Money, Part II

The short history of central banking (free)

The idea of the central bank was born in the Middle-Ages, when failures of the largest merchant banks of that era, founded by the Bardi and Peruzzi families, shocked the Italian City-State of Florence in 1343 and 1346.¹ These financial crises gave birth to the idea that the commercial banking sector would need a ‘liquidity backstop’, i.e., an entity that could lend to private financial institutions in trouble. This was the original aim of central banks: to act as ‘piggy banks’ for commercial banks.

The first central bank that resembled the modern ones emerged in 1609, when the Dutch empire created an exchange bank, Amsterdamsche Wisselbank or the Bank of Amsterdam, to convert foreign coins into domestic currency.² The depositor received a bank receipt denominated in bank money called banco shillengen. This receipt could be used either to redeem the original deposit or be employed as a book entry (“giro”) for payments between customers and the bank—such as was done by earlier deposit banks such as the Casa di San Giorgio in Genoa and Rialto Bank in Venice. The receipts were also tradable, essentially creating secondary markets.

Thus, the Wisselbank carried out one of the main duties of a modern central bank from its inception. It operated a giro or book-entry payment system that allowed for (efficient) settlement of the large volume of commercial transactions that flowed through Amsterdam.³ The mint ordinance of 1659 effectively ended the multicoinage system in Dutch Republic and the Wisselbank was set to guard a separate, privileged medium of exchange. This implicitly put the Bank in charge of price stability, which has been one the main responsibilities of modern central banks

The first central banks

The central bank of Sweden, the Riksbanken, was created in 1668, and the Bank of England (BoE) in 1694. They were the first actual central banks in a sense that they were created to handle the obligations and responsibilities associated with modern central banks.

Riksbanken (originally: Riksens Ständers Ban) was created to issue credit notes (banknotes) after its predecessor, Stockholms Banco, failed due to overissuance of credit notes (Sweden is said to have had the first paper currency in the world). From the beginning it was the responsibilty of the Riksbank to "maintain the domestic coinage at its right and fair value".

The birth of the Bank of England, or BoE, was a bit more complex process.⁴ BoE was essentially founded to restructure the debts of the crown held by William of Orange, but how it accomplish this was rather innovative. The idea was that investors would subscribe capital to the Bank, which would lend the money to the government. The Bank had the right to issue banknotes, that is, paper currency representing its own liabilities, which would circulate as money. This created a massive “power grap” from the sovereign.

The so called Whig grandees (a political party) quickly realized that, if they would align with the private money interest they represented and agree to kings terms, they would gain control over his most guarded prerogative, i.e., the creation of money and its standard.⁵ While they would lend their credit to the sovereign, he/she would lend his/her authority to the bank they operated. Thus, a very profitable private-public partnership was agreed creating the foundation upon which future central banks would be build. One of the most prominent economists of all time, Adam Smith, succintly summarized the statutory nature of the bank:⁶ “The stability of the Bank is equal to that of the British government”.

First the BoE provided just emergency fiscal financing, but quickly grew to handle accounts of the sovereign, an agent of its payments, the manager of its bonds issues and the sole issuer of banknotes within England. The BoE thus took full control of monetary powers of the sovereign.

Modern central banks can be fully owned by the pubic sector. They can be public-private consortiums and fully owned by private sector entities. Regardless of the form of ownership, the state holds considerably power over the central bank, except to those central banks that are under no sovereign, like the European Central Bank.

After the creation of the BoE, another major ‘plot-twist’ came in 1914, when the U.S. Federal Reserve Bank was created.

The Federal Reserve

There had been several attempts to create a national bank in prior decades in the U.S., but these efforts had failed. The Panic of 1907, the first American financial crisis of the twentieth century, was a game-changer.

The crisis started after several investors suffered crippling losses on their speculative bets.⁷ This started runs in the banks these investors were associated with. Runs spread to trust companies, which were unregulated financial intermediaries outside the banking system, despite the efforts of the authorities to calm widening fear. Within a period of just two weeks, the U.S. financial system came to the brink of a collapse. To stem the panic, banker J. Pierpont Morgan personally guaranteed key firms in the U.S. banking system.⁸

However, despite Morgan’s success, the panic gave more credence to assertions that the stability of the U.S. banking system required a permanent institution of last resort to provide liquidity, when required. Yet the creation of the Federal Reserve system was dogged by worries that it would lead to the "socialization" of the economy. Those worries were quickly justified.

Into the ‘Great Depression’

The Fed started its “open market operations” almost immediately in the 1920s.⁹ In an operation of this kind the Fed buys or sells U.S. Treasury securities from or to banks to control the short-term interest rate (more precisely the “Fed Funds Rate”) used in overnight lending activities between banks, and to influence the availability of credit in the economy.

Under a gold standard, the national stock of gold and the demand for it affected the availability of money, in terms of gold, and inflation. The process was simple. The increase in the supply of gold increased gold reserves and thus the supply of money and credit in the economy. To neutralize, or “sterilize” this increase, the central bank could let the ratio of gold reserves to notes in circulation rise, or it could raise interest rates to tighten the supply of short-term credit.¹⁰

In the 1920s the Fed allowed the ratio of gold reserves to notes to rise, effectively sterilizing all gold purchases from abroad. This was seen as the principal means of keeping consumer price inflation at bay in the U.S. However, the flow of gold to the U.S. and its sterilization also exported deflation to other countries, which were forced to cut back the supply of domestic credit due to falling gold reserves.¹¹

While the money stock of the U.S. was controlled by letting the share of gold reserves rise, this also meant that interest rates were kept relatively low from roughly 1922 to 1928.¹² Speculation in the asset and real estate markets increased as a result. The credit boom intensified, first peaking in 1925 and again in 1927.¹³ A noticeable industry of non-bank lenders also developed during the 1920s, which fueled the boom in consumer durables, the commercial property market, the automobile industry and of course in the stock market.¹⁴

Effectively the Fed’s market interference fostered a gigantic credit expansion whose subsequent deflationary collapse, which began from the ‘Great Crash’ in October 1929, helped to create conditions for the Great Depression of the 1930s. This was the first major policy failure of a modern central bank.

“Monetary policy”

Since the 1930s, “monetary policy” (where central banks manipulate interest rates by setting, in one example, the interest rates charged on the “excess reserves” banks are obliged to keep at the central bank) has grown into a tool to combat recessions. The idea is to lower interest rates in a recession in an effort to stimulate banks to lend and businessess and households to borrow and invest.

In 1987, the then-Chairman of the Fed, Alan Greenspan, expanded the interventionist doctrine by bailing-out financial markets when he slashed interest rates and provided billions in liquidity (a lot of money at the time!) after the collapse of the stock market on the 19th of October.¹⁵ This perceived liquidity guarantee became known as the ‘Greenspan Put’.

After the Global Financial Crisis of 2007-2008, central bank meddling went into overdrive with various banks setting low—or even negative—interest rates, and implementing asset purchase or, as Ben Bernanke obliquely put it, “quantitative easing” (QE) programs. They had many detrimental effects on the financial markets and the economy. More on that later.

From a saviour to a speculator (and then some)

Since 2012, the now infamous “Whatever it takes” speech by the then ECB President, Mario Draghi, central banks have run several market bailout operations. These include:

• In October 2010, the BoJ started to buy Exchange Traded Funds (“ETF”) linked to the Japanese stock market. It became customary that the BoJ would begin buying whenever the Topix stock market index fell more than a 0.2 percentage points by midday.

• In 2015, the Swiss National Bank started to “invest” in foreign assets, including U.S. equities. In many cases, such purchases coincided with increased market turbulence/risk, as during the first actual rate hike cycle of the Fed in 2016/2017.

• The ‘pivot’ of the Federal Reserve in early January 2019 to stave off the collapse of stock and credit markets.

• The “Not-QE” program of the Fed enacted in September/October 2019 to to halt the implosion of the U.S. repurchase (repo) -market (caused by the quantitative tightening).

• The “corona bailout” of the U.S. financial market by the Fed in March-June 2020.

• The ‘Transmission protection instrument’ of the ECB aimed at halting the rise of the sovereign yields of weaker member nations of the Eurozone (unveiled in July 2022).

So, essentially, modern central banks have transformed their original role of a ‘liquidity backstopper’ into an outright market maker, or a speculator. One could argue that modern central bankers have fully corrupted their original purpose.

This has also had a very detrimental effect to our economies , which are now becoming plainly visible with inflation, ‘zombification’, and multitude of issues in the financial sector. Moreover, they have utterly corrupted our monetary systems and threaten to complete it through their own digital currencies, or CBDC’s. More on those later.

1. See, e.g., Hunt (1990). A New Look at the Dealings of the Bardi and Peruzzi with Edward III. Journal of Economic History, 50(1): 149-162.

2. See, Stephen, Q. and W. Roberts (2009, p. 33) in Atack, J. and L. Neal: The Origins and Development of Financial Markets and InstitutionsCambridge: Cambridge University Press. https://www.uv.mx/personal/clelanda/files/2013/02/Atack-Jeremy-and-NealLarry-2009-The-origins-and-development-of-financial-markets-and-institutions.pdf

3. See, Stephen, Q. and W. Roberts (2009, p. 65) in Atack, J. and L. Neal: The Origins and Development of Financial Markets and Institutions.

4. See, F. Martin (2014, p. 117-118). Money: The Unauthorised Biography.

5. See, F. Martin (2014, p. 118). Money: The Unauthorised Biography.

6. From Smith, A. (1776). An Inquiry Into the Nature and Causes of the Wealth of Nations. Quoted by F. Martin (2014, p. 119). Money: The Unauthorised Biography.

7. See, e.g., Federal Reserve History.

8. See, Gorton, G. (2012, p. 142). Misunderstanding Financial Crises: Why We Don’t See Them Coming.

9. See the History of the Federal Reserve.

10. See, Eichengreen, B. (1986). The Bank of France and the Sterilization of Gold, 1926-1932. Explorations in Economic History, 23: 56-84.

11. See, Craft, N. and P. Fearon (2010). Lesson from the 1930s Great Depression. Oxford Review of Economic Policy, 26(3): 285-317.

12. See, The Federal Reserve in the 1920s.

13. See, Craft, N. and P. Fearon (2010). Lesson from the 1930s Great Depression. Oxford Review of Economic Policy, 26(3): 285-317.

14. See, Eichengreen, B. and K. Mitchener (2003). The Great Depression as a credit boom gone wrong. BIS Working Paper no. 137.

15. See our blog on the Crash of 1987.