The Purpose of Central Banks. Jane Knodell The University of Vermont | by Monetary Policy Institute Blog | Apr, 2024

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Jane Knodell
The University of Vermont

Monetary Policy Institute Blog #133

“This historical scan reveals two primary constituencies and purposes that gave rise to central banks: national governments, which needed fiscal and financial support; and merchants, which needed better payment systems.”

Why were central banks originally created? This blog reviews the origin stories for a group of western institutions from the early 17th century to the early 20th century. This historical scan reveals two primary constituencies and purposes that gave rise to the early central banks: national governments, which needed fiscal and financial support (the Anglo-American case) and merchants, which needed better payment systems (the European case).

It is now conventionally viewed as unwise for central banks to lend directly to their national governments, particularly if they are in financial distress, but this is exactly how and why the English Parliament created the Bank of England (1694). In her late 17th-century war with France, England’s debt issuance ran ahead of revenues, merchants and investors became less willing to lend to the government, and the value of its short-term debt fell to larger and larger discounts. The exigencies of war finance coalesced a majority in Parliament around the idea of authorizing a group of investors to subscribe to a long-term loan to the government in exchange for banking privileges, and the Bank was born.

The First Bank of the United States (1791) was created to put the postwar U.S. government on a solid financial foundation. Under the Articles of Confederation (1781–1789), the national government was funded through requisitions on state governments. By 1790, the U.S. had defaulted on much of its debt held abroad. The Constitution gave the national government taxing power that made a credible restructuring of the national debt possible. The national government also needed to be able to collect taxes in a timely way, and with a better form of money than was available at the time. This is where the First Bank of the United States came into play.

After deciding not to renew the charter of the First Bank, then waging war against Great Britain without a national bank, Congress decided to try again. Under the leadership of Nicholas Biddle, the Second Bank of the U.S. provided the same fiscal-monetary services its predecessor had, now over a far larger geographic space. Specie was increasingly centralized within the Bank, where it was used to protect the Bank against raids from the state-chartered banks and the national economy against international specie drains. The Second Bank lost its bid for charter renewal in 1834.

The common theme in the origin stories of proto central banks of Western Europe is currency stabilization to improve the payment system. This benefited all users of money, but particularly merchants who carried out the work of commodity circulation within national and global market systems.

For instance, the Bank of Amsterdam (1609) was created by the municipality in response to merchants’ complaints about the chaotic payments system (a multiplicity of coin and devalued coin). As banker to the international merchants of Amsterdam, the Bank became the central location where bills of exchange were settled and reliable high-value coins could be procured. Sweden’s Riksbank (1668), modeled after the Bank of Amsterdam, was also set up to reduce high transaction costs, here associated with the use of silver and copper coins and plates.

The Bank of France (1800) was the last in a series of central bank-type Parisian institutions established and capitalized by coalitions of Parisian merchant bankers in the late 18th century to stabilize the payments system. By 1803, the Bank had merged with all remaining Paris banks, making it the monopoly issuer of bank notes. The Bank of France, unlike the Bank of England, was not founded as a fiscal support to the national government and only took on this role with World War I .

The central banks of Germany, Switzerland, and Italy were all created to resolve problems associated with a multiplicity of currency and coinage systems within their national boundaries. Germany’s Reichsbank (1875) unified the note issue and improved long-distance payments within the country. The Swiss National Bank (1905) also replaced a system of multiple local notes that circulated non-locally at a discount with its notes. The Bank of Italy (1893) was created as part of a reorganization of Italy’s banks of issue in the context of national political unification.

The Federal Reserve (1913) also belongs in this group. It was not created as a lender of last resort; this authority was not provided until 1932. In the late 19th century, the economy had experienced regular, and increasingly severe, shortages of currency that undermined the stability of the banking system. The notes of the Federal Reserve Banks were conceived only as temporary emergency notes provided to member banks with eligible collateral. World War I brought about legislative changes that turned Federal Reserve liabilities into the banking system’s reserve currency, and positioned the Federal Reserve to become the nation’s central bank.

To conclude, the early central banks were flexible institutions that were created to address specific national circumstances, and that took on new purposes as they, their founding nations, and their national banking systems evolved.

Today, central banks are, for the most part, politically independent institutions that are relied on to provide vital macroeconomic services: continuous and secure large-value payment systems, stable inflation rates and “maximum” levels of employment, and financial stability.

When these goals conflict with each other, it is up to the central banks to decide which goals are most important, decisions that may or may not reflect the priorities of national governments.

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