Banking, Central

BIBLIOGRAPHY

Central banking, the function of central banks, consists essentially of the exercise of the public duty of influencing—by regulation, persuasion, or market operation—the behavior of banks and other financial intermediaries in a country. Although they have antecedents as private institutions in the economic development of a few countries, central banks are now primarily public institutions for implementing economic policies of governments. They are appropriate to the Western-type economies; in the communist countries, where economic activity is more comprehensively organized by governments, there is little scope for central banking, although institutions described as central banks exist. In true central banking the public interest is universally paramount, although for historical and other reasons there is some clinging to vestigial private forms and some insistence on a peculiar independence from the central machinery of government.

The activity of central banking emerged gradually from attempts by bankers to protect themselves by organized action and attempts by governments to ensure that monetary conditions serve the purposes of financial policy (at first) and general economic policy (later); this twofold origin is reflected in the formal organization of central banks as banks and in their ultimate subjection to the sovereign power in the state. Before 1900, the development of central banking was almost entirely empirical. Ideas on the subject sprang largely from the efforts of the Bank of England to deal with practical problems; there were also important experiences in the United States before 1836 and in Europe at times during the nineteenth century. Although some aspects were discussed in official inquiries, in English pamphlet literature (W. Bagehot’s Lombard Street, 1873, being the classic example), and in European controversy on the issue of bank notes, systematic thought on central banking in recognizably modern form can be dated from the United States controversy and public inquiry from which the Federal Reserve System emerged in 1913.

The development of thought received further impetus from the problems of monetary reconstruction in the years immediately following World War i; it was in this phase that the central bank was seen as the independent controller of the supply of money, and therefore as the custodian of its value against the assaults of improvident ministers of finance. Incidental to the rehabilitation of the monetary systems of countries that had passed through extreme inflations, new central banks were established and older institutions were reconstructed and explicitly charged with the function of central banking.

Since 1945 there has been a further spate of new central banks, especially in countries emerging from the breakup of colonial empires. In this latest phase, in these and other underdeveloped economies, central banks have been seen as part of the administrative machinery for speeding economic growth. There has also been a disposition to regard a central bank as a symbol of economic independence in reaction against the tutelage of the colonial period. In the more highly developed economies, the emergence of more positive and more complex economic policies (such as “full employment”) has tended to make the objectives of central banks more complex and their operations more extensive.

Early philosophy. Because central banking grew out of the attempts of practical men to deal with situations arising in the business world, the historical theories of central banking have had little logical relationship with each other, although all have left their mark on the broad body of ideas current among central bankers in various countries. Throughout the earliest phase the “stand-by” theory was predominant: the central bank was a large institution continuously but cautiously engaged in the ordinary business of banking, but having a public duty to prevent, by its occasional aid to other financial operators, the collapse of the structure of credit. In fulfillment of this duty—a duty that served alike the needs of government finance and of the banking community—the central bank emerged as the “lender of last resort.” This function as lender of last resort remains a cardinal feature of central banking; from it much else has developed, including powers of control more continuous than anything envisaged in the pure standby theory.

Emergence of the central bank as lender of last resort and as a curb on the lending practices of commercial bankers was closely associated with, and sometimes preceded by, its emergence as “the bankers’ bank,” in the sense of allowing the commercial banks to keep their own banking accounts with itself. In London, this development arose primarily from the strength of the Bank of Eng-land as the government’s banker, enjoying privileges won in return for its substantial help to a needy government in time of war. The prestige of this privileged body, combined with its business as banker to the government, gave bank notes issued by it a circulation displacing, in London, the notes of other bankers. Both because other banks had continuous business with it as the government’s banker and because its notes were in such demand, other London banks soon found it advantageous, and eventually vital, to keep accounts at the Bank of England. The Bank had become the bankers’ bank. The other banks found it convenient to settle clearing differences by transferring Bank of England debts (at first notes and later deposit balances), and the Bank gained further prestige.

There were analogous developments in some European financial centers, but slower development of the banking habit on the Continent, and particularly the absence of such extreme financial centralization as that of London in the English economy, made the process slower and more dependent on deliberate centralization of the note issue. In the United States and other countries with no effective central bank before 1900, there was no analogous evolutionary process; instead, there has been simple application, by legislative fiat, of the theory that the central bank must be the bankers’ bank and lender of last resort. This twofold relationship with the commercial banks gives the central bank, incidentally, a twofold sanction: a recalcitrant bank would be unable to count upon help in time of trouble, and at any time its business could be drastically inconvenienced by enforced closure of its account at the central bank. This double sanction remains important: its existence, although not often mentioned, is as important as any legislative sanction in giving force to the moral suasion that has become such an important part of the central bank’s practice in England and elsewhere.

Stand-by theory. In its strictest form the standby theory of central banking leaves the central bank comparatively inactive at ordinary times: the central bank comes importantly into play only on rare crisis occasions, when it has to save the banking system from collapse. A more sophisticated form of this theory appeared in the controversies leading to the establishment of the Federal Reserve System. The pre-1913 banking system of the United States, lacking a central bank, was alleged—perhaps without adequate justification—to lack the “elasticity” desirable for seasonal and other variations in the “needs of trade.” Coinciding with the traditional banking view that the safest lending is that which provides for the legitimate needs of trade, the demand for elasticity was responsible for the doctrine that the reserve banks should adopt the passive role of standing ready to rediscount good commercial paper when commercial banks, finding themselves unable to meet their customers’ requirements for finance of current trade, brought paper to the reserve banks. On this view, although it was a stand-by theory of central banking, the central bank was expected to be operating continuously, and not only at periods of incipient crisis, to meet the continually varying needs of the economy.

Stand-by theories of central banking, of varying sophistication, continue to be held in some quarters, although rarely explicitly. The attitude is consistent with the central bank’s taking continuous interest in the “quality” of credit granted by various financial institutions; this is a side of central banking more systematically developed since 1935. It has received added impetus from the policy, important in the underdeveloped countries, of promoting healthy financial institutions to facilitate the growth of the economy.

Regulator of credit. The second main strand of development in central banking has its roots in the Bank of England’s preoccupation, over a long period, with the connection between the terms at which it lent to customers and its power to maintain convertibility of its notes into gold at a fixed rate. Into discussions of this practical problem the theoretical ideas of economists were woven early in the nineteenth century. Throughout this century development flowed, however, rather from efforts of practical men than from economic theorists; but in the twentieth century the economists have taken a leading part in the formulation of ideas on the duty of the central bank as the regulator of the price and quantity of credit. From the first, both theorists and practical central bankers have regarded the price (the rate of discount or interest) and the quantity as being interdependent: regulating the price has implied regulating the quantity, and regulating the quantity has implied regulating the price. In the two major countries in which central banking has been most consciously developed—Britain and the United States—the emphasis has been different. In Britain the emphasis has nearly always been on regulation of the rate of interest, whereas in the United States the emphasis has been rather on regulation of the quantity of credit.

British experience. The view that control of the quantity of money is the prime function of the central bank derives directly from the classic debate in Britain—the Bullionist controversy—during the Napoleonic wars. The Bank of England began to think of control of the volume of its own lending (with important influence on the total supply of credit) as the principal means of protecting its gold reserve and maintaining the gold standard. This policy (always liable to modification in crisis, when the Bank had, as lender of last resort, to increase its own lending to avert a collapse in the supply of credit) soon led to the device of manipulation of the discount rate (Bank Rate), which was destined to alter the whole complexion of English central banking.

The movement of the Bank of England’s discount rate, or Bank Rate, was at first seen simply as a practical banker’s method for protecting his cash reserve against the effects of unusual demands for credit. To raise Bank Rate was a less abrupt alternative to outright refusal of customers’ requirements, and it was at first seen in this light of a more tolerable and less damaging way of rationing credit and so of limiting any demand for gold in exchange for notes. Theorists were quick to connect this practical view with quantity theory views [seeMoney, article onquantity theory] of the determination of price levels: a rise in Bank Rate, enforcing limitation of the volume of credit, caused prices to fall, thus both reducing the demand for gold for circulation and, by improving the balance of trade, eliminating the demand for gold for export. Correspondingly, when its gold reserve (the Bank’s “cash” reserve) was unnecessarily large, Bank Rate could be reduced, encouraging expansion of credit and rising prices. This simple association of Bank Rate movements with the behavior of prices, and so with the maintenance of the gold standard, remained for more than a century the mainstream of orthodoxy on the working of monetary systems. From it flowed the view that central banks could and should regulate their monetary systems by manipulation of discount rates.

Whether the English—or any other—monetary system ever did work like this is unlikely, although doubtless there was always an element of truth in the theory. Certainly the English economy in the second quarter of the nineteenth century, with its immense dependence on a speculative export trade and a connected but equally speculative import trade, both largely dependent on mercantile credit, was an economy unusually sensitive to the price and quantity of credit. The association of rising discount rates with the imminence of an extreme liquidity crisis—always liable to occur in pre-Bagehot England—was another factor enhancing the responsiveness of the price level to the movement of Bank Rate. Both these circumstances were, however, fading as the nineteenth century went on, while the power of the Bank to maintain the gold standard by manipulating Bank Rate grew beyond question.

This extraordinary power of Bank Rate was based on the position of London as an international financial center. In the first decades of the use of Bank Rate, it had already been noticed that a rise of rates in London deterred the discounting of international bills in London and attracted some foreign money into the purchase of bills in London. This influence on international movement of short-term capital grew with London’s importance as an inter-national financial center, and after about 1870 this effect of Bank Rate changes was so much more obvious than any other that it came to be regarded as almost the whole mechanism. The Bank saw its central duty as the maintenance of the gold standard, which it could protect by raising Bank Rate to attract short-term money and to repel short-term borrowers whenever the gold reserve was running down. The success of this policy depended partly on the disposition, in that period, of some of the principal European central banks to maintain stable discount rates, so that the absolute movements in London implied relative international change.

Throughout the remaining decades before 1914, this manipulation of Bank Rate remained the Bank of England’s principal function, such openmarket operations as it engaged in being usually designed to ensure that the discount rates ruling in the market remained close to the official Bank Rate. Open-market operations were said “to make Bank Rate effective,” a phrase that underlined the importance attached to short interest rates, to the exclusion of any repercussions of Bank Rate on the internal economy. Indeed, in such discussion of the system as there was in these decades, the possibility that a high Bank Rate would have effects on industry and trade was regarded rather as an incidental disadvantage than as an integral part of the mechanism of international economic adjustment. The importance attached to maintenance of the gold standard by differential movements in discount rates bit deeply into the philosophy of practical central bankers. This emerges in the correspondence between Montagu Norman of the Bank of England and Benjamin Strong of the Federal Reserve Bank of New York, where development of a short-money market in New York is seen as a prerequisite of an international gold standard in which gold reserves—and so internal credit conditions—are seen as protected from international exchange disequilibria by differential movements in short rates. This strand of thought, besides influencing the development of central banking in the United States, also lay behind the wish of Montagu Norman to see money markets develop as an essential framework for central banking in the British Dominions and elsewhere. Much of the recent fostering of new money markets has its roots in this notion of how an international gold standard should be managed by central banks on the pre-1914 Bank of England pattern.

U.S. experience. The development of the Bank of England’s functions in the pre-1914 period had some influence on the American discussions leading up to the establishment of the Federal Reserve System in 1913–1914; but a more powerful influence was the desire to provide directly for avoidance of the supposed (and perhaps real) disadvantages of the existing monetary system under the National Bank Acts. The new system was to operate as lender of last resort, and so save the United States from the periodic breakdowns that had characterized the banking history of previous decades; but it was to go further, and provide an elastic system responsive to “the needs of trade” as manifested in the supply of good commercial paper in the commercial banks. It was also—in further protection against periodic breakdown, and to reduce the need to adjust internally in the face of an international disequilibrium—to pool the reserves. In the light of subsequent developments, it is instructive to note that the possibilities and aims of open-market operations did not feature prominently either in the preliminary discussions or in the early history of the system itself.

The new system gradually got on its feet during World War i, especially in developing banking and in conducting foreign exchange business for the government. In the immediate postwar phase, it found itself confronted with an inflationary situation, and in dealing with this the Federal Reserve System relied mainly on a steep rise in discount rates. The use of this weapon—and the system had, at this juncture, no effective alternative— seemed appropriate not only in the light of the pre-1914 Bank of England practice but also in the light of economists’ views, now focused on this aspect of economic policy and henceforward exercising more influence on central bank thought.

Development of theory. Stemming directly from the quantity theory and the theory of the international price mechanism as formulated by the economists, and enlivened by controversies on the effects of changes in the production of the precious metals, monetary theory had in the first decades of the twentieth century attracted further interest from economists’ attempts to penetrate the mysteries of the trade cycle. Fisher in the United States, Marshall in Cambridge, Wicksell and Cassell in Sweden, and Fanno in Italy were prominent in developing this theoretical background of the first postwar policies of central banks. The grafting of this theoretical work on to the notions of the central bankers themselves, deriving from the practices of the im-mediate prewar period, can be seen in the English Cunliffe Report, of 1918. This report, aimed at the elimination of inflation and restoration of the international gold standard, pinpointed the central bank’s discount rate (Bank Rate) as the proper weapon. In advocating the use of Bank Rate, the Cunliffe Report concentrated not, as might have been supposed from prewar practice alone, on its influence on international capital movements, but on its influence in reducing the volume and use of credit internally, thus causing reductions in prices and employment.

The functions of central banks were now much under review; central banking became for the first time fully self-conscious; and the theory of the internal effects of Bank Rate changes quickly gained influence in many countries of the world. When, in the 1920s, new central banks were founded, or old ones were rechartered, discount rate was ac-corded the highest importance, even in countries where it could have little relevance to its traditional field of international capital movements.

In Britain, where the practical men found in its prewar success a reason for reliance on Bank Rate, and where it indeed still had some relevance to international capital movements, Bank Rate policy was given a new lease on life as the principal business of the central bank. Simultaneously, there was a great burst of interest among the theorists, especially Hawtrey and Keynes, in central banking in general and Bank Rate in particular. Hawtrey stressed the direct impact of Bank Rate on demand for working capital, while Keynes, along Wick-sellian lines, stressed indirect influence on the demand for fixed capital goods. Whether they leaned to Hawtrey or to Keynes, all alike among the econo-mists and practical men came to think of Bank Rate as having a pivotal place in the control of the internal situation of prices and employment; the conduct of the central banks was therefore of great interest in interpreting the difficulties of the restored international gold standard and in evolving national policies for stimulating revival after the breakdown of that standard.

Extension of powers. In the United States there was a similar trend in thought, but the upshot in practical central banking took rather a different turn, largely as a result of the radically different situation in which the Federal Reserve System found itself. The early postwar inflation, which the system had fought by high discount rates and other hindrances to the expansion of credit, was soon over, and the international trading position brought to the United States an unnecessarily large gold reserve. In an effort to overcome the technically weak position in which the reserve banks found themselves, the system stumbled into a great extension (from about 1922–1923) in its open-market operations. The effect of these operations on the reserves of member banks was at once realized and arrangements were made within the system to coordinate the open-market operations. This was the beginning of the Open Market Committee, now the effective policy-making body in the system. Thanks to the strength of classical views on changes in the quantity of money, the open-market operations quickly came to be regarded as a fairly direct way of operating on the internal price and employment situation, and not, as analogous operations in London had traditionally been, as merely technical devices for enforcing the central bank’s discount rate. With its strong balance of payments and excessive gold reserve, the Federal Reserve System was then able to develop its open-market operations, with discount rate policy in support, for the purpose of stabilizing the price level, this being regarded as the most effective way of averting cyclical fluctuations in output and employment. From some points of view, this radical development of American monetary policy, dating from about 1923, can be considered the beginning of genuine central banking. In the sense of there being avowed recognition of a complex of public (noncommercial) objectives, and a final break from reliance on semiautomatic indicators within the central bank’s asset structure, this is indeed the beginning of the self-conscious, discretionary central banking we know today.

The new turn in central banking in the United States was watched with great interest by authorities in other countries; along with the new British interest in the internal effects of Bank Rate, the American open-market operations became prominent in the literature of central banking. This literature included works by Keynes (Treatise on Money, 1930), Hawtrey, and leading United States economists both inside and outside the Federal Reserve System; there were important official inquiries in the United States (especially the “stabilization” inquiry), in Britain (the “Macmillan” Committee on Finance and Industry), and in the British Dominions. Much of this academic and official literature belongs to the restored gold standard period (1925–1931) and takes an international standard for granted.

Later, after the 1931 breakdown, central banks were also seen as advisers to governments on foreign exchange questions and as official operators in the foreign exchange markets. In the 1940s these functions were commonly extended to include administration of foreign exchange restrictions, and since 1945 the establishment of the International Monetary Fund and the elaboration of international cooperation generally have meant that frequent contacts with other central banks form an important function of a central bank.

In many countries, the disasters of the early 1930s prompted sharper assertion of the ultimate authority of political ministers for monetary policy and therefore, implicitly if not explicitly, for the activity of central banks. Another effect was extension of the technical powers of central banks, in the hope that a broader range of weapons would enable central banks more effectively to stem the contraction of bank credit in a slump. In the United States, where the system had proved a broken reed in the slump, no great change occurred in constitutional relationships, but the centripetal forces in the Federal Reserve System became stronger, changes were made in the power of the reserve banks to act as lenders of last resort, power to vary reserve ratios was introduced, and the system was given some control over stock market credit. Throughout the world, the crisis had the effect of shaking up thought on central banking, and it became normal to regard every country—or almost every country—as needing a central bank that would pursue a complex of aims with a wide range of technical weapons.

The central banks established since 1945—most of them in the emergent countries of Asia and Africa—have therefore been based on the view that the main business of a central bank is to control the monetary system in a way conducive to the broad economic policies of government (high levels of employment, economic growth, stable prices, foreign exchange stability, etc.) by exercising the following powers: (1) action as lender of last resort at an announced rate of interest (Bank Rate); (2) open-market operations; (3) fixing reserve requirements for commercial banks; (4) supervision of commercial banking; (5) banker to the government (generally involving important functions in relation to government debt); (6) adviser to the government on foreign exchange policy; (7) custodian of the country’s international reserves; (8) administrator of foreign exchange restrictions; and (9) dealer in foreign currencies and gold.

The relative importance attached to these powers varies greatly from country to country, in reflection of the varying histories, institutions, and prevailing economic doctrines in the different countries.

Regulation of credit. Importance is universally attached to the power of the central bank to avert a breakdown of the system, acting as lender of last resort. In most countries, however, this is no mere safety valve for operation in rare emergencies; the central bank commonly lends considerable amounts to banks at penalty rates of interest, and bankers therefore take note of the rates announced by the central bank. An elaboration of this Bank Rate weapon is the use of a scale of interest rates, rates higher than the basic rate being charged for successive tranches of assistance; or higher rates may be related not to the amount of lending but to some recent increase in the assisted bank’s lending to its customers.

Similar elaboration has been seen in reserve requirements, which are usually in the form of cash in hand and/or deposits at the central bank, but occasionally include also certain government securities. Normally these requirements are fixed as percentages of prescribed deposit liabilities. Until the 1930s such percentages were unvarying, but most central banks now have power to vary the percentages and other features of the requirements; in some European countries such variations have become frequent, especially where the central bank encounters technical difficulty in the use of open-market operations to vary the absolute levels of reserves available to the commercial banks. In addition to the basic percentage, a commercial bank may be required to make deposits (at the central bank) proportional to its “excess” lending to customers, or certain groups of customers; this elaboration of reserve requirements is particularly useful in action against an inflation that is being obviously fed by bank lending in particular directions.

Outside Britain and the United States, the scope for open-market operations (the immediate object of which is control of the absolute level of bank reserves ) has been narrowly limited by the absence of active markets in the classes of securities (primarily government short-term bonds and first-class short-term commercial paper) in which central banks are willing to deal. The Bank of Canada, however, has been outstandingly successful in fostering a market and then operating in it to control bank reserves. The National Bank of Belgium has also advanced notably along this line; so, in narrower limits, has the Netherlands Bank, but the central bank of West Germany has been notably impeded by the difficulty of any large-scale operations. In some other European countries, and in the emergent countries of Africa and Asia, central banks have not been able to do anything at all with this traditional weapon.

Central banks universally act as bankers for their governments, although the extent of these duties varies from one country to another. In some European countries this banker–customer relationship has allowed the authorities to operate on the reserve position of the commercial banks, in that the retention of an unusually large balance in the government’s account at the central bank has effectively prevented growth (from other origins such as influx of gold) in the reserves of the commercial banks, and vice versa.

As the government’s banker, the central bank advises the government on debt operations; and it has become usual for the government in such operations to heed the central bank’s view of the monetary repercussions of the debt operations. Usually the actual management of the debt is in the central bank’s hands; even where, as in the United States, it is deliberately kept out of the bank’s hands, there is cooperation between bank and Treasury.

Historically, some central banks established themselves largely by gaining from the government—in return for some financial support—privileges of note issue, which allowed them to become the principal, and sometimes the sole, issuers of bank notes in the country. Under nineteenth-century conditions, high importance came to be attached to control of the note issue, and the tendency in some countries has been to concentrate the note issue exclusively in the central bank. With the development of commercial banks and other credit institutions, the note issue has lost its former pivotal position, but management of the note issue remains one of the important routine functions of the central bank.

International functions. Under the gold standard conditions prevailing in the late nineteenth century and the early twentieth century, the notes issued by the central bank were freely convertible into gold (at fixed rates) and gold into notes, and the holding of a gold reserve—eventually the country’s principal or only gold reserve—by the central bank was thus incidental to its function as issuer of notes. After the breakdown of the gold standard in 1931, foreign exchange rates became flexible and matters of great political interest, and central banks became more active in foreign exchange markets. Foreign exchange restrictions then and later were administered by, or in consultation with, central banks. Under the International Monetary Fund system ruling since 1946, central banks have been responsible for maintaining the foreign exchange rates within the agreed narrow limits, and in some countries (notably England) they have been active in futures markets in foreign currencies. With the development of international monetary cooperation throughout the postwar period, this side of central banking has been accepted as an essential part of management of a country’s monetary system. It is significant that in the United States discussion of foreign exchange business has become, alongside domestic open-market operations and discount rates, the regular business of the Federal Open Market Committee.

In the 1920s, in the Sterling Area, contact with the new central banks in the British Dominions was cultivated by Montagu Norman, governor of the Bank of England; since 1939 the contacts and cooperation between the central banks (now much more numerous) of the Sterling Area have been continuous. Between European central banks (including the Bank of England) contacts have been developed especially in the monthly meetings of the Bank for International Settlements at Basel. European central bank cooperation received great impetus in the management of the European Payments Union; and the arrangements of the European Common Market, under the Treaty of Rome, involve consultations that may develop into concerted action.

Varied philosophies. While these international functions of central banks have been rapidly developing in the same direction in all countries, and the pattern of technical powers of domestic operation has been becoming almost common form throughout the world, the philosophy of central banks has shown little sign of falling into a common pattern. Only a systematic survey of a large number of countries would fully expose the range of ideas; the more important ideas can, however, be found in the development of central banking in the United States and in England.

The Federal Reserve. In the United States, since 1951, Federal Reserve control has been directed primarily at the availability of credit. The reserve requirements of the commercial banks, fixed by the Federal Reserve, are mostly held stable, and the excess reserves of commercial banks increased, and their indebtedness at the reserve banks decreased, by purchases of short-term paper in the market, whenever an expansion of credit has been thought appropriate, and vice versa. Movements of the discount rate have been comparatively rare: when expansionist forces in the economy pull market rates of interest up, so that banks are inclined to lend freely even when their reserve positions are tight, the Reserve System raises the discount rate; correspondingly, the Reserve System reduces its rates, in times of slack trade, in order to reinforce the stimulus of easy reserve conditions in the banking system.

The open-market operations through the earlier years of this period were ordinarily confined to short-term government paper. Federal Reserve authorities held that this sufficed for their purpose, since their concern was with member bank reserves and not with the structure of interest rates. This was the famous “bills only” doctrine; in support, it was further argued that any proper effects on longer-term interest rates would be transmitted from the short end of the interest rate spectrum by the normal arbitrage adjustments of a free market, and that official intervention at the long end of the market would almost certainly give rise to false expectations and so would undesirably distort the structure of interest rates.

At the end of the 1950s the development of a serious balance-of-payments problem in the United States destroyed the simplicity of aims of monetary policy. Conflict appeared between the internal aim of promoting full employment in a growing economy and the external aim of maintaining the international demand for dollars; the Reserve System was then forced to attempt a reconciliation of easy credit conditions and steady low long-term interest rates with some rise in short-term rates. Under the pressure of this conflict, the bills-only doctrine gave way and the authorities began to operate on a large scale in medium-term and long-term securities. Whether they succeeded in making the structure of interest rates different from what it would have been is much disputed; the facts are inconclusive.

This modification of Federal Reserve doctrine, under the pressure of events, nevertheless leaves unchanged the position that the system’s crucial powers are considered to be, in open-market operations, the fixing of reserve ratios for the member banks, and the fixing of the discount rates at which member banks can, by borrowing at the reserve banks, replenish their reserves. It is by the exercise of these powers that the Reserve System conditions the attitude of the commercial banks in lending to business firms throughout the country, and this is regarded as the main duty of the system.

In addition to these general methods of regulating the banking system, the Federal Reserve System has special powers to regulate the credit terms on which transactions in stock market securities are financed. The system was given these powers to enable it to attack directly any repetition of the 1928–1929 stock market boom. At times the system has been authorized to prescribe terms on which installment credit and certain real estate credit could be extended, and also to encourage lenders to restrict other types of credit voluntarily. Since 1951, although the stock market credit regulations have been used, all these possibilities of “selective” credit control have been rather out of fashion in the United States. This has been partly because the Federal Reserve authorities have felt themselves exposed to political pressures from sectional interests hurt by such controls. But the attitude has also been partly due to the confidence the Reserve System has felt in its broader powers to control the banking system and its belief that this is the proper business of the central bank. In many other countries, where the central bank has less confidence in its general powers, comparable measures of selective credit control have been greatly developed since 1945.

Another important activity of the Federal Reserve System is in the foreign exchange market. This activity, begun during World War i, was given new impetus by the events of the middle 1930s, and has been greatly developed since the International Monetary Fund was established and especially as part of the intensified international monetary cooperation that characterized the years 1958 to 1963.

Finally, the Federal Reserve System has extensive powers of inspection of its member banks. These powers have existed from the outset, and have been exercised not for direct support of the system’s monetary policy but for the promotion of “sound” commercial banking.

For its own guidance in exercising all these functions, the Reserve System maintains a distinguished research division. The material produced by this division, besides being used internally, is in large part published. This is part of the effort of the system to foster an informed public opinion, an objective also sought by the efforts of the system’s governors and officials to keep in touch with the banking and commercial communities all over the country.

The Bank of England. During the period 1951 to 1963, the functioning of the Bank of England has been quite different from that of the Federal Reserve System. The difference has been mainly due to the constant preoccupation of the Bank of England with the balance of international payments, a preoccupation that reinforced the traditional primacy of Bank Rate. At first the tradition itself was important, in that the use of Bank Rate affected international confidence in sterling and so had useful effects on international capital flows. Later, especially after 1958, Bank Rate operated in the traditional way of regulating international interest rate differentials. Although the Bank was moving Bank Rate primarily for the sake of influencing international capital movements, it has also entertained some hope that the changes in Bank Rate would affect the pressure of internal spending; in the 1950s these two objectives did not conflict.

Open-market operations have been further developed, particularly at the long-term end of the market. In the short-term market there has been no important departure from the pre-1939 and wartime technique. The Bank of England has operated to keep short-term rates in the desired relationship with Bank Rate; since 1951, this control has included action as lender of last resort (“front door” operations) as well as trading at rates below Bank Rate (“back door” operations). The implication of this technique is that the commercial banks’ liquid assets ratio (conventionally “the 30 per cent ratio”) rather than the cash ratio (8 per cent) has been the fulcrum for central bank influence on commercial bank liquidity. This has given new importance to operations in longer-term securities. These operations, carried out on the stock exchange by the Government Broker under daily instruction from the Bank, are at once the technical channel for management of the national debt and a device for operating on the reserve positions of the commercial banks. In effect, the Bank increases bank liquidity when the Government Broker buys bonds and decreases bank liquidity when he sells bonds. Throughout most of the postwar period, the desire of the authorities has been to reduce bank liquidity by selling more bonds and longer bonds, and to replace Treasury bills or very short bonds: this policy is usually referred to as “funding.”

In pursuing its funding policy, the Bank has tried to avoid appearance of manipulation of market prices of securities. Unfortunately, since the Bank’s policy on short-term rates tended over the 1950s to cause a gradual rise in long-term rates, the Bank was for long periods operating in a falling market and found itself unable to sell any large volume of longer-term bonds. It therefore continued to be embarrassed by the high level of liquid assets in the commercial banks. Concerned that this could add to inflationary pressures, the Bank, until 1960, resorted to increasingly stern instructions, of an informal kind, limiting lending by the commercial banks. Such instructions have been easy to use in England, where the banking system is characterized by geographical, political, and intellectual concentration. Complaints that these controls were ineffective and unfair, because as lenders the banks are competing with a variety of other financial intermediaries, have been met by extension of the range of financial intermediaries to which “requests” are addressed by the Bank of England.

Another innovation precipitated by the relative failure of the funding policy has been the imitation of a device common in other central banks, including the Federal Reserve: this is the variation of percentage reserve requirements imposed on the commercial banks. Throughout the 1950s, the Bank of England adhered to the percentages evolved by the commercial practices of the London Clearing banks: a fixed 8 per cent cash rate and a minimum of 30 per cent liquid assets. In 1960, however, a fresh bout of restriction was decided upon, at a time when the Bank’s funding operations had still not entirely eliminated the excess liquidity of the commercial banks. The Bank raised the reserve requirements, eventually by 3 per cent, by requiring the banks to make “special deposits” at the Bank of England. Two aspects of this special deposits system are noteworthy. First, the arrangements were made without any legal change, and the details were agreed upon between the Bank and the commercial banks. Second, although at the outset the banks were given no instructions as to how to adapt themselves to the raised requirements, when the weapon was pressed furthest (to 3 per cent) the banks were told precisely how they were to react. The new device had already become a piece of ritual, and the really effective step was the direct instruction to the banks on their lending policies. As much as ever before, the English authorities rely on moral suasion as a major technique.

When relaxation became appropriate in 1962–1963, the special deposits were reduced (by stages) to zero, and then the 30 per cent liquid assets ratio was reduced to 28 per cent. Announcement of this change implicitly left open the possibility of further flexibility in reserve requirements.

The Bank of England has also during the postwar period shown willingness to consider long-term interest rates as its proper concern. Until about 1955, the Bank’s attitude was that its direct responsibility in interest rates was limited to the short end. This did not imply any denial of the Wicksell–Keynes view of long rates as instruments for controlling, via fixed investment, the pressure of total demand; rather it was that the Bank thought of itself as influencing long rates only through its action at the short end of the market (including both Bank Rate policy and its action on bank liquidity). From about 1957, however, the Bank began to pay some regard, in its operations in the gilt-edged market, to the possible effects of these operations on long rates. This shift of emphasis did not, however, go very far, and there appears to have been some retreat from it in 1962–1963.

Until the postwar period, the Bank of England was an extremely secretive body. At first this was because its business was essentially that of a private banker, but the tradition continued long after its public duties became paramount. In the postwar period, this attitude was strongly and persistently attacked, and a change has been evident. This change, associated with an effort to improve the economic information on which policies may be based, is to be seen in the Bank’s quarterly bulletin. Thus, both the world’s leading central banks now appear to accept the view that an informed public opinion is the surest foundation for monetary policy.

The developments in the functioning of the Bank of England, described in these paragraphs, indicate that England has gone appreciably further than the United States in accepting the view that both the ends and the means of central banking are multiple and that there can therefore not be any golden rule for its conduct.

R. S. Savers

[See alsoMoney; Monetarypolicy; and the articles underInternational Monetary economics.]

BIBLIOGRAPHY

Aschheim, Joseph 1961 Techniques of Monetary Control. Baltimore: Johns Hopkins Press. ? The best detailed study of central banking techniques but almost exclusively related to American practice.

Bank for International Settlements 1963 Eight European Central Banks. New York: Praeger. ? Shows how central bank officials see the institutions in which they work.

Burgess, Warren R. 1927 The Reserve Banks and the Money Market. New York: Harper.

Chandler, Lester V. 1958 Benjamin Strong: Central Banker. Washington: Brookings Institution.

Clay, Henry 1957 Lord Norman. New York: St. Martins.

Commission on Money and Credit 1961 Money and Credit: Their Influence on Jobs, Prices, and Growth. Englewood Cliffs, N.J.: Prentice-Hall.

Crick, Wilfred F. 1965 Commonwealth Banking Systems. Oxford: Clarendon.

Federal Reserve Bulletin. ? Published since 1915 by the Board of Governors of the Federal Reserve System.

Goldenweiser, Emanuel A. 1951 American Monetary Policy. New York: McGraw-Hill.

Great Britain, Committee on the Working of the Monetary System 1959 Report. Papers by Command, Cmnd. 827. London: H.M. Stationery Office. ? Known as the Radcliffe Report. Includes material from other countries.

Hardy, Charles O. 1932 Credit Policy of the Federal Reserve System. Washington: Brookings Institution.

Hawtrey, Ralph G. (1932) 1962 The Art of Central Banking. 2d ed. London: Cass. ? Provides important material on British experience.

Keynes, John Maynard (1930) 1958–1960 A Treatise on Money. 2 vols. London: Macmillan. ? Volume 1: The Pure Theory of Money. Volume 2: The Applied Theory of Money. Provides a pre-1935 view of central banking in the United States and Britain.

Kisch, Cecil H.; and Elkin, Winifred A. (1928) 1932 Central Banks: A Study of the Constitutions of Banks of Issue, With an Analysis of Representative Charters. 4th ed., rev. & enl. London: Macmillan. ? Documents central banking statutes in the interwar period.

Plumptre, Arthur F. W. 1940 Central Banking in the British Dominions. Toronto Univ. Press; Oxford Univ. Press. ? The best study of early central banking in the less developed systems.

Reed, Harold L. 1922 The Development of Federal Reserve Policy. Boston and New York: Houghton Mifflin.

Reed, Harold L. 1930 Federal Reserve Policy: 1921–1930. New York: McGraw-Hill.

Riefler, Winfield W. 1930 Money Rates and Money Markets in the United States. New York: Harper.

Ritter, Lawrence S. 1962 Official Central Banking Theory in the United States, 1939–1961; Four Editions of the Federal Reserve System: Purposes and Functions. Journal of Political Economy 70:14–29.

Sayers, R. S. 1957 Central Banking After Bagehot. Oxford Univ. Press.

Sayers, R. S. (editor) 1962 Banking in Western Europe. Oxford Univ. Press.

[U.S.] Board of Governors of the Federal Reserve System (1939) 1963 The Federal Reserve System: Purposes and Functions. 5th ed. Washington: The Board.

U.S. National Monetary Commission 1909–1912 Publications of National Monetary Commission. 24 vols. Washington: Government Printing Office. ? Includes material on early developments throughout the world.

Willis, Henry P. 1923 The Federal Reserve System: Legislation, Organization and Operation. New York: Ronald.