Introduction to Economics                                 Lesson 5 / 08


Central Banking

Central Banking is one of the most significant, and from time to time, controversial aspects of political economy.  However, few people know what it is, much less are they aware of its significance.  Nevertheless, in a real sense, the finances of the modern world are controlled by the concept of central banking.


What is Central Banking?

Central banking is the concept that there should exist a bank within the state [or group of states] charged with one or more of a variety of tasks intended to enhance the financial fortunes of the relevant state [or group of states.]  Whilst it may be publicly or privately owned, ultimate power and control resides in the relevant government or governments.

Some of the tasks traditionally associated with central banks include the following;

  • Acting as the government’s banker
  • Control of the money supply
  • Managing the stock of precious metals and foreign exchange.
  • Acting as regulator and supervisor of the banking industry
  • Acting as a lender of last resort to the banking industry
  • Operating a cheque clearing system
  • Setting interest rates and managing and controlling their implementation.

Most states, and some groups of states, such as the European Union, presently have a central bank   Examples include the U.S. Federal Reserve, which is nominally owned by private banks, the European Central Bank, the Bank of England, and the Reserve Bank of Australia.



Credit for the creation of modern central banking is generally attributed to the Dutch.  In 1609 the Amsterdam Wisselbank was founded to provide credit to the province of Holland, in particular to the city of Amsterdam, and to fund the Dutch East India Company.  In 1668, Dutch businessmen helped set up what is now the world’s oldest central bank, Sweden’s Riksbank.

The English followed suit in 1694 with the founding of the Bank of England.  In return for holding government bonds the bank was granted the power to issue bank notes based thereon, and to conduct banking business generally.  In effect this gave rise to the national debt.  This was quite momentous.  Previously rulers wishing to expend money on national projects, particularly wars, had had to raise the money themselves, secured by specie or real property.  But now the government could obtain the money from the Bank, secured only by its own bonds ie its promise to pay.  The concept that this money was backed by government’s access to the wealth of the nation, including the government’s ongoing access to its future wealth, was thus established.


In France acceptance of the concept of central banking suffered a setback due to the activities of John Laws [1671-1729].  Laws was a Scottish banker and economist who persuaded the French royalty in 1716 to set up in effect a royal bank, initially called the Banque Generale and later the Banque Royale, along similar lines to the Bank of England.  For a while the Banque enjoyed phenomenal success and Laws was feted as a financial genius.  In a manner reminiscent of the fame enjoyed by the recent Chairman of the American Federal Reserve, Alan Greenspan, Laws was showered with honours; the Pope sent a special envoy to his daughter’s wedding.  However in 1720 the Banque collapsed.  The effect thereof was so traumatic to the nation that for a long time the word ‘banque’ in French was in disfavour, the word ‘credit’ being preferred instead.  Eventually a French central bank was set up by Napoleon in 1806.

In the USA, central banking was an issue of dispute virtually from the founding of the nation.  The Constitution gave the Federal government no specific power to establish a central bank.  Despite objections President Washington chartered the first Bank of the US in 1791, modeled on the Bank of England.  However opposition to the bank continued and its charter was not renewed when it expired in 1811.  However in 1816 a further attempt to establish a national bank was successful and the Second Bank of the US was chartered along similar lines to the first.  Despite the US Supreme Court voting unanimously in the famous 1819 case of McCulloch v Maryland that the Bank was constitutional, opposition to the bank was again such that its charter too was not renewed when it expired in 1836.  Thereafter, apart from temporary measures instituted by the Lincoln administration to finance the Civil War, the USA did not have a central bank until the creation of the Federal Reserve in 1913.


The Present

Presently, central banks throughout the world are seemingly in crisis.  We can ask why this should be so.  Is it coincidently worldwide mismanagement ?  Was there an egregious, or set of egregious unfortunate events ?  Or is it that central banking is inherently flawed?

Central banks are not all completely separate and equal.  There is a hierarchy of central banks at the head of which is the Federal Reserve.  Until the early 1930s most central banks stood ready to redeem their currency, if and when required, with gold.  This placed some constraint on their power to create money.  Post WW2 however, only the Federal Reserve was prepared [at least until 1971] to do so.  During this time moreover the USA has been the world’s largest and richest trading nation.  It was convenient for the world to accept the US dollar as the preferred foreign currency.  The actions of the Federal Reserve, particularly of its chairman, thus became crucial.

The nominal rationale of central banking is that by enabling governments to acquire the monetary means to achieve their desires, the relevant economy will develop faster and production will increase more than it otherwise would, thereby producing the wealth to secure the money created to achieve it.  If however the production of wealth fails to keep pace with the supply of money created to achieve it, the currency will lose value.  In fact, this is what has happened; since 1913 the US dollar has lost more than 95% of its value.  Most, if not all, other currencies have fared similarly. However the loss in value has been largely steady, albeit continuous.  The real risk to central banking is runaway inflation.

The fact that central banks have the power to create money gives rise to what economists call ‘moral hazard’, ie bad or negative incentives.  In the case of central banking, the relevant moral hazards are theft and irresponsibility.  Economists, even those in favour of central banking, have long recognized the inherent danger thereto of moral hazard   They have stressed that money must not be created, in effect to bail out losers, or otherwise merely to buy political support.  Milton Friedman [1912-2006] for instance urged that the money supply should be permitted to increase only by a set and unchangeable percentage each year.  Governments loudly, if somewhat dubiously, proclaim the independence of their central bank 

What then is the cause of the seeming present crisis ?  Perhaps the most credible suggestion is that it is the fault of Alan Greenspan, the recently retired Federal Reserve Chairman.  If a central banking system is to work as intended, it requires a chairperson of intellect, courage and integrity.  Greenspan’s predecessor, Paul Volcker, demonstrated such qualities.  When the economy was threatened with inflation, Volcker, to use his phrase, had taken away the punchbowl.  He had stopped the creation of money, at the cost of considerable personal opprobrium.  Inflation had been tamed. 

In Greenspan’s term, the problem, in the early years of the present decade, was to cope with a boom that was coming to an end, threatening recession.  Rather than taking the sound but unpopular step of merely easing the fall, Greenspan had kept the boom going for several years more by the creation of ever more easy money, creating in the process debts and deficits of a magnitude never seen before.  Perhaps we should not have expected otherwise.  As an economist, Greenspan had written in 1966, an incisive article in support of the gold standard, effectively condemning virtually every principle of central banking.  When asked to explain how, in seeking the office of Chairman, he equated such article with the holding of such position, he explained that he no longer held such views


                               David Sharp

                               22 April 2008




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