Michael D. Bordo, Rutgers University and NBER

Paper prepared for the Norges Bank Symposium “What is a Useful Central Bank?”; Oslo, Norway; November 18, 2010

Long-Term Perspectives on Central Banking

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IntroductionThe recent global financial crisis has led for calls

by some to remake the model of central banking to focus much more on financial stability

Others argue that central banks should stick to the successful model that led to the Great Moderation and should continue to attach ultimate importance to maintaining credibility for low inflation

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Introduction (cont.)Financial stability concerns should be treated

separately by a Financial Stability authority or if based within the central bank by statute, should be managed by tools other than the policy rate

This essay takes an historical perspective to consider whether we need to rewrite the central banking rule book

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Introduction (cont.)I argue that central banking evolved into a golden

age of following credible rules to maintain price stability and serve as a LLR during the classical gold standard from 1870-1914

The Great Depression threw central banks into the dark ages, a fate created largely by their adherence to bad doctrine and the flawed interwar gold exchange standard

central banks lost their independence and became adjuncts of the fiscal authorities

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Introduction (cont.)Central banks regained their independence

starting in the 1950s, but lost it again with the Great Inflation

The renaissance of central banking followed the Volcker/Thatcher shocks of 1979-1981 led to new regime of a credible nominal anchor in a fiat money regime based on rules similar to the gold standard convertibility rule

This led to the Great Moderation from the 1980s to 2007

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Introduction (cont.)The recent global crisis stemmed from policy

failures in the USDespite the crisis, central banks should stick to

the tried and true rules for central banking that have evolved through history

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The Origins of Central BankingThe story of central banking goes back to the

Swedish Riksbank (1668) and the Bank of England (1694)

Both were chartered as note issuing joint stock banks to lend to the government

Early central banks became bankers banks which ultimately allowed them to become LLR

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The Origins of Central Banking (cont.)Monetary policy began by central banks

discounting the paper of other financial institutions. The discount rate could influence credit conditions in the economy

Central banking achieved its maturity during the classical gold standard

The key rule for a central bank under the gold standard was to adhere to convertibility of its notes in terms of gold at the official fixed parity (except in wartime or serious financial crises)

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The Origins of Central Banking (cont.)The classical gold standard had automatic

mechanisms to ensure long-run price stabilityHence adhering to gold convertibility ensured

price stabilityThe gold standard was a commitment mechanism

to prevent monetary authorities from following time-inconsistent policies

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The Origins of Central Banking (cont.)Under the gold standard, central banks were

supposed to follow the “rules of the game”To use their discount rates to speed up the

adjustment to external shocks to the balance of payments

Central banks learned to became LLR during this period

According to Bagehot’s (1873) responsibility doctrine, the Bank of England (which was private) was urged to place primary importance on its role as LLR

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The Origins of Central Banking (cont.)The Bank of England learned to follow Bagehot’s

rule - in the face of an internal drain to lend freely on the basis of sound collateral, in the face of an external drain to raise bank rate, and in the face of both to lend freely at a high rate

The Bank of England learned to lend anonymously to the money market

No banking panics occurred in England after 1866

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The Origins of Central Banking (cont.)Other European central banks followed suit in

becoming effective LLRsSuccessful LLR policy and credible gold standard

adherence were intertwinedCentral banks under the gold standard attached

little weight to real economic stability and unemployment, because of wage flexibility, labor mobility and the absence of labor unions and Labor parties

However credibility granted a modicum of policy independence

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In the Dark AgesThe classical gold standard ended with WWI. It

was reinstated as a gold exchange standard in which central banks substituted foreign exchange for gold reserves and discouraged gold holdings by the private sector

The central banks of Britain, France and Germany joined with the Federal Reserve to coordinate monetary policies

The gold exchange standard only lasted until 1931. It failed because of fatal flaws and because it did not embody a credible commitment mechanism

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In the Dark Ages (cont.)The fatal flaws

asymmetric adjustment between deficit countries such as Britain and surplus countries such as France and the US

the failure of countries to follow the rules of the game

inadequate gold supplies and the substitution of key currencies for gold as international reserves, leading to a convertibility crisis

the confidence problem leading to shifts among key currencies and between key currencies and gold

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In the Dark Ages (cont.)The commitment mechanism was weaker than

under the gold standard, because with the advent of organized labor preserving jobs became more important

This meant that preserving convertibility was no longer paramount

The GE standard collapsed with the Great Depression

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In the Dark Ages (cont.)The Great Depression reflected the failure of the

Fed to serve as LLR in the face of 4 banking panics from 1930-33

Fed tightening in 1928 to stem stock market speculation based on the CB’s adherence to the real bills doctrine led to the downturn in August 1928, followed by the crash in October

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In the Dark Ages (cont.)The Fed’s failure reflected:

adherence to the flawed real bills doctrine ( Meltzer 2003)

flaws in the Fed’s structure (Friedman and Schwartz 1963)

inability of the architects of the Fed to adapt the successful European LLR model to the U.S. institutional environment (Bordo and Wheelock 2010)

The Great Depression was spread abroad by the fixed exchange rate gold standard

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In the Dark Ages (cont.)Golden Fetters prevented central banks from

acting as LLRCountries only escaped the depression by exiting

the gold standardThe Great Depression was blamed on

commercial banks for taking undue risks and central banks for restoring and maintaining a flawed gold standard

This led in every country to massive regulation of the financial system

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In the Dark Ages (cont.)And the subservience of central banks to the

TreasuryIn the 30s and 40s, central banks followed low

interest pegs to stimulate the economy and aid the Treasury in fueling its debt

This policies fueled inflation during and after WWII

Monetary policy independence was restored to the CB’s beginning in the 1950s, e.g. the Federal Reserve Treasury Accord of 1951

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In the Dark Ages (cont.)1950s and 60s, the CB’s followed successfully

countercyclical policy and low inflation within the context of the Bretton Woods system

Bretton Woods indirect link to gold helped maintain price stability

However Bretton Woods had similar flaws to the GE standard

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In the Dark Ages (cont.)It collapsed in the 1960s largely because the U.S.

as the key provider of international reserves, broke the rules of gold standard and began following expansionary monetary policy to fund fiscal deficits

It collapsed because the rest of the world was unwilling to absorb additional dollars that would lead to inflation

The advent of generalized floating in 1973 allowed each country more flexibility to conduct independent monetary policies

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In the Dark Ages (cont.)In the 1970s inflation accelerated as many

countries attempted to use monetary policy to maintain full employment and to accommodate oil price shocks in 1973 and 1979

Finally in the face of heavy regulation of the financial sector and the institution of a financial safety net there were no banking crises from the 1940s to the 1970s

The LLR function of CB’s was in abeyance

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A Renewed Golden Agethe Great Inflation ended with the Volcker shock

of 1979-81 in the U.S. and U.K. and similar policies in other countries

Tight money broke the back of inflation and inflationary expectations at the expense of a severe recession

The 1980s witnessed renewed emphasis by CB’s on low inflation as their primary objective

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A Renewed Golden Age (cont.)Many countries granted their central bank

independence from the fiscal authority and instituted mandates for low inflation

Inflation targeting first instituted in New Zealand in 1990

Subsequent two decades referred to as the Great Moderation with low inflation and stable growth

Some similarity to the gold standard convertibility principle

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A Renewed Golden Age (cont.)Financial instability became a problem again in

the 1970s in the face of inflation which led to financial innovation and deregulation

Banking crises again erupted in advanced countries, but CB’s no longer followed Bagehot’s rules and adopted the “Too big to fail” doctrine

Asset booms and busts reappeared but the experience of the 1929 crash and Japan’s bursting bubble in 1990 led the Fed and other CB’s to become unwilling to use monetary policy to deflate bubbles

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The Crisis of 2007-2008: A Game Changer?The subprime mortgage crisis of 2007-2008

originated in the U.S. and spread to the RoWIt was precipitated by the collapse of a major

housing boom in 2006 which severely impacted the financial system

Its causes include: U.S. government policies since the 1930s to extend homeownership, major changes in regulation, lax regulatory oversight, a relaxation of normal standards of prudent lending, and a period of abnormally low interest rates

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The Crisis of 2007-2008: A Game Changer? (cont.)The story is very familiar:

the subprime crisis led to spillover effects around the world via securitized mortgage

uncertainty over the value of MBS led to the freezing of the interbank lending market in fall 2007

this led to extensive CB liquidity injections and credit policies

the crisis worsened with the failure of Lehman Brothers in September 2008

this led to bailouts of major financial firmsthe US Treasury TARPBailouts in EuropeQuantitative Easing in December 2008 after ZLB

reached

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The Crisis of 2007-2008: A Game Changer? (cont.)Unlike the liquidity panics of the 1930s, the

deepest problem facing the financial system was insolvency based on the difficulty of pricing securities backed by a pool of assets

Another hallmark of the recent crisis was that the Fed and other MAs engaged in bailouts of firms deemed too systemically connected to fail

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The Crisis of 2007-2008: A Game Changer? (cont.)The Fed and other CBs were criticized for not

preventing the crisis:the Fed fuelled the housing boom with low interest

rates 2002-2001credit policy picked favoritesCBs lost independencethe Fed created panic by first rescuing Bear

Stearns in March 2008 and then letting Lehman fail in September

bailout based on “too interconnected to fail”CB’s did not follow Bagehot’s strictures

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The Crisis of 2007-2008: A Game Changer? (cont.)These criticisms and more led to calls for

changes in the basic CB model based on rules prescribing credibility for low inflation and CB independence

Reforms suggested include:greatly increasing the CB’s role in financial stabilityusing monetary policies to lean against the wind of

asset boomsadminister macro prudential rules for commercial

and investment bankswork more closely with the fiscal authoritiesstick to transparent rules

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Sticking to the RulesHistory of CB teaches that first responsibility is to

maintain price stability. If the CB is successful in maintaining a stable and credible nominal anchor then real macro stability should obtain

But, in face of shocks CB’s need to follow short-run stabilization policies consistent with long-run price stability

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Sticking to the Rules (cont.)History teaches the importance of CB’s to act as

LLR to the money marketLLR involves temporarily expanding liquidityshould be done by OMO rather than DWL if DWL is used then loans should only be made to

solvent but illiquid banksno bailouts

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Sticking to the Rules (cont.)Lessons of 1929 suggest tools of monetary policy

should not be used to head off asset price boomsin the event of a bubble whose bursting would

adversely affect the real economy, should use non monetary tools to deflate it

Comparative advantage of monetary policy tools is to influence the money market and not asset prices

History suggests CBs should protect the payments system and provide liquidity only to FI’s that provide means of payment

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Sticking to the Rules (cont.)History of past inflations and recent crisis teaches

us that CBs should be independent of the fiscal authorities

In sum the events of the recent crisis leads to the conclusion that CBs should stick to tried and true rules to maintain price stability

Flexible inflation targeting as practiced by the Norges Bank and the Riksbank seems to be a reasonable way to go forward

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Sticking to the Rules (cont.)Flexible inflation targeting allows the CB to both

accommodate real shocks and financial shocks into its forecasts

Finally, a lesson from the recent crisis is that financial regulation (by agencies other than the CB) should be based on providing incentives for private financial agents to take prudential actions --to have “skin in the game”

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