Definition

A central bank is an institution that possesses a legal monopoly over the creation of money. It conducts monetary policies and manages the supply of credit and money in a given territory – a country or a union of countries.

The History, Role, and Critique of Central Banking

Central banks – although often considered to be politically independent – are the monetary authorities of states or unions of states. In contrast to commercial banks, they possess legal monopolies over the issuance of money in given territories. They control and manage the supply of credit and money, which usually exhibits legal tender status, through monetary policy tools, such as open market operations, discount window lending, and changes in reserve requirements. Examples of central banks are the Federal Reserve System (FED) in the United States, the Bank of England, and the European Central Bank (ECB) in the eurozone.

According to Bordo (2007), there are three key goals of modern monetary policy. These are price stability or stability of the value of money; economic stability, that is, smoothing business cycles by offsetting shocks to the economy; and financial stability which essentially means granting credit to commercial banks suffering from liquidity shortages as a lender of last resort. Historically, the importance of these goals and the goals as such have changed substantially, along with the monetary regimes within which central banks were acting.

A Brief History of Central Banking

In the following section, a brief historical sketch of the development of central banks as monopolists over the supply of money and credit and the economic debates around the subject is presented.

Historically, moneys have been commodities, most often precious metals such as silver and gold. So it was under commodity money regimes that the first institutions resembling central banks were established. According to Glasner (1998, p.27), banking in general “evolved because it provided two services that proved to be strongly complementary: provision of a medium of exchange and intermediation between borrowers and lenders.” Instead of using precious metals directly as coins, people could use money substitutes that represented claims to fixed amounts of precious metals that were stored in the banks’ vaults.

Bank money was less costly than coins for several reasons. Holders of deposits often received interest and bore no losses from the wear and tear of coins. They also bore no costs of transporting coins or of protecting them against theft or robbery. And, when making transactions, they could avoid the costs of counting, weighting, and inspecting coins. (Glasner 1998, p. 28)

Obviously, banks were put in a very powerful position. There are several historical examples in which these powers were misused. Italian bankers in England, for example, financed the military expenses of Edward I around 1300, when he faced social upheavals in Wales and Scotland. With the financial support of the Italian bankers, he could gather a much greater army than his predecessors were ever able to (Prestwich 1979).

The temptation for banks to issue more money substitutes than there were precious metals in the vaults was compelling. So the municipal bank of Barcelona, for example, had to suspend convertibility into specie during the Catalonian fight for independence in Spain in the fifteenth century (Usher 1943). In the sixteenth and seventeenth centuries, private but highly regulated banks in Venice financed war expenses by creating deposits against government debt. Due to high government demand for funds, the convertibility had to be suspended and the bank money depreciated against precious metals (de Roover 1976; Lane 1937).

In fact, on the way to complete monopolization of the money supply, military conflicts within and between states played a fundamental role. One of the first institutions that are commonly considered to be central banks is the Swedish Riksbank founded in the 1660s. It is also the oldest still existing central bank in the world. Another early example is the Bank of England founded in the 1690s. The Swedish authorities tried to prevent interference and misuse of the King, whereas the Bank of England was specifically founded with the objective of financing the ongoing conflicts with France. It was only through the establishment of this institution that William III was able to borrow £1,200,000, half of which was used to rebuild the navy. The Banque de France is another case in point. It was established after the French Revolution and just before the Napoleonic Wars (1803–1815) in 1800. Malpractices of private banks as well as increasing threats from aggressive foreign countries set strong incentives for the establishment of centralized monetary authorities in other European countries and around the world. All that happened mostly under more or less binding silver, gold, or bimetallic standards, which restricted the powers of central banks as long as convertibility of bank notes into specie and the trust of the people in the currency were not to be jeopardized lightly. However, not before 1816, shortly after the Napoleonic Wars, during which convertibility was suspended, has the British pound for the first time been legally defined as a fixed weight of gold, although Britain had been on a de facto gold standard since 1717, due to an overvaluation of gold relative to silver by Sir Isaac Newton who was at that time Master of the Royal Mint.

In 1844, the Bank Charter Act reinforced the gold backing of the pound and marked the beginning of a period known as the classical gold standard that lasted until 1914. Also other currencies such as the franc, the mark (since 1871), and the US dollar were legally defined as fixed amounts of gold. Therefore, the classical gold standard was a period of fixed exchange rates between currencies, which lowered risks and fostered international trade, as has been suggested in various empirical studies (see, e.g., López-Córdova and Meissner 2003 or Flandreau and Maurel 2001).

What is today called the time-inconsistency problem of central banking might have played an important role in this development. On the one hand, the monetary authorities could have exploited their monopoly status on a slow but constant basis by inflating the money supply at a modest rate. On the other hand, this would lower the profit-earning potential under emergencies, such as military invasions or economic crises. In order to effectively exploit the monopoly status in emergencies, it is necessary to build up confidence in the stability and soundness of the currency among the general public during normal times. The authorities have to make a credible commitment to price stability (Kydland and Prescott 1977). The developments toward the universal gold standard can be interpreted as such a commitment (Bordo and Kydland 1995). On the other hand, it might be interpreted as a restriction on governmental despotism and as a political effect of the spread of classical liberal philosophies and enlightenment ideas that generally endorsed limited state powers. The most important function of central banks in that era was to store and exchange gold reserves in correspondence to the national currencies in circulation.

Although there already existed institutions that resembled central banks in the United States in the nineteenth century, namely, the First (1790–1811) and the Second Bank of the United States (1816–1836), the Federal Reserve System as we know it today was only founded in 1913. Shortly after, with the beginning of the Great War (1914–1918), the era of the classical gold standard ended. The United States which entered the war in 1917 inflated their currency less than the European nations and was thus the only country that de jure remained on a gold standard throughout this period. The German, French, and British currencies depreciated substantially with respect to the US dollar and gold. They returned to gold in the 1920s at an artificially overvalued rate which lead to constant complains about gold or liquidity shortages, particularly in Britain, but also in other European countries (Rothbard 1998). The gold exchange standard that was established during the interwar period was essentially a pound sterling standard, since only the British pound sterling was redeemable in gold. Central banks of other European countries mostly held pounds as reserves. The United States was virtually the only country that remained on the gold standard in the classical sense. During the Great Depression in the 1930s, many countries suspended convertibility again. After the catastrophe of the Second World War, with the establishment of the Bretton Woods system in 1945, the British pound lost its status as a reserve currency to the US dollar. The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank, were founded. The US dollar remained convertible into gold on a fixed rate of $35 per fine ounce. Central banks of other countries were responsible for keeping their currencies in a fixed relationship to the US dollar. Only central banks, but no private citizens, were able to hand in US dollars for redemption at the FED. The system lasted until the fifteenth of August 1971, when President Richard Nixon eventually suspended convertibility of the US dollar in a unilateral act. Since then, the global financial system is based on fiat money, that is, money which derives its value from government law and is independent of any commodity.

During the transition period from the classical gold standard to a fiat money system, several economic and political arguments against the gold standard and in favor of fiat currencies have been brought forward. First of all, it would have facilitated the financing of political projects, such as the New Deal under Franklin D. Roosevelt in response to the Great Depression. Furthermore, it would not have been necessary to increase interest rates in 1931 to maintain convertibility of the US dollar, after Britain was already forced to suspend convertibility (Romer 2003). A policy of low interest rates can only be maintained as long as needed under fiat currencies. Since the money production is not restricted by the production of any commodity, it renders monetary policy much more flexible. The Keynesian theory of business cycles suggests that economic downturns can be cured by stimulating aggregate demand through expansive monetary policy in combination with deficit spending (Keynes 1936; Krugman 2006). There have, of course, been critics of this view (see, e.g., Hazlitt 1959), but it is today accepted by the majority of economists that central banks should intervene more actively into the economy by adjusting the money supply appropriately. In doing so, they should consider and control, as far as possible, macroeconomic aggregates, such as price inflation, unemployment, and economic growth. Often, objectives of monetary policy are in conflict. Simulating aggregate demand and economic growth through expansive monetary policies, for example, is in conflict to the general goal of price stability. Expanding the money supply can only be done at the risk of higher price inflation. Therefore, conflicting policy goals have to be weighed out. Still today, there is a lively debate on which policy instruments should be applied for which purposes and whether central bank policies should be conducted passively, based on rules, or whether we should adopt a discretionary and more flexible central bank policy.

The Role and Functioning of Central Banks Today

Theoretically speaking, there exist two types of money in our financial system: base money and commercial bank money. Base money, the core of the money supply, is created by central banks whenever they buy assets or extend credit to commercial banks. It can be destroyed when central banks sell assets or when credit is repaid. According to Belke and Polleit (2009, p. 29), “[c]ommercial banks need base money for at least three reasons: (i) making inter-bank payments; (ii) meeting any cash drain as non-banks want to keep a portion of their deposits in cash (notes and coins); and (iii) holding a certain portion of their liabilities in the form of base money with the central bank (minimum reserves).” The minimum reserve requirement is one instrument of monetary policy to regulate the overall money supply in the economy. Minimum reserves are held in cash directly at the commercial bank or as deposits with the corresponding central bank. Given a reserve requirement of 1% as currently in the eurozone, for any unit of base money, a commercial bank can create commercial bank money by extending loans of up to 99 units to the private sector (excess reserves). Hence, the maximum money creation potential of the banking sector is determined by the central bank through minimum reserve requirements.

The primary tools of central banks to manage the supply of base money are open market operations (Belke and Polleit 2009, p. 33). Their implementations work similarly in the United States and in the eurozone. However, minor differences can be observed. In the United States, the Domestic Trading Desk (Desk) arranges open market operations on a daily basis. It has to figure out whether there are imbalances between supply and demand for base money and react accordingly. Imbalances are indicated by differentials between the effective interest rate at which base money is borrowed and lent on the interbank market and the target interest rate set by the Federal Open Market Committee. Usually, short-lived imbalances are corrected through temporary operations. In special cases, when imbalances turn out to be more persistent than expected, the Desk may perform outright operations. These operations involve the buying and selling of government bonds on the secondary market, that is, the market in which formerly issued government bonds are traded. This means that, under normal circumstances, the FED does not buy bonds directly from the government. Outright open market operations affect the base money supply permanently, whereas the much more common temporary open market operations will unwind after a specified number of days. The latter are combined with repurchase agreements. For example, the Desk may decide to increase the base money supply and buys government securities from commercial banks. In order to keep this increase temporary, it agrees to resell those securities to its counterparties on a future date. Matched sale-purchase transactions are the tool with which the base money supply is temporarily decreased. Securities are first sold and will then be bought back in the future. The Desk may also redeem maturing securities, rather than replacing them with new ones, and can thereby reduce the portfolio without entering the market directly (Edwards 1997).

Similar to the Desk, the ECB mostly uses reverse transactions, that is, buying or selling eligible assets under repurchase agreements or lending money against eligible assets provided as collateral (Belke and Polleit 2009, p. 43). These transactions are used for main refinancing operations with a maturity of usually one week as well as longer-term refinancing operations with a maturity of usually three months. The ECB may use fine-tuning operations in reaction to unexpected liquidity fluctuations to steer interest rates in the form of outright transactions and foreign exchange swaps. The latter are spot and forward transactions in euro against foreign currencies. Furthermore, the ECB manages its structural position vis-à-vis the financial sector by issuing ECB debt certificates (ECB 2006). One of the main policy objectives of the ECB is to control short-term interest rates and reduce their volatilities. The marginal lending facility and the deposit facility are always available for credit institutions on their own initiative, whenever there is a lack of trading partners on the money market. Interest rates at the lending facility are usually higher than on the money market. The deposit facility usually offers lower interest rates. Those two institutions therefore provide boundaries within which interest rates on the overnight money market fluctuate. There is no limit on the access to these facilities other than collateral requirements at the lending facility.

Central banks generally have to decide on which policy instruments to use. In a simplified version, the problem can be seen as a choice between setting interest rates and letting the money supply be determined endogenously or the other way around. In practice, as Blinder (1998) points out, there are many more choices to be made, including various definitions of the money supply, several different choices for interest rates, bank reserves, and exchange rates. The practical problems involved might be more complicated than the theory suggests.

The intellectual problem is straightforward in principle. For any choice of instrument, you can write down and solve an appropriately complex dynamic optimization problem, compute the minimized value of the loss function, and then select the minimum minimorum to determine the optimal policy instrument. In practice, this is a prodigious technical feat that is rarely carried out. And I am pretty sure that no central bank has ever selected its instrument this way. But, then again, billiards players may practice physics only intuitively. (Blinder 1998, pp. 26–27)

As the above quote suggests, there is usually a clear discrepancy between the theoretically optimal and the practically possible. One of the various controversial subjects, when it comes to monetary policy in practice, is the question whether political actions should be rule based or discretionary. It has been argued that central banks left with discretion tend to err systematically in the direction of too much inflation. In order to correct this bias, one needs more or less strict rules (Kydland and Prescott 1977). Simons (1936) favored a strict commitment of the FED to price stability, that is, zero inflation, rather than pursuing any other possible policy goals. Friedman (1959) and other economists in the monetarist tradition advocated a low but constant growth rate of the money stock. Yet another, even more restrictive, rule was proposed by Wallace (1977). He argued that the FED should consider holding the money stock constant. Such a rule would essentially end monetary policy altogether. This view has not found many adherents. Instead, a modern trend in central banking is inflation rate targeting that only evolved after the end of the Bretton Woods system, in which exchange rates were targeted. Usually, inflation targets are given in a more or less narrow range around 2%. Allowing some inflation to take place within a certain range provides more flexibility to pursue other policy goals. The target can be met through adjusting interest rates appropriately. Whenever inflation rates are below the target range, interest rates can be lowered and vice versa. A declared inflation target also makes central bank policy more transparent. Investors can more easily anticipate possible changes in interest rates. This may lead to an overall stabilization of the economy. However, in the course of the current financial crisis (since 2008), inflation targeting has been abandoned in order to intervene more actively into the economy by means of more expansionary monetary policy. Interest rates are lower than ever before, providing liquidity for credit institutions on the financial markets at the risk of higher inflation rates. The reactions on the current crisis have been criticized on very different grounds. For some economists, they are still too conservative. For others, they constitute only a treatment of the symptoms, rather than the causes. In their view, they will prolong the problem instead of solving it. Central banking practices in general have been criticized, both on purely economical and ethical grounds.

Critique of Central Banking

A first very general point of criticism lies in the state-granted monopoly status of central banks. What justifies a legal monopoly over the supply of money? There has been a lively debate over the question whether money is a natural monopoly. For this to be the case, according to the traditional definition, the production of money should exhibit economies of scale, which means that the average costs of production for one firm producing the whole output are always lower than if two or more firms with access to the same technology divide the output (Glasner 1998, p. 23). However, the fact that central banks under today’s fiat money regime produce money at almost zero production costs does not imply economies of scale. Anyone could produce an unbacked or digital money at almost zero production costs.

The demand side characteristics of money also fall short of justifying its legal monopoly. Even if it is theoretically beneficial and cost reducing to use only one universally accepted medium of exchange within a given area and even if in fact only one universally accepted medium of exchange would emerge among freely cooperating individuals, for example, gold, there is no justification for legally restricting the production of that medium to one authorized institution. Evidently, for the functioning of a fiat money regime, it is necessary to restrict production to one institution, since otherwise competition would lead to an excessive expansion of the money supply and a rapid devaluation until its value reaches production costs – essentially zero (Hoppe 2006). But as mentioned above, the fiat money regimes that govern today’s global economy are themselves the result of state interventions into traditional commodity standards. Therefore, the mere existence of a fiat money regime cannot justify the legal monopoly per se. Furthermore, to consider money to be a public good is false, since it lacks the criteria of non-rivalness and non-excludability (Vaubel 1984). If, however, the money production is legally monopolized by establishing central banks, then the general economic analysis of monopolies should be applicable to it. In general, monopolies are considered to be economically inefficient and costly. There is an omnipresent danger that the monopoly status is irresponsibly exploited at the expense of the public.

Central banks in a fiat money regime are able to create as much money as they please and can serve as a lender of last resort for banks that lack liquidity. Within such an environment, an incentive for commercial banks is set to operate under a lower equity ratio, to hold less money, and to engage in riskier projects, as they can always borrow money at relatively low interest rates from the central bank. Hence, a moral hazard problem arises. As a result, the financial system as a whole becomes more fragile and susceptible to crises. The same analysis holds for governments. The European debt and financial crisis is a dramatic case in point (Bagus 2012).

Opposed to the Keynesian theory that ultimately monetary spending determines economic progress, the Austrian Theory of the Business Cycle advises against artificial credit expansion through lowering interest rates, which is easier to accomplish than ever before under a fiat money regime controlled by central banks. This theory, introduced by Ludwig von Mises (Mises 1912) and further developed by Friedrich August von Hayek (Hayek 1935), sees the root cause of economic depressions in an imbalance between investments and real savings brought about through this very process of credit expansion. In the Austrian view, the interest rate is not an arbitrary number that should be interfered with. Instead, it is the price that tends to accommodate the roundaboutness of production processes or investment projects to the available subsistence fund in the economy. Interest rates tend to fall when consumers save more and thereby increase the subsistence fund. In these situations, more roundabout investment projects can be sustained. If, however, interest rates are lowered artificially, the subsequent excess investments are not covered by real savings. At least some of the malinvestments have to be liquidated when the imbalance becomes evident. This situation constitutes the economic bust.

Another point of criticism lies in the inflationary tendencies of the modern monetary system under central bank control. Hyperinflation rates of more than 100%, as in the Weimar Republic or more recently in Zimbabwe, have obviously devastating effects. But also, moderate inflation rates are not neutral. They can be interpreted as a tax that enables governments to pursue policy goals that lack democratic legitimization (Hülsmann 2008, p. 191). State control over money was the result of the “characteristic quest by the state for sources of revenue” (Glasner 1998, p. 24). Fiat inflation therefore leads to an excessive growth of the state for which the citizens do not pay directly through taxes but rather indirectly through a devaluation of the currency they use. The redistributive effects of inflation are known as Cantillon effects (Cantillon 2010). Since inflation does not take place uniformly, but rather gradually ripples through the economy, the first receivers of the newly created money benefit on the expense of all others, since they can buy goods on the market for still relatively low prices. As they spend the money, prices tend to rise. Late receivers and people on fixed incomes face price increases before or entirely without increases in their incomes. They suffer a loss in real terms. Usually, the first receivers and beneficiaries of newly created money are commercial banks, other financial institutions, governments, and closely related industries. It is argued that the general public carries the burden. Although some groups doubtlessly benefit from the inflationary tendencies of the fiat money system, some economists argue that it cannot benefit society as a whole. The mere possibility to position oneself on the winner side leads to some kind of “collective corruption” and the maintenance of the system (Polleit 2011).