what is a useful central bank? lessons from the interwar years gianni toniolo duke university...

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What is A Useful Central Bank? Lessons from the Interwar Years Gianni Toniolo Duke University Symposium What is a useful central bank? in honor of Governor Svein Gjedrem Norges Bank, Oslo, 18 November 2010

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What is A Useful Central Bank? Lessons from the Interwar Years

Gianni Toniolo Duke University

Symposium What is a useful central bank? in honor

of Governor Svein GjedremNorges Bank, Oslo, 18 November 2010

Outline of the paper

1. “Useful” central banks in transition2. The 1920s: “useful” central banks, monetary

policy, and macro imbalances3. The monetary response to the great

depression4. Central bank cooperation5. Unorthodox lending of last resort 6. Central bank independence7. Interwar lessons for a “useful” central bank.

The long transition of central banking from gold standard to fiat money (1914-1971)

1914 ‘Classical’ gold standard ends

1919-24 Fiat money, inflations

1924-31 Gold exchange standard

1931-36 Long exit from gold standard

1936-39 Attempts at peg (failed)

The transformation of central banks

Central banks were transformed by the process. At the end of 19th century they were private banks of issue entrusted by governments with the public function of maintaining currency convertibility.

By the 1950s most CBs were, de facto or de jure, public institutions with a wide range of responsibilities, often including bank supervision, and close relations, often subordination, with the national governments.

In the interwar years CBs were not always as “useful” as they might have been.

Nevertheless, the number of central banks in the world increased from 18 in 1900 to 59 in 1950.

Monetary policy in the 1920s

Europe: monetary policy was dictated by the decision to reintroduce convertibility. NO parallel with and NO lessons for today.

US: similarities 1920s & 1995-2007- Real economy growth pushed by

innovations- Stock market boom- Financial innovation- High leverage- Accommodating monetary policy until 1928

Should central banks target asset prices?

R.G. Hawtrey (1933):“Much controversy has been aroused as to the proper functions of a central bank when faced with an inordinate Stock Exchange speculation. Apart from the condemnation of gambling as a vice (a matter which hardly concerns a central bank) the central bank is only concerned with speculation as a possible cause of inflation”

After 2007-09: do we still agree with Hawtrey? Or should CBs also target asset prices?

The intellectual lesson of the 1920s:this time is NOT different

US monetary policy of the 1920s, “was supposed to achieve three ends: mitigate business fluctuations, prevent inflation and restore the international gold standard […] The apparent success of postwar policies in achieving the three main objectives and preventing financial panics increased the credibility of policies and the belief that a new and more stable era had begun” (Meltzer (2003: 261)

A similar belief that a new era of great moderation had dawned was widespread among the public, economists and even central bankers in the decade or so prior to 2007

The lesson for both economists and ‘useful’ central banks is unequivocal: in the future a larger dose of humility will create the appropriate intellectual environment for policy making.

A minor lesson: ‘useful’ central banks should consider employing more economic historians

The monetary tale of 2 Depressions(Eichengreen & O’Rourke)

2007-09 was potentially more disruptive than 1929-33

Policy response was different and, so far, also the outcome

Monetary policy in the second half of the 1930s

After 1935 “Eccles and the Board became convinced after 1935 that the growing volume of (free) reserves at the member banks posed threat of future inflation. The Board’s principal policy action in these years increased reserve requirement ratios as a preemptive act against inflation… thereby contributing to a steep recession in 1937-38” (Meltzer 2003: 416).

France deflated to stay on gold after a relatively mild Depression: growth was sluggish

The UK, off gold, expanded and revived the real economy

Germany and Italy expanded (for the wrong reasons) in 1934-35: output and employment rose

Central bank cooperation

International relations were strained in the interwar years: CBs allowed to cooperate only when consistent with their governments’ foreign policy. They resorted to low-key cooperation in technical matters

Unlike in the 1930s CB cooperation in 2008 was intense and unrestrained. The lesson was learned (international relations allowed strict CB cooperation)

In the last year or so, international relations have shown some distressing similarities with the interwar

Lessons: a) Coordination of domestic monetary policy is only possible when international relations are favorable;b) technical cooperation is useful even at times of “currency wars”

Unorthodox lending of last resort (LLR)

• Bagehot’s model of LLR (“Lend freely at high rates”) approximates the Bank of England’s operations in most of the 19th century.

• The game changed with the banking crises of the early 1920s. It entailed accepting collateral of every kind to “bail out” both financial and non-financial firms

• To do so, CBs had to adjust their practices often by creating their own “off-balance-sheet vehicles” allowed to lend on securities not admissible for discount at the CB

The most orthodox of them all..

• The Bank of England undertook to bail out Banks and support industrial companies in distress, no longer eligible for loans from private sources.

• Norman’s preferred the indirect ways of moral suasion (“privacy, speed, determination, and reliance on a few good men”). But sometimes direct financial intervention was needed (e.g. for the Williams Deacon’s Bank, the Banca Italo-Britannica and the Anglo-South Bank). The Bank of England ended up with indirect holding of bank equity and direct involvement in bank management.

• In 1928, the BoE rescued Vickers-Armstrong an armament manufacturing firm. Besides holding equity in the company, the Bank got involved with its restructuring and management.

• In 1929, the BoE created a Securities Management Trust, as “the channel through which the Bank would provide funds for schemes supported by the Bank”. Norman explained the SMT to the Macmillan Committee saying that “he was a public servant who believed that the Bank should be the catalyst in bringing together the needs for industrial reconstruction and the financial resources the City would mobilize”. It turned out that the resources cam only from the central bank.

The Reichsbank

The Reichsbank “became practically a dictator over the credit life of the nation. The increased importance of the Reichsbank came not only through its position of court of last resort for foreign exchange, money, and credit but also through actual ownership participation in the control of the Joint Stock banks and the central banking institutions” (Northorp 1938).

Hjalmar Schacht

The Banca d’Italia

In the late 1920s, the three largest Italian banks had direct or indirect control of almost one half of the companies listed in the Milan Stock Exchange.

In 1931 the government required the Bank of Italy to provide a massive liquidity infusion to the three banks, the bank took industrial equity as collateral.

For a time (1931-33) the central bank found itself indirectly owing the majority stake in several of the country’s largest industrial companies

Alberto Beneduce

The FED

1932 Reconstruction Finance Corporation (RFC) created to grant credit to banks that could not get it from the market.

1933 Emergency Banking Act calls upon RFC to reorganize and support solvent banks.

1934, the RFC and Federal Reserve began lending directly to business and in due time the former came to have direct or indirect control of banks, in which it was invested. It often used this position to “replace officers and significantly alter the business practices of the institution” involved

• FDR & Marriner S. Eccles

Lessons from RFC?

Analogy RFC - TARP (2008), in both cases:1. close cooperation between the Treasury and the central bank, 2. impact on the asset side of the Fed’s balance sheet3. costs turned out to be a small fraction of what was originally

planned or feared.

The ‘lessons’:a) governments (and central banks) should not be unduly deterred from support programs for ailing financial institutions by fears about their long-term fiscal impact: in due time, markets recovered and what in 1933 looked like a heavy burden on the federal budget, turned out to be of much lesser relevance by 1937.b) both patience in avoiding a fire sale of assets and the choice of the appropriate exit timing are of crucial importance.

LLR & bank supervision

• Massive lending of last resort during the Great Depression convinced legislators that bank supervision was essential to the pursuit of financial stability. In various countries public enquiries showed that the balance sheets of the banks were, if not utterly ‘cooked’, inflated by unrealistic valuations of assets and credits

• Until the mid-1920s, only the US Fed was endowed with powers of bank supervision. The banking crises of the early 1920s, resulted in supervisory authority being conferred on the Bank of Italy in 1926. Japan followed suit in 1928.

• During and after the Great Depression, provisions for bank supervision became a standard item in the legislation to regulate the banking system (US, Germany, France, Belgium, Switzerland, Italy).

• The main exception was the United Kingdom where the Treasury and the central bank preferred to issue “recommendations” to the commercial banks.

• Lesson: the LLR authority (central bank) should also have full supervisory powers (as learned by the UK)

Central bank independence

• WW I: CBs subordinated to governments• Transition to peacetime economy: slow recovery

of independence• Gold Standard: recreates CB independence• Great Depression: mismanagement lowers CB

prestige; governments step in• 1930s: CBs as Government agencies for

managing exchange rates, clearings, even bank supervision

Norman and Strong apostles of CB independence…

• Norman • Strong

Norman and Strong became the self-styled apostles of central bank independence. They had the principle of independence proclaimed at every economic conference and engraved in the tables of the League of Nations.

…and yet they disagreed on the limits to CB independence

Norman’s view was radical to the point of arguing the Bank should have the right to rebuke the government in public and to be free to make decisions regardless of any political consideration.

Strong told Norman that the Fed could never openly act against the government’s interest

Keynes on CB and Treasury

“You can have the two bodies which maintain their respective spheres of responsibility and of power and yet necessarily always work together. It is the fundamental question of the relation between any central bank and any Treasury”

Interwar lessons on CB independence

CB independence depends on (and is ‘useful’ according to) circumstances (as in the ebbs and flows in the interwar years)

CB independence is idiosyncratic to national culture and institutions (e.g. BoE vs. Fed, today’s Asian vs. Western CBs)

CBs may be independent in monetary policy and yet cooperative and/or subordinate in other matters (e.g. “bailouts”): great talent is required in managing independence, cooperation, and dependence.

The 3 lessons already learned

(i) a major financial cum real shock requires immediate monetary reaction of adequate size

(ii) lending of last resort should use all available tools

(iii) international cooperation is essential

Lessons/questions for the future:(i) how to manage the upswing

The following questions remain answered from the 1920s and are in need of attention

(i) Should central banks target asset prices, and if so how?

(ii) Is there a way of knowing the appropriate moment for raising rates in a real/ stock-market boom?

(iii) Can/should central banks reconcile their domestic with their international responsibilities?

Lessons/questions for the future:(ii) long-term unemployment & policy

The 1930s show that the legacy of a major depression is “a substantial increase in long-term unemployment and economic inactivity” and, thus, a lower level of potential output”.

Given this, risk is probably minimized by erring on the expansionary rather than on the deflationary side.

Lessons/questions for the future:(iii) exit from unorthodox lending

It is undesirable for central banks to hold on indefinitely to industrial equity and illiquid bonds. In the 1930s CB involvement in financing - even managing - banks, companies, and ad hoc institutions violated the principle of allocative neutrality of monetary policy, exposed them to criticism and contributed to their loss of independence.

Today it is desirable that central banks return as soon as possible to “the type of lender of last resort transactions that fit within the Bagehot Standards” (Feldstein 2010:137), and to smaller and more liquid balance sheets.

Another “lesson” from the 1930s however is to expect difficulties and delays down the road. “Conditions on the ground” will determine the timing of the “exit strategy”. Unwinding TARP has already proven to be a success story even though the initial time table has not been completely met.

Lessons/questions for the future:(iv) CB independence

• In the 1930s central banks lost their independence because:- they mismanaged the Depression- governments took over policy making & availed themselves of CBs t

their technical arms • The Great Recession has been better managed than Great Depression: no

reputational loss awaits central bankers.• There is no reason to expect a new wave of autarky, exchange controls, and state-

managed credit allocation. The notion that a “useful” central bank must be independent in setting monetary instruments will not be challenged.

• The definition and practice of independence, however, might evolve:- Managing the crisis entailed closer cooperation with the Treasuries which

will continue during and beyond the “exit” period. - Central banks from emerging-market countries will gain international weight and many of them are assigned, like the Fed, the dual targets of price stability and some measure of real-economy performance (growth, employment). Each of them interprets “independence” according to national tradition and institutions.

The banal but important lesson is that in the future, as in the interwar years, a simple, one-size-fits-all concept of independence will not apply to every “useful” central banks.