The Evolution of Central Banking

24 Pages Posted: 20 Apr 2016

Date Written: November 1995

Abstract

What have we learned about central banks? The principal factors affecting central bank autonomy in the past two centuries have been prevailing political conditions, a laissez faire environment, and the exchange rate regime (whether fixed or floating).

Institutions we know as central banks emerged or were established as commercial banks or government banks. Their evolution into central banks came with their monopoly issuing notes and their role as lender of last resort, among other functions. Carrying out commercial business on a large scale created a conflict of interest, so this practice was abandoned. Depending on government also hindered maximum performance.

Establishing the right degree of dependence was difficult, and changed in times of crisis. Independence is important: it helps to establish reputation, which is everything in banking. Independence can't be established overnight and is liable to abrupt alteration. The Great Depression, widely attributed to inept Central Bank behavior, interrupted central bank independence, but poor price behavior brought about its return. In the nineteenth century, laissez faire and the gold standard encouraged and sometimes allowed for considerable independence. After the end of the intermission of mercantilism, which arrived with World War I, preferences changed. Crisis provoked intervention. But wartime inflation and the return of peace allowed independence to return briefly. Greater changes came in the new dirigiste environment following the Great Depression and the rise of the managed economy. In the current climate - in which market solutions are ascendant and intervention is falling out of favor - the pendulum has swung again.

Economies in transition confront high inflation and the problem of maintaining monetary stability just as newly independent developing countries did in the 1960s. How can inflation be controlled? Under fiat regimes, the money supply is controlled by the domestic monetary authority. But can they control monetary growth? Prior and current records are not encouraging. Even if authorities have good intentions, will they be believed? Credibility, so essential to success, does not come easily.

Options include maintaining a fixed exchange rate or reviving currency boards. Currency boards function like an independent central bank, holding reserves and tying domestic currency to strong foreign currency. Such arrangements have succeeded, but most operated when sterling was strong. And most countries with currency boards conducted most of their trade with Britain, at least in sterling.

There are drawbacks to currency boards, especially for countries in transition. They require a considerable sacrifice of sovereignty, and are unlikely to appeal to countries that are only beginning to recover lost sovereignty.

This paper - a joint product of the Finance and Private Sector Development Division, Policy Research Department, and the Financial Sector Development Department - was presented at a Bank seminar, Financial History: Lessons of the Past for Reformers of the Present, and is a chapter in a forthcoming volume, Reforming Finance: Some Lessons from History, edited by Gerard Caprio, Jr. and Dimitri Vittas.

Suggested Citation

Capie, Forrest, The Evolution of Central Banking (November 1995). World Bank Policy Research Working Paper No. 1534. Available at SSRN: https://ssrn.com/abstract=604919

Forrest Capie (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom
020 7601 3680 (Phone)

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