AM13 CB History

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History of Central Banks -- their varying purposes, and philosophies -- see BOTTOM of page for links to posts/videos

Questions

Q1. Explain the terms monetization of debt, and maturity transformation -- do both a forest level conceptual analyis, and a tree level detailed analysis -- on the pattern of the two posts linked below -- one is tree level history while the other is forest level conceptual. Explain how these techniques, together with sovereign debt, enabled the Bank of England to make loans to the King of England without having money, and without asking him for the money back.

Answer 1: Historically, when we traced back the history of banks, it emerged out of the need to finance war between different powers. There were the clusters of exchange banks before the advent of central banks. The exchange banks were used to carry out trade across countries without having carried money with them. The question of how bank of England the mother of all bank was formed and what function did it play which later leads to known as the term of monetization of debt. There were three main bodies which worked in the formation of BOE. The Queen/King of England, the money lenders and the Cromwell. The story begins with the entry of Queen Elizabeth in 16 century when she kicked out all money lenders from England and became a sovereign authority who could only issue a metal coin as legal tender and the rest coins were become worthless. The money lenders did not like this at all as the privilege power of creating money was taken away from them. The money lenders were actually comprises of merchant class, goldsmith and financiers. They started looking to revolt against existing king in order to get back the sovereign power. They got an opportunity from Cromwell’s revolution against Charles II. The kings are always against the parliament consist of upper class who become an opportunist trying to take away the kingship from King. Cromwell’s revolution was instigated and financed, on the condition that financiers were allowed back into England. In the process, the power to print money was given to the Parliament. The moneylenders agreed to provide the funds to back Parliament, on condition that they be allowed back into England and that the loans be guaranteed. That meant the permanent removal of King Charles, who would have repudiated the loans had he gotten back into power. Charles’ recapture, trial, and execution were duly arranged and carried out to secure the loans to the Parliament. Having wrested the power of creation of money away from the King, the moneylenders restored the aristocracy, but gained much greater powers in the process, by providing financial aid to the King. After Cromwell’s death, Charles’ son Charles II was invited to return; but Parliament had no intention of granting him the sovereign power over the money supply enjoyed by his predecessors. When the king needed a standing army, Parliament refused to vote the funds, forcing him to borrow instead from the English goldsmiths at usurious interest rates. The final blow to the royal prerogative was the Free Coinage Act of 1666, which allowed anyone to bring gold or silver to the mint to have it stamped into coins. The power to issue money, which had for centuries been the sole right of the king, was transferred into private hands, giving bankers the power to cause inflations and depressions at will by issuing or withholding their gold coins. None of the earlier English kings or queens would have agreed to charter a private central bank that had the power to create money and lend it to the government. Since they could issue money themselves, they had no need for loans. But King William III, who followed James II, was a Dutchman and a tool of the powerful Wisselbank of Amsterdam. England’s crushing defeat by France, the dominant naval power, in naval engagements culminating in the 1690 Battle of Beachy Head, became the catalyst for England rebuilding itself as a global power. England had no choice but to build a powerful navy. No public funds were available, and the credit of William III‘s government was so low in London that it was impossible for it to borrow the £1,200,000 (at 8% p.a.) that the government wanted. Actually, William was soon at war with Louis XIV of France. To finance his war, he borrowed 1.2 million pounds in gold from a group of moneylenders, whose names were to be kept secret. The money was raised by a novel device that is still used by governments today: the lenders would issue a permanent loan on which interest would be paid but the principal portion of the loan would not be repaid.⁶ The loan also came with other strings attached. They included:

· The lenders were to be granted a charter to establish a Bank of England, which would issue banknotes that would circulate as the national paper currency.

· The Bank would create banknotes out of nothing, with only a fraction of them backed by coin. Banknotes created and lent to the government would be backed mainly by government I.O.U.s, which would serve as the “reserves” for creating additional loans to private parties.

· Interest of 8 percent would be paid by the government on its loans, marking the birth of the national debt.

· The lenders would be allowed to secure payment on the national debt by direct taxation of the people. Taxes were immediately imposed on a whole range of goods to pay the interest owed to the Bank.⁷

The Bank of England has been called “the Mother of Central Banks.” It was chartered in 1694 to William Paterson, a Scotsman who had previously lived in Amsterdam.⁸ A circular distributed to attract subscribers to the Bank’s initial stock offering said, “The Bank hath benefit of interest on all moneys which it, the Bank, creates out of nothing.”⁹ The negotiation of additional loans caused England’s national debt to go from 1.2 million pounds in 1694 to 16 million pounds in 1698. By 1815, the debt was up to 885 million pounds, largely due to the compounding of interest. The lenders not only reaped huge profits, but the indebtedness gave them substantial political leverage.

The Bank’s charter gave the force of law to the “fractional reserve” banking scheme that put control of the country’s money in a privately owned company. The Bank of England had the legal right to create paper money out of nothing and lend it to the government at interest. It did this by trading its own paper notes for paper bonds representing the government’s promise to pay principal and interest back to the Bank — the same device used by the U.S. Federal Reserve and other central banks today. This was called as monetization of debt.

The process by which money was created by the Bank of England is extremely interesting. They acquired the debt of the King. This debt was used as collateral/backing for the money they created. The notes they issued were legal tender in England. Whenever necessary, they were prepared to exchange them for gold, at the prescribed rates. However, when the confidence of the public is high, the need for actual gold as backing is substantially reduced.

There is a small mystery here. The King’s debt was used as the backing for the money issued by the Bank of England. Why couldn’t the King issue debt directly, and have it used as money? This is the basic concept of sovereign money, and would have saved the King the 8% interest on the amount he had to borrow. The key here is to understand Minsky’s dictum: “Anybody can create money. The problem lies in having it be accepted.” The reason King William could not create money which would be widely acceptable by the public are the following

1. The authority to create money had been transferred to the Parliament.

2. The King could borrow, but did not have gold to pay back his debts.

3. When the King borrowed from the moneylenders, they did not give him gold. They gave him the authority to write checks on the Bank. The Bank could redeem these checks in notes which were backed by the King’s debt. Thus, the Bank “monetized” the debt of the King.

4. The Bank’s created money was far more acceptable than the King’s debt, because it had the appearance of being backed by gold (in addition to the King’s debt). The bankers, unlike the King, could convert bank-notes to gold as needed. This ability of the Bank to do so, created the confidence in the public, which allowed the bank to keep only a fraction of the entire amount of notes in circulation, in the form of gold.

This same system, fractional reserve banking, and the monetization of the debt of the Government, is still in operation. But very few have correct understanding of how the system works. It is worth pointing out that the reason the Bank of England was able to obtain a charter to print money was because it offered very generous terms to King William. It offered to provide him with all money that he needed, in return for his IOU’s — After all, having captured the Sovereign right to print money, it had the ability to print arbitrary amounts. Also, it did not ask for repayment of the principal, but only the interest on the debt. Finally, it also offered to collect this repayment, in form of taxes, on behalf of the King. This was a very sweet deal for the cash-strapped King.

Q 2. The textbook says that Volker showed the monetarism fails. But Friedman says that it was never tried -- Volker announce that he would keep the money supply growing steadily at 6% but he did not do it! Money growth was very erratic over this period. Explain this conflict.

Answer 2: The textbook says that Volker showed the monetarism fails. But Friedman says that it was never tried -- Volker announce that he would keep the money supply growing steadily at 6% but he did not do it! Money growth was very erratic over this period. Explain this conflict.

According to Friedman monetarism money supply in the economy is the multiple of reserves so we just keep reserves growing at a fixed amount. For this he also ensured that money should grow similar to the rate of the growth of the economy. If economy is growing at 3% and you grow money supply at 3% then you have 0 inflation in the economy and have exactly enough money for the need of the economy. But because of price rigidities some prices cannot go down so if you allow inflation to happen then real price will automatically go down even though the nominal prices are fixed and that will allow to equilibrate so certain low amount of inflation is good for the economy. Friedman says keep reserves growing at 6%, economy grow at 3% and inflation will be at 3% so this will create fixed and known rate of inflation. This is the Friedman fixed rule which will create price stability, financial stability and growth by ensuring full employment because of lack of money illusions. Neoclassical misunderstood Keynes that unemployment caused by money illusion.

So Volker announced in 1980 that I am going to follow this fixed rule of Friedman but it failed because it created the greatest depression. It did bring down the inflation rate but it also created the huge amount of depression. Volcker also could not control the money supply. He tried to control the reserves but ration between the reserves and actual money was very erratic and that is because credit creation by bank was not regulated by central banks. Wen economy is in boom they create massive money creation and when falls it contracts the money supply. He kept thinking that this would be a short run phenomena and it will wipe out but it did not actually.

However Friedman once asked in interview that your Friedman rule was failed when tried by Volcker. He denied that by saying the Volcker did not observe that money was not growing at 6% so he did not tried Friedman rule. There were other money aggregates like interest rate that need to be observed at the time of Volcker but he did not do actually. But if you look at the data of the countries of the world, monetary aggregates were going down from 1980 to 1995 which leads to inflation in the different countries. So inflation is everywhere is a monetary phenomenon.

Nevertheless in 2014, bank of England admitted that multiplier was a wrong theory and monetarist experiment was a spectacular failure and this was known by all central banks. These theories of multipliers were continue to studies in different text books as things are continuously misinterpreted and misrepresented by different economist like Friedman did. All monetary equation failed to work. Richard Werner introduced alternative as Quantity theory of Credit. He emphasized that if you take into account credit creation by banks then quantity theory money could work. Only reserves cannot be enough to see the phenomenon clearly as reserves are only used to do credit creation but actually credit creation is important in itself. He also emphasized to include stock, bonds and land prices in consumer price as it did not include it. So inflation does not capture all of the places where money is going to play its role.

Q 3. The Taylor rule is based on the idea that Central Banks have to try to meet two targets - low inflation and low unemployment -- using monetary policy. Inflation targeting only tries to meet one target. Explain how and why Central Banks moved from the Keynesian style Taylor rule towards the modern idea of Inflation Targeting.

Answer 3: Once it was cleared that Friedman rule did not work so the alternative search for conducting monetary policy got attention from many economist and countries. Roger Douglas from New Zealand emphasized that instead of targeting reserve to control money supply in order to further control inflation we directly targeted inflation with discount rates. He realized that reserve requirement was not enough to control inflation. This also led to the question of operational independence of central bank. Central bank and government have conflict of interest as one wants to increase spending creating inflation in the economy while the other wants to control inflation so simultaneously both cannot work together.