Question

Summarize key events in the central banking system’s history.

Answer 1

The central banking story goes back at least to the seventeenth century, to the founding of Swedish Riksbank, the first institution known as a central bank. Established as a joint stock bank in 1668, it was chartered to lend the government funds and act as a trade clearing house. A few decades later (1694), the Bank of England, the most famous central bank of the era, was also founded as a joint stock corporation to buy government debt. Most central banks were later established for similar purposes in Europe, although some were established to tackle monetary disarray

For example, Napoleon created the Banque de France in 1800 to stabilize the currency following the hyperinflation of paper money during the French Revolution, as well as to help in government financing. Early central banks issued private notes that acted as currency, and often had a monopoly over the issue of such a note. Although these early central banks helped to fund the government's debt, they were also private entities engaged in banking. Since they kept other banks ' deposits, they came to work as bankers, facilitating transactions between banks, or other banking services.

The Federal Reserve System is part of a later central bank surge that originated at the turn of the 20th century. These banks were primarily created to consolidate the various instruments that people used for currency purposes, and to provide financial stability. Many were also developed to enforce the gold standard that most countries adhered to. The gold standard, which prevailed until 1914, meant that each country defined a fixed weight of gold as its currency. Central banks kept large reserves of gold to ensure their notes could be transformed into gold, as their charters demanded.

Central banks adhered to the law of holding gold convertibility above all other aspects of the gold standard. Gold convertibility acted as the nominal anchor for the economy. That is, the amount of money banks that could supply was limited by the value of the gold that they held in reserve, and that in turn dictated the prevailing level of price. And because the price level was tied to a known commodity, whose long-run value was decided by market forces, it was also tied to assumptions about the future price level. Early central banks were, in a way, firmly committed to price stability.

Financial stability is an increasingly important task for central banks. The evolution of that obligation across the advanced countries has been similar. Central banks had established a lender-of-last-resort role in the gold standard period, following the rule of Bagehot. But between the world wars financial systems became unstable, as widespread banking crises plagued the early 1920s and 1930s. The Fed's experience had been the worst. At the time, the solution to banking crises in Europe was usually to bail out the distressed banks with government funds. This strategy was later adopted by the United States, but on a limited scale, with the Reconstruction Finance Company.

Central bank independence has been a crucial factor in central banking history. The central banks that emerged were private and independent. They relied on the government to keep their charters, but otherwise they were free to select their own tools and policies. Their objectives were limited by convertibility to gold. Most of these central banks were nationalized in the twentieth century, and lost their independence completely. The Fiscal authorities dictated their policies. After 1951, the Fed regained its independence but it is not absolute. It has to report to Congress, which has the authority eventually to amend the Federal Reserve Act.