaves the central bank comparatively inactive at ordinary times: the central bank comes importantly into play only on rare crisis occasions, when it has to save the banking system from collapse. A more sophisticated form of this theory appeared in the controversies leading to the establishment of the Federal Reserve System. The pre-1913 banking system of the United States, lacking a central bank, was alleged—perhaps without adequate justification—to lack the “elasticity” desirable for seasonal and other variations in the “needs of trade.” Coinciding with the traditional banking view that the safest lending is that which provides for the legitimate needs of trade, the demand for elasticity was responsible for the doctrine that the reserve banks should adopt the passive role of standing ready to rediscount good commercial paper when commercial banks, finding themselves unable to meet their customers’ requirements for finance of current trade, brought paper to the reserve banks. On this view, although it was a stand-by theory of central banking, the central bank was expected to be operating continuously, and not only at periods of incipient crisis, to meet the continually varying needs of the economy.
Stand-by theories of central banking, of varying sophistication, continue to be held in some quarters, although rarely explicitly. The attitude is consistent with the central bank’s taking continuous interest in the “quality” of credit granted by various financial institutions; this is a side of central banking more systematically developed since 1935. It has received added impetus from the policy, important in the underdeveloped countries, of promoting healthy financial institutions to facilitate the growth of the economy.
Regulator of credit. The second main strand of development in central banking has its roots in the Bank of England’s preoccupation, over a long period, with the connection between the terms at which it lent to customers and its power to maintain convertibility of its notes into gold at a fixed rate. Into discussions of this practical problem the theoretical ideas of economists were woven early in the nineteenth century. Throughout this century development flowed, however, rather from efforts of practical men than from economic theorists; but in the twentieth century the economists have taken a leading part in the formulation of ideas on the duty of the central bank as the regulator of the price and quantity of credit. From the first, both theorists and practical central bankers have regarded the price (the rate of discount or interest) and the quantity as being interdependent: regulating the price has implied regulating the quantity, and regulating the quantity has implied regulating the price. In the two major countries in which central banking has been most consciously developed—Britain and the United States—the emphasis has been different. In Britain the emphasis has nearly always been on regulation of the rate of interest, whereas in the United States the emphasis has been rather on regulation of the quantity of credit.
British experience. The view that control of the quantity of money is the prime function of the central bank derives directly from the classic debate in Britain—the Bullionist controversy—during the Napoleonic wars. The Bank of England began to think of control of the volume of its own lending (with important influence on the total supply of credit) as the principal means of protecting its gold reserve and maintaining the gold standard. This policy (always liable to modification in crisis, when the Bank had, as lender of last resort, to increase its own lending to avert a collapse in the supply of credit) soon led to the device of manipulation of the discount rate (Bank Rate), which was destined to alter the whole complexion of English central banking.
The movement of the Bank of England’s discount rate, or Bank Rate, was at first seen simply as a practical banker’s method for protecting his cash reserve against the effects of unusual demands for credit. To raise Bank Rate was a less abrupt alternative to outright refusal of customers’ requirements, and it was at first seen in this light of a more tolerable and less damaging way of rationing credit and so of limiting any demand for gold in exchange for notes. Theorists were quick to connect this practical view with quantity theory views [seeMoney, article onquantity theory] of the determination of price levels: a rise in Bank Rate, enforcing limitation of the volume of credit, caused prices to fall, thus both reducing the demand for gold for circulation and, by improving the balance of trade, eliminating the demand for gold for export. Correspondingly, when its gold reserve (the Bank’s “cash” reserve) was unnecessarily large, Bank Rate could be reduced, encouraging expansion of credit and rising prices. This simple association of Bank Rate movements with the behavior of prices, and so with the maintenance of the gold standard, remained for more than a century the mainstream of orthodoxy on the working of monetary systems. From it flowed the view that central banks could and should regulate their monetary systems by manipulation of discount rates.
Whether the English—or any other—monetary system ever did work like this is unlikely, although doubtless there was always an element of truth in the theory. Certainly the English economy in the second quarter of the nineteenth century, with its immense dependence on a speculative export trade and a connected but equally speculative import trade, both largely dependent on mercantile credit, was an economy unusually sensitive to the price and quantity of credit. The association of rising discount rates with the imminence of an extreme liquidity crisis—always liable to occur in pre-Bagehot England—was another factor enhancing the responsiveness of the price level to the movement of Bank Rate. Both these circumstances were, however, fading as the nineteenth century went on, while the power of the Bank to maintain the gold standard by manipulating Bank Rate grew beyond question.
This extraordinary power of Bank Rate was based on the position of London as an international financial center. In the first decades of the use of Bank Rate, it had already been noticed that a rise of rates in London deterred the discounting of international bills in London and attracted some foreign money into the purchase of bills in London. This influence on international movement of short-term capital grew with London’s importance as an inter-national financial center, and after about 1870 this effect of Bank Rate changes was so much more obvious than any other that it came to be regarded as almost the whole mechanism. The Bank saw its central duty as the maintenance of the gold standard, which it could protect by raising Bank Rate to attract short-term money and to repel short-term borrowers whenever the gold reserve was running down. The success of this policy depended partly on the disposition, in that period, of some of the principal European central banks to maintain stable discount rates, so that the absolute movements in London implied relative international change.
Throughout the remaining decades before 1914, this manipulation of Bank Rate remained the Bank of England’s principal function, such openmarket operations as it engaged in being usually designed to ensure that the discount rates ruling in the market remained close to the official Bank Rate. Open-market operations were said “to make Bank Rate effective,” a phrase that underlined the importance attached to short interest rates, to the exclusion of any repercussions of Bank Rate on the internal economy. Indeed, in such discussion of the system as there was in these decades, the possibility that a high Bank Rate would have effects on industry and trade was regarded rather as an incidental disadvantage than as an integral part of the mechanism of international economic adjustment. The importance attached to maintenance of the gold standard by differential movements in discount rates bit deeply into the philosophy of practical central bankers. This emerges in the correspondence between Montagu Norman of the Bank of England and Benjamin Strong of the Federal Reserve Bank of New York, where development of a short-money market in New York is seen as a prerequisite of an international gold standard in which gold reserves—and so internal credit conditions—are seen as protected from international exchange disequilibria by differential movements in short rates. This strand of thought, besides influencing the development of central banking in the United States, also lay behind the wish of Montagu Norman to see money markets develop as an essential framework for central banking in the British Dominions and elsewhere. Much of the recent fostering of new money markets has its roots in this notion of how an international gold standard should be managed by central banks on the pre-1914 Bank of England pattern.
U.S. experience. The development of the Bank of England’s functions in the pre-1914 period had some influence on the American discussions leading up to the establishment of the Federal Reserve System in 1913–1914; but a more powerful influence was the desire to provide directly for avoidance of the supposed (and perhaps real) disadvantages of the existing monetary system under the National Bank Acts. The new system was to operate as lender of last resort, and so save the United States from the periodic breakdowns that had characterized the banking history of previous decades; but it was to go further, and provide an elastic system responsive to “the needs of trade” as manifested in the supply of good commercial paper in the commercial banks. It was also—in further protection against periodic breakdown, and to reduce the need to adjust internally in the face of an international disequilibrium—to pool the reserves. In the light of subsequent developments, it is instructive to note that the possibilities and aims of open-market operations did not feature prominently either in the preliminary discussions or in the early history of the system itself.
The new system gradually got on its feet during World War i, especially in developing banking and in conducting foreign exchange business for the government. In the immediate postwar phase, it found itself confronted with an inflationary situation, and in dealing with this the Federal Reserve System relied mainly on a steep rise in discount rates. The use of this weapon—and the system had, at this juncture, no effective alternative— seemed appropriate not only in the light of the pre-1914 Bank of England practice but also in the light of economists’ views, now focused on this aspect of economic policy and henceforward exercising more influence on central bank thought.
Development of theory. Stemming directly from the quantity theory and the theory of the international price mechanism as formulated by the economists, and enlivened by controversies on the effects of changes in the production of the precious metals, monetary theory had in the first decades of the twentieth century attracted further interest from economists’ attempts to penetrate the mysteries of the trade cycle. Fisher in the United States, Marshall in Cambridge, Wicksell and Cassell in Sweden, and Fanno in Italy were prominent in developing this theoretical background of the first postwar policies of central banks. The grafting of this theoretical work on to the notions of the central bankers themselves, deriving from the practices of the im-mediate prewar period, can be seen in the English Cunliffe Report, of 1918. This report, aimed at the elimination of inflation and restoration of the international gold standard, pinpointed the central bank’s discount rate (Bank Rate) as the proper weapon. In advocating the use of Bank Rate, the Cunliffe Report concentrated not, as might have been supposed from prewar practice alone, on its influence on international capital movements, but on its influence in reducing the volume and use of credit internally, thus causing reductions in prices and employment.
The functions of central banks were now much under review; central banking became for the first time fully self-conscious; and the theory of the internal effects of Bank Rate changes quickly gained influence in many countries of the world. When, in the 1920s, new central banks were founded, or old ones were rechartered, discount rate was ac-corded the highest importance, even in countries where it could have little relevance to its traditional field of international capital movements.
In Britain, where the practical men found in its prewar success a reason for reliance on Bank Rate, and where it indeed still had some relevance to international capital movements, Bank Rate policy was given a new lease on life as the principal business of the central bank. Simultaneously, there was a great burst of interest among the theorists, especially Hawtrey and Keynes, in central banking in general and Bank Rate in particular. Hawtrey stressed the direct impact of Bank Rate on demand for working capital, while Keynes, along Wick-sellian lines, stressed indirect influence on the demand for fixed capital goods. Whether they leaned to Hawtrey or to Keynes, all alike among the econo-mists and practical men came to think of Bank Rate as having a pivotal place in the control of the internal situation of prices and employment; the conduct of the central banks was therefore of great interest in interpreting the difficulties of the restored international gold standard and in evolving national policies for stimulating revival after the breakdown of that standard.
Extension of powers. In the United States there was a similar trend in thought, but the upshot in practical central banking took rather a different turn, largely as a result of the radically different situation in which the Federal Reserve System found itself. The early postwar inflation, which the system had fought by high discount rates and other hindrances to the expansion of credit, was soon over, and the international trading position brought to the United States an unnecessarily large gold reserve. In an effort to overcome the technically weak position in which the reserve banks found themselves, the system stumbled into a great extension (from about 1922–1923) in its open-market operations. The effect of these operations on the reserves of member banks was at once realized and arrangements were made within the system to coordinate the open-market operations. This was the beginning of the Open Market Committee, now the effective policy-making body in the system. Thanks to the strength of classical views on changes in the quantity of money, the open-market operations quickly came to be regarded as a fairly direct way of operating on the internal price and employment situation, and not, as analogous operations in London had traditionally been, as merely technical devices for enforcing the central bank’s discount rate. With its strong balance of payments and excessive gold reserve, the Federal Reserve System was then able to develop its open-market operations, with discount rate policy in support, for the purpose of stabilizing the price level, this being regarded as the most effective way of averting cyclical fluctuations in output and employment. From some points of view, this radical development of American monetary policy, dating from about 1923, can be considered the beginning of genuine central banking. In the sense of there being avowed recognition of a complex of public (noncommercial) objectives, and a final break from reliance on semiautomatic indicators within the central bank’s asset structure, this is indeed the beginning of the self-conscious, discretionary central banking we know today.
The new turn in central banking in the United States was watched with great interest by authorities in other countries; along with the new British interest in the internal effects of Bank Rate, the American open-market operations became prominent in the literature of central banking. This literature included works by Keynes (Treatise on Money, 1930), Hawtrey, and leading United States economists both inside and outside the Federal Reserve System; there were important official inquiries in the United States (especially the “stabilization” inquiry), in Britain (the “Macmillan” Committee on Finance and Industry), and in the British Dominions. Much of this academic and official literature belongs to the restored gold standard period (1925–1931) and takes an international standard for granted.
Later, after the 1931 breakdown, central banks were also seen as advisers to governments on foreign exchange questions and as official operators in the foreign exchange markets. In the 1940s these functions were commonly extended to include administration of foreign exchange restrictions, and since 1945 the establishment of the International Monetary Fund and the elaboration of international cooperation generally have meant that frequent contacts with other central banks form an important function of a central bank.
In many countries, the disasters of the early 1930s prompted sharper assertion of the ultimate authority of political ministers for monetary policy and therefore, implicitly if not explicitly, for the activity of central banks. Another effect was extension of the technical powers of central banks, in the hope that a broader range of weapons would enable central banks more effectively to stem the contraction of bank credit in a slump. In the United States, where the system had proved a broken reed in the slump, no great change occurred in constitutional relationships, but the centripetal forces in the Federal Reserve System became stronger, changes were made in the power of the reserve banks to act as lenders of last resort, power to vary reserve ratios was introduced, and the system was given some control over stock market credit. Throughout the world, the crisis had the effect of shaking up thought on central banking, and it became normal to regard every country—or almost every country—as needing a central bank that would pursue a complex of aims with a wide range of technical weapons.
The central banks established since 1945—most of them in the emergent countries of Asia and Africa—have therefore been based on the view that the main business of a central bank is to control the monetary system in a way conducive to the broad economic policies of government (high levels of employment, economic growth, stable prices, foreign exchange stability, etc.) by exercising the following powers: (1) action as lender of last resort at an announced rate of interest (Bank Rate); (2) open-market operations; (3) fixing reserve requirements for commercial banks; (4) supervision of commercial banking; (5) banker to the government (generally involving important functions in relation to government debt); (6) adviser to the government on foreign exchange policy; (7) custodian of the country’s international reserves; (8) administrator of foreign exchange restrictions; and (9) dealer in foreign currencies and gold.
The relative importance attached to these powers varies greatly from country to country, in reflection of the varying histories, institutions, and prevailing economic doctrines in the different countries.
Regulation of credit. Importance is universally attached to the power of the central bank to avert a breakdown of the system, acting as lender of last resort. In most countries, however, this is no mere safety valve for operation in rare emergencies; the central bank commonly lends considerable amounts to banks at penalty rates of interest, and bankers therefore take note of the rates announced by the central bank. An elaboration of this Bank Rate weapon is the use of a scale of interest rates, rates higher than the basic rate being charged for successive tranches of assistance; or higher rates may be related not to the amount of lending but to some recent increase in the assisted bank’s lending to its customers.
Similar elaboration has been seen in reserve requirements, which are usually in the form of cash in hand and/or deposits at the central bank, but occasionally include also certain government securities. Normally these requirements are fixed as percentages of prescribed deposit liabilities. Until the 1930s such percentages were unvarying, but most central banks now have power to vary the percentages and other features of the requirements; in some European countries such variations have become frequent, especially where the central bank encounters technical difficulty in the use of open-market operations to vary the absolute levels of reserves available to the commercial banks. In addition to the basic percentage, a commercial bank may be required to make deposits (at the central bank) proportional to its “excess” lending to customers, or certain groups of customers; this elaboration of reserve requirements is particularly useful in action against an inflation that is being obviously fed by bank lending in particular directions.
Outside Britain and the United States, the scope for open-market operations (the immediate object of which is control of the absolute level of bank reserves ) has been narrowly limited by the absence of active markets in the classes of securities (primarily government short-term bonds and first-class short-term commercial paper) in which central banks are willing to deal. The Bank of Canada, however, has been outstandingly successful in fostering a market and then operating in it to control bank reserves. The National Bank of Belgium has also advanced notably along this line; so, in narrower limits, has the Netherlands Bank, but the central bank of West Germany has been notably impeded by the difficulty of any large-scale operations. In some other European countries, and in the emergent countries of Africa and Asia, central banks have not been able to do anything at all with this traditional weapon.
Central banks universally act as bankers for their governments, although the extent of these duties varies from one country to another. In some European countries this banker–customer relationship has allowed the authorities to operate on the reserve position of the commercial banks, in that the retention of an unusually large balance in the government’s account at the central bank has effectively prevented growth (from other origins such as influx of gold) in the reserves of the commercial banks, and vice versa.
As the government’s banker, the central bank advises the government on debt operations; and it has become usual for the government in such operations to heed the central bank’s view of the monetary repercussions of the debt operations. Usually the actual management of the debt is in the central bank’s hands; even where, as in the United States, it is deliberately kept out of the bank’s hands, there is cooperation between bank and Treasury.
Historically, some central banks established themselves largely by gaining from the government—in return for some financial support—privileges of note issue, which allowed them to become the principal, and sometimes the sole, issuers of bank notes in the country. Under nineteenth-century conditions, high importance came to be attached to control of the note issue, and the tendency in some countries has been to concentrate the note issue exclusively in the central bank. With the development of commercial banks and other credit institutions, the note issue has lost its former pivotal position, but management of the note issue remains one of the important routine functions of the central bank.
International functions. Under the gold standard conditions prevailing in the late nineteenth century and the early twentieth century, the notes issued by the central bank were freely convertible into gold (at fixed rates) and gold into notes, and the holding of a gold reserve—eventually the country’s principal or only gold reserve—by the central bank was thus incidental to its function as issuer of notes. After the breakdown of the gold standard in 1931, foreign exchange rates became flexible and matters of great political interest, and central banks became more active in foreign exchange markets. Foreign exchange restrictions then and later were administered by, or in consultation with, central banks. Under the International Monetary Fund system ruling since 1946, central banks have been responsible for maintaining the foreign exchange rates within the agreed narrow limits, and in some countries (notably England) they have been active in futures markets in foreign currencies. With the development of international monetary cooperation throughout the postwar period, this side of central banking has been accepted as an essential part of management of a country’s monetary system. It is significant that in the United States discussion of foreign exchange business has become, alongside domestic open-market operations and discount rates, the regular business of the Federal Open Market Committee.
In the 1920s, in the Sterling Area, contact with the new central banks in the British Dominions was cultivated by Montagu Norman, governor of the Bank of England; since 1939 the contacts and cooperation between the central banks (now much more numerous) of the Sterling Area have been continuous. Between European central banks (including the Bank of England) contacts have been developed especially in the monthly meetings of the Bank for International Settlements at Basel. European central bank cooperation received great impetus in the management of the European Payments Union; and the arrangements of the European Common Market, under the Treaty of Rome, involve consultations that may develop into concerted action.
Varied philosophies. While these international functions of central banks have been rapidly developing in the same direction in all countries, and the pattern of technical powers of domestic operation has been becoming almost common form throughout the world, the philosophy of central banks has shown little sign of falling into a common pattern. Only a systematic survey of a large number of countries would fully expose the range of ideas; the more important ideas can, however, be found in the development of central banking in the United States and in England.
The Federal Reserve. In the United States, since 1951, Federal Reserve control has been directed primarily at the availability of credit. The reserve requirements of the commercial banks, fixed by the Federal Reserve, are mostly held stable, and the excess reserves of commercial banks increased, and their indebtedness at the reserve banks decreased, by purchases of short-term paper in the market, whenever an expansion of credit has been thought appropriate, and vice versa. Movements of the discount rate have been comparatively rare: when expansionist forces in the economy pull market rates of interest up, so that banks are inclined to lend freely even when their reserve positions are tight, the Reserve System raises the discount rate; correspondingly, the Reserve System reduces its rates, in times of slack trade, in order to reinforce the stimulus of easy reserve conditions in the banking system.
The open-market operations through the earlier years of this period were ordinarily confined to short-term government paper. Federal Reserve authorities held that this sufficed for their purpose, since their concern was with member bank reserves and not with the structure of interest rates. This was the famous “bills only” doctrine; in support, it was further argued that any proper effects on longer-term interest rates would be transmitted from the short end of the interest rate spectrum by the normal arbitrage adjustments of a free market, and that official intervention at the long end of the market would almost certainly give rise to false expectations and so would undesirably distort the structure of interest rates.
At the end of the 1950s the development of a serious balance-of-payments problem in the United States destroyed the simplicity of aims of monetary policy. Conflict appeared between the internal aim of promoting full employment in a growing economy and the external aim of maintaining the international demand for dollars; the Reserve System was then forced to attempt a reconciliation of easy credit conditions and steady low long-term interest rates with some rise in short-term rates. Under the pressure of this conflict, the bills-only doctrine gave way and the authorities began to operate on a large scale in medium-term and long-term securities. Whether they succeeded in making the structure of interest rates different from what it would have been is much disputed; the facts are inconclusive.
This modification of Federal Reserve doctrine, under the pressure of events, nevertheless leaves unchanged the position that the system’s crucial powers are considered to be, in open-market operations, the fixing of reserve ratios for the member banks, and the fixing of the discount rates at which member banks can, by borrowing at the reserve banks, replenish their reserves. It is by the exercise of these powers that the Reserve System conditions the attitude of the commercial banks in lending to business firms throughout the country, and this is regarded as the main duty of the system.
In addition to these general methods of regulating the banking system, the Federal Reserve System has special powers to regulate the credit terms on which transactions in stock market securities are financed. The system was given these powers to enable it to attack directly any repetition of the 1928–1929 stock market boom. At times the system has been authorized to prescribe terms on which installment credit and certain real estate credit could be extended, and also to encourage lenders to restrict other types of credit voluntarily. Since 1951, although the stock market credit regulations have been used, all these possibilities of “selective” credit control have been rather out of fashion in the United States. This has been partly because the Federal Reserve authorities have felt themselves exposed to political pressures from sectional interests hurt by such controls. But the attitude has also been partly due to the confidence the Reserve System has felt in its broader powers to control the banking system and its belief that this is the proper business of the central bank. In many other countries, where the central bank has less confidence in its general powers, comparable measures of selective credit control have been greatly developed since 1945.
Another important activity of the Federal Reserve System is in the foreign exchange market. This activity, begun during World War i, was given new impetus by the events of the middle 1930s, and has been greatly developed since the International Monetary Fund was established and especially as part of the intensified international monetary cooperation that characterized the years 1958 to 1963.
Finally, the Federal Reserve System has extensive powers of inspection of its member banks. These powers have existed from the outset, and have been exercised not for direct support of the system’s monetary policy but for the promotion of “sound” commercial banking.
For its own guidance in exercising all these functions, the Reserve System maintains a distinguished research division. The material produced by this division, besides being used internally, is in large part published. This is part of the effort of the system to foster an informed public opinion, an objective also sought by the efforts of the system’s governors and officials to keep in touch with the banking and commercial communities all over the country.
The Bank of England. During the period 1951 to 1963, the functioning of the Bank of England has been quite different from that of the Federal Reserve System. The difference has been mainly due to the constant preoccupation of the Bank of England with the balance of international payments, a preoccupation that reinforced the traditional primacy of Bank Rate. At first the tradition itself was important, in that the use of Bank Rate affected international confidence in sterling and so had useful effects on international capital flows. Later, especially after 1958, Bank Rate operated in the traditional way of regulating international interest rate differentials. Although the Bank was moving Bank Rate primarily for the sake of influencing international capital movements, it has also entertained some hope that the changes in Bank Rate would affect the pressure of internal spending; in the 1950s these two objectives did not conflict.
Open-market operations have been further developed, particularly at the long-term end of the market. In the short-term market there has been no important departure from the pre-1939 and wartime technique. The Bank of England has operated to keep short-term rates in the desired relationship with Bank Rate; since 1951, this control has included action as lender of last resort (“front door” operations) as well as trading at rates below Bank Rate (“back door” operations). The implication of this technique is that the commercial banks’ liquid assets ratio (conventionally “the 30 per cent ratio”) rather than the cash ratio (8 per cent) has been the fulcrum for central bank influence on commercial bank liquidity. This has given new importance to operations in longer-term securities. These operations, carried out on the stock exchange by the Government Broker under daily instruction from the Bank, are at once the technical channel for management of the national debt and a device for operating on the reserve positions of the commercial banks. In effect, the Bank increases bank liquidity when the Government Broker buys bonds and decreases bank liquidity when he sells bonds. Throughout most of the postwar period, the desire of the authorities has been to reduce bank liquidity by selling more bonds and longer bonds, and to replace Treasury bills or very short bonds: this policy is usually referred to as “funding.”
In pursuing its funding policy, the Bank has tried to avoid appearance of manipulation of market prices of securities. Unfortunately, since the Bank’s policy on short-term rates tended over the 1950s to cause a gradual rise in long-term rates, the Bank was for long periods operating in a falling market and found itself unable to sell any large volume of longer-term bonds. It therefore continued to be embarrassed by the high level of liquid assets in the commercial banks. Concerned that this could add to inflationary pressures, the Bank, until 1960, resorted to increasingly stern instructions, of an informal kind, limiting lending by the commercial banks. Such instructions have been easy to use in England, where the banking system is characterized by geographical, political, and intellectual concentration. Complaints that these controls were ineffective and unfair, because as lenders the banks are competing with a variety of other financial intermediaries, have been met by extension of the range of financial intermediaries to which “requests” are addressed by the Bank of England.
Another innovation precipitated by the relative failure of the funding policy has been the imitation of a device common in other central banks, including the Federal Reserve: this is the variation of percentage reserve requirements imposed on the commercial banks. Throughout the 1950s, the Bank of England adhered to the percentages evolved by the commercial practices of the London Clearing banks: a fixed 8 per cent cash rate and a minimum of 30 per cent liquid assets. In 1960, however, a fresh bout of restriction was decided upon, at a time when the Bank’s funding operations had still not entirely eliminated the excess liquidity of the commercial banks. The Bank raised the reserve requirements, eventually by 3 per cent, by requiring the banks to make “special deposits” at the Bank of England. Two aspects of this special deposits system are noteworthy. First, the arrangements were made without any legal change, and the details were agreed upon between the Bank and the commercial banks. Second, although at the outset the banks were given no instructions as to how to adapt themselves to the raised requirements, when the weapon was pressed furthest (to 3 per cent) the banks were told precisely how they were to react. The new device had already become a piece of ritual, and the really effective step was the direct instruction to the banks on their lending policies. As much as ever before, the English authorities rely on moral suasion as a major technique.
When relaxation became appropriate in 1962–1963, the special deposits were reduced (by stages) to zero, and then the 30 per cent liquid assets ratio was reduced to 28 per cent. Announcement of this change implicitly left open the possibility of further flexibility in reserve requirements.
The Bank of England has also during the postwar period shown willingness to consider long-term interest rates as its proper concern. Until about 1955, the Bank’s attitude was that its direct responsibility in interest rates was limited to the short end. This did not imply any denial of the Wicksell–Keynes view of long rates as instruments for controlling, via fixed investment, the pressure of total demand; rather it was that the Bank thought of itself as influencing long rates only through its action at the short end of the market (including both Bank Rate policy and its action on bank liquidity). From about 1957, however, the Bank began to pay some regard, in its operations in the gilt-edged market, to the possible effects of these operations on long rates. This shift of emphasis did not, however, go very far, and there appears to have been some retreat from it in 1962–1963.
Until the postwar period, the Bank of England was an extremely secretive body. At first this was because its business was essentially that of a private banker, but the tradition continued long after its public duties became paramount. In the postwar period, this attitude was strongly and persistently attacked, and a change has been evident. This change, associated with an effort to improve the economic information on which policies may be based, is to be seen in the Bank’s quarterly bulletin. Thus, both the world’s leading central banks now appear to accept the view that an informed public opinion is the surest foundation for monetary policy.
The developments in the functioning of the Bank of England, described in these paragraphs, indicate that England has gone appreciably further than the United States in accepting the view that both the ends and the means of central banking are multiple and that there can therefore not be any golden rule for its conduct.
R. S. Savers
Aschheim, Joseph 1961 Techniques of Monetary Control. Baltimore: Johns Hopkins Press. → The best detailed study of central banking techniques but almost exclusively related to American practice.
Bank for International Settlements 1963 Eight European Central Banks. New York: Praeger. → Shows how central bank officials see the institutions in which they work.
Burgess, Warren R. 1927 The Reserve Banks and the Money Market. New York: Harper.
Chandler, Lester V. 1958 Benjamin Strong: Central Banker. Washington: Brookings Institution.
Clay, Henry 1957 Lord Norman. New York: St. Martins.
Commission on Money and Credit 1961 Money and Credit: Their Influence on Jobs, Prices, and Growth. Englewood Cliffs, N.J.: Prentice-Hall.
Crick, Wilfred F. 1965 Commonwealth Banking Systems. Oxford: Clarendon.
Federal Reserve Bulletin. → Published since 1915 by the Board of Governors of the Federal Reserve System.
Goldenweiser, Emanuel A. 1951 American Monetary Policy. New York: McGraw-Hill.
Great Britain, Committee on the Working of the Monetary System 1959 Report. Papers by Command, Cmnd. 827. London: H.M. Stationery Office. → Known as the Radcliffe Report. Includes material from other countries.
Hardy, Charles O. 1932 Credit Policy of the Federal Reserve System. Washington: Brookings Institution.
Hawtrey, Ralph G. (1932) 1962 The Art of Central Banking. 2d ed. London: Cass. → Provides important material on British experience.
Keynes, John Maynard (1930) 1958–1960 A Treatise on Money. 2 vols. London: Macmillan. → Volume 1: The Pure Theory of Money. Volume 2: The Applied Theory of Money. Provides a pre-1935 view of central banking in the United States and Britain.
Kisch, Cecil H.; and Elkin, Winifred A. (1928) 1932 Central Banks: A Study of the Constitutions of Banks of Issue, With an Analysis of Representative Charters. 4th ed., rev. & enl. London: Macmillan. → Documents central banking statutes in the interwar period.
Plumptre, Arthur F. W. 1940 Central Banking in the British Dominions. Toronto Univ. Press; Oxford Univ. Press. → The best study of early central banking in the less developed systems.
Reed, Harold L. 1922 The Development of Federal Reserve Policy. Boston and New York: Houghton Mifflin.
Reed, Harold L. 1930 Federal Reserve Policy: 1921–1930. New York: McGraw-Hill.
Riefler, Winfield W. 1930 Money Rates and Money Markets in the United States. New York: Harper.
Ritter, Lawrence S. 1962 Official Central Banking Theory in the United States, 1939–1961; Four Editions of the Federal Reserve System: Purposes and Functions. Journal of Political Economy 70:14–29.
Sayers, R. S. 1957 Central Banking After Bagehot. Oxford Univ. Press.
Sayers, R. S. (editor) 1962 Banking in Western Europe. Oxford Univ. Press.
[U.S.] Board of Governors of the Federal Reserve System (1939) 1963 The Federal Reserve System: Purposes and Functions. 5th ed. Washington: The Board.
U.S. National Monetary Commission 1909–1912 Publications of National Monetary Commission. 24 vols. Washington: Government Printing Office. → Includes material on early developments throughout the world.
Willis, Henry P. 1923 The Federal Reserve System: Legislation, Organization and Operation. New York: Ronald.
Central banks came into being in Europe in the late seventeenth century (Sweden in 1668, England in 1694) as government sponsored banks that were either state-owned (Swedish Riksbank) or privately owned (Bank of England). Their initial functions were basic in nature: giving financial support to the state in return for legislative advantages and monopoly power in the banking business. Central banks were also established to help centralize and standardize payments systems in countries such as Italy, Germany, and Switzerland, and, in Austria in 1816, to restore the value of the currency after government overspending during the Napoleonic wars. Regardless of the initial functions assigned to central banks, they slowly evolved into bankers’ banks—in addition to being the government’s bank—by becoming the main reserves depository institutions for the banking system.
Theories on central banking did not emerge until the late nineteenth century, when it was recognized that discretionary monetary policy had macroeconomic consequences for domestic economic activity as well as international trade balances, especially with regard to exchange rate policies under the gold standard, which was a commodity-money system since the currency was backed by gold reserves at the central bank (and the Bretton Woods system in the twentieth century, under which the U.S. dollar replaced gold as the international reserve currency). One of the early analysts of central banking, Walter Bagehot (1826–1877), founder of The Economist magazine, argued in his famous Lombard Street (1873) that central bankers are incapable of thinking theoretically about the daily transactions they engage in.
Central banks play a crucial role in macroeconomic policy by acting as a lender of last resort to the banking system and by regulating and supervising the financial system. Policy priorities and the emphases of policies, however, differ depending on the theoretical framework from which central bank economists draw their policy inspiration.
Mainstream Approach The mainstream (neoclassical) approach argues that central banks should focus on price stability through money-supply targeting or inflation targeting. According to the logic of this argument, money is neutral in the long run; therefore any increase in the quantity of money would only lead to inflation in the long run. The mainstream approach recommends that the central bank be completely independent from the fiscal authority to prevent monetary expansions by irresponsible governments. Instead, the central bank is commissioned to expand the money supply steadily at a pre-announced rate (a monetary rule). This approach relies on the assumption that the central bank can actually control the quantity of money (verticalist or exogenous money approach) through the three traditional monetary tools: required reserve ration, discount rate, and open market operations. Hence the central bank can increase the quantity of money by decreasing the required reserve ratio, decreasing the discount rate, or buying bonds; and it can decrease the money supply by doing the opposite. The neoclassical view holds therefore that the quantity of money is exogenously determined by the central bank, whereas the interest rate is an endogenous variable determined by the interaction between money supply and money demand. This neoclassical model came under attack during the Great Depression by Cambridge University economist John Maynard Keynes, and later by the followers of the Keynesian revolution.
Post-Keynesian Approach The Post Keynesian approach, by contrast, argues that the money supply is an endogenous process over which the central bank has no control. The quantity of money is driven by the demand for credit by the private sector. The demand for credit is systematically accommodated by profit-seeking banks regardless of the required reserves available to them (horizontalist approach). In a fractional reserve banking system, financial innovation is the key to a successful banking operation. Banks usually extend credit to creditworthy customers, then worry about meeting their reserve requirements. Reserve requirements can be met by borrowing from domestic or foreign banks, by selling financial assets, signing repurchasing agreements with other financial institutions, shifting checking account balances to low-reserve requirement savings accounts, and, as a last resort, borrowing from the central bank (the lender of last resort). Post-Keynesian economists argue that the central bank has no control over an expanding economy, as it is the demand side that is pulling reserves from the central bank, with the latter being compelled to accommodate the market or else risk a financial crisis. For instance, a rapidly expanding economy requires a credit expansion by the entire banking system; the latter will face an inevitable shortage of reserves, thus driving up short-term interest rates above the central bank’s target rate. The central bank must therefore intervene by providing liquidity to the market to prevent financial instability due to rising interest rates. The Post-Keynesian approach holds that the central bank’s policy target cannot be the quantity of money, but rather the short-term interest rate that serves as a benchmark for the entire economy. Hence the interest rate is set exogenously while the quantity of money is an endogenous phenomenon.
Major financial crises have been prevented through central bank intervention as a lender of last resort, as for example after the September 11, 2001, attacks in the United States. In anticipation of a panic after the reopening of financial markets, the Federal Reserve Bank in an emergency meeting lowered its short-term interest rate target by fifty basis points; but most important, it snapped up all government securities offered by dealers, thus pumping up a record sum of $70.2 billion on September 13, 2001. As Paul Davidson notes in his 2002 book, the liquidity injection served not only to prevent a bond-market crash but also to reinstate positive expectations about the stability of the financial system.
Central bank leaders also play a crucial role in the formation of market expectations. Financial investors pay close attention to statements made by central bank officials because they know that central bankers have access to more accurate economic information and unpublished economic indicators, in addition to being in charge of key interest rates that act as benchmarks for the rest of the economy. If, for instance, investors detect a signal from the central bankers suggesting that the central bank is worried about inflation acceleration, and that the central bank is about to raise interest rates, then one would expect bond prices to go up, thus encouraging bond investors to buy more bonds and sell them at a later date; the reverse would ensue if investors were led to believe that the central bank was about to lower interest rates.
The advocates of central bank independence argue that politicians cannot be trusted to make the tough political decisions as they tend to give in to political pressures, thus only an independent central bank can take action without fear of political retaliation. An independent central bank is expected to slow down the economy by raising interest rates when the unemployment rate drops low. This neoclassical argument rests on the idea that there is a trade off between unemployment and inflation, and that low unemployment rates will inevitably lead to accelerating inflation.
In addition to improved credibility and transparency, central bank independence favors the implementation of monetary rules. This is based on the New Classical view that money is neutral and that monetary policy is ineffective. The Lucas policy ineffectiveness argument states that any anticipated monetary policy will not affect output (thus will not affect employment). The policy ineffectiveness argument does not hold in the case of long-term labor contracts because policymakers in this case can change their behavior (for instance, the central bank can cheat on the announced rate of growth of the money supply). Thus a systematic monetary policy can have real effects. Finn Kydland and Edward Prescott (1977) argue that private agents are rational and thus expect the central bank to reoptimize its (previously announced) policy in the future. In game theory terms, this can be illustrated in a noncooperative Stackelberg game in which the central bank is the leader (it has private information and could change its policy at almost any time) and the private agents are the followers. This will lead the economy to a time-consistent suboptimal (Nash) equilibrium in which the social welfare function is not optimal, even though both the leader and the followers have tried their best to maximize their own respective utilities. It is noteworthy that the concept of the monetary authorities’ credibility is of critical importance to the dynamic game described above, if the central bank wishes to implement a monetary rule rather than discretionary monetary policy because of the repeated aspect of the game.
Between 1970 and 1982 New Classical economists demonstrated that anticipated monetary policy is ineffective because economic agents are rational. During that period they produced a substantial literature explaining business cycle fluctuations in terms of the rational expectations hypothesis and supply-side (mainly technological) shocks. The rational expectations hypothesis states that economic agents’ subjective expectations concerning economic variables will coincide with the true or objective mathematical conditional expectations of those variables. This assumption should not, however, be considered as synonymous with perfect foresight. Rational expectations in the forward-looking approach (as opposed to the backward-looking approach of the adaptive expectations) imply that economic agents will use the publicly available information and will not systematically form wrong expectations. William Nordhaus used this approach to show that “a perfect democracy with retrospective evaluation of parties will make decisions against future generations” (1975, p. 187). Politicians can use an expansionist monetary policy during an electoral period in order to reduce unemployment and thereby collect more votes. Once reelected, the government can start fighting against the inflation caused by money expansion and therefore push unemployment probably above its initial level. Governments succeed in making use of this political business cycle because the public has a short memory and will not recognize the use of this policy during the next election. The political business cycle theory represents a major argument for central bank independence, meaning that an independent central bank is more likely to implement a noninflationary monetary policy that is consistent with the stability of the general level of prices. The empirical evidence, however, does not show any significant correlation between central bank independence and inflation. In fact, one of the key variables used to measure the central bank independence index is inflation. This approach tends to reduce inflation to expansionary monetary policy and does not take into account other factors such as price-setting power and external shocks in international commodity markets.
Central banks in developing countries face considerable challenges. The conventional wisdom argues that developing countries must maintain a steady inflow of financial capital to finance their savings gap and to fuel the process of economic development. To ensure such conditions, the central bank has to keep inflation low and stable and the exchange rate pegged to a basket of hard currencies, and in some cases to a single hard currency such as the U.S. dollar or the euro. Such strategies entail keeping interest rates high and the value of the currency artificially overvalued—thus the need to accumulate hard currency reserves to defend the value of the currency. Most developing countries, however, run trade deficits that must be financed through borrowing in hard currencies, which accounts for most developing countries’ recurring external debt problem. In order to prevent financial crisis, the central bank is then obliged to cater to the needs of financial markets by keeping interest rates artificially high, which helps create an inadequate climate for domestic investment. This neoliberal view has dominated central banking in developing countries since the 1980s. The primacy of the low-inflation goal over other macroeconomic goals has crippled many economies in the developing world. As Gerald Epstein (2005) argues, this approach stands in sharp contrast to what central banks have historically done in both developed and developing countries, namely financing government spending, promoting full employment, managing exchange rates, enforcing capital controls, and allocating credit to sectors of special social need such as health care, education, and housing.
Post Keynesians argue that the central bank can help coordinate the achievement of full employment in both developed and developing countries. Because the government is the monopoly-issuer of its sovereign currency, it follows that there can be no financial constraint on government spending. Money is injected into the system through government spending, and is withdrawn from it through taxation or bond sales. Bonds are not issued to “finance” government deficits, but rather to give the private sector an interest-bearing alternative to cash. The government accepts its own money in payment of tax liabilities, hence creating a demand for the sovereign currency. The value of money then depends on the government’s (and the central bank’s) capability to manage the quantity of money and the level of interest rates in the economy. From this perspective, the government can finance a full employment program by offering to hire anyone at a fixed, socially established living wage to perform socially desirable tasks that the private sector would not otherwise perform. The role of the central bank becomes crucial in financing the program, managing the national debt, and adopting a flexible exchange rate regime. As L. Randall Wray (1998) observes, the central bank independence mantra becomes meaningless if one accepts the necessity of policy coordination between the treasury and the central bank in order to accommodate the economy.
SEE ALSO Business Cycles, Real; Economic Crises; Economics, Keynesian; Economics, Neoclassical; Economics, New Classical; Economics, Post Keynesian; Expectations, Rational; Federal Reserve System, U.S.; Financial Markets; Full Employment; Game Theory; Inflation; Interest Rates; Macroeconomics; Monetarism; Monetary Base; Monetary Theory; Money; Nash Equilibrium; Policy, Monetary; Unemployment
Bagehot, Walter. 1873. Lombard Street: A Description of the Money Market. New York: Wiley, 1999.
Davidson, Paul. 2002. Financial Markets, Money, and the Real World. Cheltenham, U.K., and Northampton, MA: Edward Elgar.
Epstein, Gerald. 2005. Central Banks as Agents of Economic Development. Political Economy Research Institute, University of Massachusetts at Amherst. Working Paper Series no. 104 (September).
Goodhart, Charles. 1988. The Evolution of Central Banks. Cambridge, MA: MIT Press.
Keynes, John M. 1936. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace.
Kydland, Finn E., and Prescott, Edward C. 1977. Rules Rather than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy 85 (3): 473–492.
Lavoie, Marc, and Mario Seccareccia, eds. 2004. Central Banking in the Modern World: Alternative Perspectives. Cheltenham, U.K., and Northampton, MA: Edward Elgar.
Lucas, Robert E. 1975. An Equilibrium Model of Business Cycle. Journal of Political Economy 83: 1113–1144.
Moore, Basil J. 1982. Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge, U.K., and New York: Cambridge University Press.
Nordhaus, William D. 1975. The Political Business Cycle. Review of Economic Studies 42 (2): 169–190.
Wray, L. Randall. 1998. Understanding Modern Money: The Key to Full Employment and Price Stability. Cheltenham, U.K., and Northampton, MA: Edward Elgar.
Central Bank (Issue)
CENTRAL BANK (ISSUE)
The idea of the central bank in the newly formed United States arose as the dusk of eighteenth-century mercantilism turned into the dawn of nineteenth-century laissez-faire economics. Its existence raised numerous issues of states rights, federal power, and the national currency. After Andrew Jackson's determination to put an end to the Second Bank of the United States during his "Bank War" of 1832 and the Panic of 1837 a few years later, the question of a central bank wasn't seriously raised again until the financial insecurities and social displacements of industrialization at the beginning of the twentieth century forced the government to establish the Federal Reserve Bank in 1913.
But for well over a century, the dispute raged between advocates of a decentralized banking system and proponents of a strong central bank. The former argued that a national bank was dangerous because it concentrated the power of granting loans and expanding currency into the hands of a relatively small group of men who would follow private rather than national interests. They argued that a large number of small state or commercial banks would better serve the nation, its people, and the economy by responding to local conditions while preventing the concentration of such powers. But proponents of a central bank disagreed. They argued that a central bank was necessary to enlarge the national manufacturing base, maintain a stable currency, and keep up with the demands of a country whose boundaries and peoples increasingly pushed westward. For them, a central bank could keep the amount of currency in circulation flexible and provide the capital and credit needed to meet the demands of population increases, territorial expansion, and heavy industrialization.
Largely through the efforts of Alexander Hamilton, the First Bank of the United States, modeled after the Bank of England, was established in 1791 and was chartered for a period of twenty years. It was a private corporation with $10 million in capital, governed by twenty-five directors, and like other commercial banks, could print notes and exchange them for borrowers' interest-bearing promises to pay. It could also extend loans to individuals and companies. But unlike other private banks, the federal government was a central partner in the enterprise. The government owned 20 percent of the Bank's holdings while the Bank served as a fiscal agent for the government. The Bank held tax receipts, paid government bills, and performed various other financial tasks. It lent money to the government and provided convenient depositories in the leading seaports like New York, Boston, Baltimore, and Charleston, where most of the federal revenues were collected. It also served the Treasury by transferring funds safely and cheaply from place to place, and facilitated the payment of taxes by increasing the supply of currency. As a partner, the government granted it special privileges unique among other state banks. It kept its cash as deposits with the Bank, giving it a huge financial base. The government borrowed from the Bank, paid it interest for the use of its notes, and also shared its profits.
According to its charter, the Bank was allowed to operate in all states, which gave it a considerable edge over state banks that could only operate in the states that chartered them. Because of this large banking network in various parts of the country and in its role as creditor, the Bank was able to hold as assets more notes issued by state banks than those banks held of their own.
Overall, the First Bank was profitable averaging 8 percent per year rate of return for those that invested in it. It succeeded in maintaining the stability of currency, in meeting government expenses, and in preventing the drain of specie from the country.
But even so, in 1812 opposition from various quarters was strong enough to prevent it from being rechartered. Thomas Jefferson and John Randolph from Virginia questioned its constitutionality, and Henry Clay from Kentucky feared the concentration of financial power. Others feared that it posed serious hurdles to the growth and spread of state banks, while an increasingly large faction criticized the growing influence that foreign investment placed on the Bank. In the end, the Bank's charter was revoked in the Senate by a tie-breaking 18-17 vote.
But within five years, federal debt associated with the War of 1812 and inflation caused in part by the rise of unregulated state banks forced Congress to reconsider its earlier decision. The Second Bank of the United States was chartered in 1816 along the same lines that the first had been. Eighty percent of its $35 million capital was private, paid in specie, 20 percent was federal, paid in government bonds, and the Bank was made the depository of government funds and also the fiscal agency of the United States. Note issues could not exceed total capital, were receivable in all payments to the United States, and were redeemable in specie on demand. It was intended that state banks would have to resume specie payments or their notes would be driven out of circulation. After the Bank's charter was granted, additional legislation was enacted to help promote specie resumption in general: all payments to the government after February 20, 1817 had to be made in coin, Treasury notes, United States Bank notes, or other convertible bank notes.
Politicians in many of the states blamed the Second Bank for the Panic of 1819. Maryland, Tennessee, Georgia, North Carolina, Kentucky and Ohio enacted laws to tax branches of the Bank out of existence. But in two Supreme Court decisions, McCulloch v. Maryland (1819) and Osborne v. United States Bank (1824), Chief Justice John Marshall declared the state acts unconstitutional.
Under the presidency of Langdon Cheves (1819-1823) and Nicholas Biddle (1823-1836), the Second Bank recaptured the standing that the First once had within the banking community. Under Biddle, the Bank and its twenty-nine branches became an effective regulator of the expanding economy. The Bank marketed government bonds, served as a reliable depository for government funds, and its bank notes provided the country with a sound paper currency. But because the Bank forced state banks to back their notes with adequate specie reserves, many, especially President Andrew Jackson, believed that this was too much power. They were afraid that the Bank's control over short-term credit was not subjected to sufficient government regulation, and that state banks risked termination under such a system. By the time of Andrew Jackson's presidency, the Bank had antagonized both those who favored "soft money" (more state-bank notes) and those who favored "hard money" (only gold and silver coins). "Soft money" proponents including land-speculators, small entrepreneurs, and anyone who was in debt felt their needs were best served with an abundant paper currency while Eastern workingmen resented receiving their wages in paper of uncertain value. On the other hand, many "hard money" advocates were hostile to banks of any kind, state or national, that issued bank notes and they tended to look upon banking in general as a parasitic enterprise.
During the Bank War, Biddle was unable to prevail over President Jackson and renew the Bank's charter with the federal government. He was, however, able to obtain a charter from the state of Pennsylvania. But during the Panic of 1837 the reorganized bank suspended specie payment and failed completely in 1841. In its absence, the number state banks rose dramatically across the country. The victorious Andrew Jackson termed these banks his "pet banks."
The charter of the Second Bank did not assign to it the public responsibilities of a central bank, as did the legislation that created the Federal Reserve System a century later. Instead, the Second Bank was responsible to its own investors, and its chief function was to earn dividends for them. Many state banks resented it not only because it forced them to maintain adequate specie reserves but also because its federal charter gave it a considerable competitive edge.
By the time that the Federal Reserve System was established under the Woodrow Wilson administration in 1913, the financial anarchy of an unregulated banking system had settled the question of the legitimacy of the central bank. In constructing the modern banking system, the Federal Reserve, established after the Panic of 1907, had two basic functions. Along with other federal agencies, it helped to investigate and insure the financial soundness of private banks. As lender of last resort, it protected banks against insufficient funds (liquid assets) when those banks were forced to cover the withdrawal demands of their depositors. This lessened the self-fulfilling fear of "bank runs," when depositors lost faith in the ability of the banking system to cover their deposits. The Federal Reserve also monitored and controlled the national money supply. It could order changes in the percentages of bank assets held as reserve. This, in turn, controlled the ability of the nation's banking system to create money by making loans. It could also affect the money supply directly by buying and selling government bonds in the market. This gave the federal government an extremely important ability to encourage growth in a sluggish economy (by creating credit) or to slow down an inflationary economy (by restricting credit). Thomas Jefferson and Andrew Jackson might not have approved, but Alexander Hamilton and Nicolas Biddle got the last laugh.
Redlich, Fritz. The Molding of American Banking: Men and Ideas. New York, Johnson Reprint Corp., 1968.
Timberlake, Richard H., Jr. The Origins of Central Banking in the United States. Cambridge: Harvard University Press, 1978.
White, Eugene. "The Membership Problem of the National Banking System." Explorations in Economic History, 19, 1982.
——. The Regulation and Reform of the American Banking System, 1900–1929. Princeton: Princeton University Press, 1983.
the tendency of a national bank is to increase public and private credit. industry is increased, commodities are multiplied, agriculture and manufacturing flourish, and herein consists the true wealth and prosperity of a state.
alexander hamilton, second report on public credit, january 1790
The Central Committee was one of the central institutions in the Communist Party of the Soviet Union (CPSU), along with the Politburo, Secretariat, party congress, Central Auditing Commission, and Party Control Committee. Given the political system's centralist, monolithic aspirations, these central institutions bore heavy responsibilities. One of the Central Committee's main functions was to elect all Party leaders, including members of the Politburo and Secretaries of the Central Committee. The Committee—whose members included powerful people in the Communist Party—met every six months in plenary session to approve decisions by the top levels of the party.
The Central Committee was also considered to be the highest organ of the party between congresses (the period known as the sozyv ). According to the party rules (Ustav ), the Central Committee was supposed to "direct all the activities of the party and the local party organs, carry out the recruitment and the assignment of leading cadres, direct the work of the central governmental and social organizations of the workers, create various organs, institutions, and enterprises of the party and supervise their activities, name the editorial staff of central newspapers and journals working under its auspices, disburse funds of the party budget and verify their accounting."
However, the Central Committee was large; in 1989, for example, it consisted of more than three hundred members. In actuality then, there were two Central Committees. One of them was the body of elected representatives of the Communist Party. The other was the name used in documents produced for and by any number of smaller Central Committee bodies, from the Politburo to the temporary commissions. Thus, the decrees of the Central Committee were seldom prepared by that body. Instead, the Politburo often initiated, discussed, and finalized them.
See also: communist party of the russian federation; communist party of the soviet union; politburo; secretariat
Schapiro, Leonard Bertram. (1960). The Communist Party of the Soviet Union. New York: Random House.