The Birth of Central Banks

A bank born of a war

In 1694 England was at war with France, and like every state at war it had a desperate need of money. The English crown, emerging from the political upheavals of the century and with a credit far from excellent, struggled to find anyone to lend it the sums needed to finance the fleet and the army. It was then that a group of wealthy merchants and financiers of London advanced a proposal destined to change the history of money. They offered to lend the government a great sum, needed for the war; but in exchange they asked for something more than a simple interest. They asked to be constituted into a company — the Bank of England — to which would be granted, among other privileges, the right to receive deposits and, above all, to issue banknotes, that is paper notes that promised the payment of a sum in metal to whoever presented them. The loan to the crown and the privilege of issuing paper money were born together, indissolubly bound: the state obtained the money for the war, the founders of the bank obtained the right to create a new kind of money. From this pact, concluded to finance a conflict, was born what is generally considered the ancestor of all modern central banks [Kynaston 2017].

It is worth dwelling on the singular nature of this agreement, because it already contains, in embryo, all the fruitful ambiguity of the central bank. The Bank of England was born as a private institution, owned by its shareholders, moved by profit like any other enterprise; but its initial capital consisted, in effect, of a loan to the state, and its privilege of issuing banknotes came to it from the state. It was, then, a hybrid creature, halfway between the private and the public: a private bank that performed a public function, bound to the state by a tie of mutual interest — the state needed its credit, the bank needed the state privilege. This ambiguous nature was not an accidental defect, but the very key to its success and its power, and it would be found again, in different forms, in all the central banks that took it as their model. The government of money, we shall discover in this chapter, has always been a matter that hangs in the balance between private and public interest, between profit and stability, and precisely in this precarious equilibrium lies much of its history.

From that original bond between the bank and the debt of the state was born, incidentally, one of the most important institutions of modern finance: the national public debt managed in a stable and reliable way. We saw in the chapter on the Middle Ages how the Italian cities had invented the negotiable public debt; now, with the Bank of England, that debt finds a permanent manager and a new solidity. The bank administered the crown’s debt, placed its securities with the public, guaranteed its regular service; and since English debt, sustained by a Parliament that ensured its payment through taxes, proved far more reliable than the debts of the absolute sovereigns of the continent — always at risk of repudiation, as we had seen with the Fugger — England could borrow at lower rates and in greater measure than its rivals. This capacity to finance itself with a reliable and cheap debt was one of the great secrets of British power in the following centuries: it allowed England to sustain long and costly wars, to build a fleet and an empire, counting on a financial system its adversaries could not equal. The central bank, the reliable public debt and the power of the state grew together, in an interweaving that is one of the foundations of the modern world, and to which we shall return in the chapter devoted to sovereign debt.

This chapter tells how, from that pact of 1694, was born and developed the institution that today governs money in every country in the world: the central bank. We shall see how a private bank became the pivot of the entire monetary system; how it was forced by crises to discover its most important function, that of lender of last resort; how its model spread through the world, down to the American case and the birth of the Federal Reserve; and what underlying tension — between service to the state and the stability of money, between independence and political control — runs through its whole history, down to the debates of our own day. And we shall meet, at the heart of it all, the mechanism we already know from the chapter on the bankers, brought here to its full maturity: the creation of money from credit, the value from nothing that is the thread of the whole book.

The printed promise

To understand what, in concrete terms, a Bank of England banknote was, one must recall the nature of money we have followed so far. The banknote was not money in the sense of precious metal: it was a promise of money, a note by which the bank undertook to pay to the bearer, on demand, a certain sum in gold or silver. On English banknotes there appeared for centuries the formula “I promise to pay the bearer on demand” — a formula that, curiously, survives even today on British banknotes, a fossil of an age in which the note was truly convertible into metal. The banknote, in origin, was worth something because it was convertible: anyone who possessed it could, in theory, present himself at the bank and obtain in exchange the promised gold. It was, once again, value as promise: a piece of paper worth something not in itself, but for the commitment of its issuer to convert it into metal.

But here intervenes the mechanism we already know, and that the central bank brings to its purest expression. The bank discovers, as the Renaissance bankers had discovered, that not all the bearers of the banknotes come together to demand conversion into gold. In normal conditions, people prefer to use the convenient paper banknotes rather than the heavy metal, and only a small part of the notes returns to the bank to be converted. The bank can therefore issue banknotes for a total value much greater than the reserve of gold it keeps in its vaults, sure that only a fraction of the bearers will present themselves to collect. It is the fractional reserve, applied this time not to deposits but to the issue of paper money: the bank creates money — the banknotes — in quantity greater than the metal it possesses, and this money created from nothing, or rather from trust, circulates and performs all the functions of money. It is the heart of the bank’s power, and it is also, as we shall see, the root of its fragility.

The Bank of England perfected this mechanism and, thanks to its bond with the state and its growing solidity, its banknotes became little by little the most reliable and accepted in the country, until they supplanted those of the other banks and became, in effect, the national paper money. It is worth recalling that, at the start, the Bank of England was by no means the only one to issue banknotes: for a long time, in England as in many other countries, numerous private banks printed their own notes, each convertible into metal at the issuing institution, and circulation was a mosaic of different papers of varying reliability. The passage to a central bank with the monopoly of issue was gradual and matured in the course of the nineteenth century, when it was understood that to leave many banks the power to create paper money was a source of instability: the less solid banks issued more notes than they could honour, and their failures shook the trust in all paper money. To concentrate the issue of banknotes in a single top institution, guaranteed by the state and held to prudent rules, seemed the way to give paper money a uniform solidity. So, in England as elsewhere, the right to print banknotes was progressively withdrawn from private banks and reserved to the central bank, which acquired the monopoly of it: the banknotes we use today, issued exclusively by the central bank, are the outcome of this long process of concentration, by which the chaotic pluralism of private papers gave way to a single reliable national money.

Thus a decisive historical passage was accomplished: from a private bank among many, the Bank of England became the bank of banks, the institution whose banknotes served as the reference money for the whole system, and at which the other banks kept their own deposits and settled their accounts. The central-bank function was, in effect, born: an institution at the top of the monetary system, whose money stands above the others, and which serves as the pivot around which all the country’s credit revolves. This position of summit, reached gradually over the course of more than a century, would give the bank an immense power, but would also impose on it, despite itself, a new responsibility: that of watching over the stability of the whole system, and of intervening when it threatened to collapse.

How trust is born and dies

To understand why the central bank had to take on that responsibility, one must comprehend the intrinsic fragility of the fractional-reserve banking system, and the terrible phenomenon that can spring from it: the bank panic, the run on the banks. We have already touched on this mechanism in the chapter on the bankers; now we must look it in the face, because it is the central problem the central bank was called to solve.

The banking system rests, we have seen, on trust: the trust that banknotes are convertible into gold, the trust that deposits can be withdrawn whenever one wishes. So long as this trust holds, everything works, and the bank can calmly keep in reserve only a fraction of what it should return, because only a fraction is actually demanded of it. But trust is a fragile thing and, above all, it is a thing that is self-fulfilling for good and for ill. If the suspicion spreads, founded or unfounded, that a bank is unable to meet its commitments — to convert the banknotes, to return the deposits — then each person has an interest in running first to withdraw his money, before the reserve runs out. But if everyone runs together, the reserve, which is only a fraction of the total, really does run out fast, and the bank, unable to repay everyone at the same time, fails — thus confirming, after the fact, the suspicion that had set off the run. The bank panic is a self-fulfilling prophecy: the fear of failure provokes failure, even of a bank that, without that fear, would have been perfectly solvent.

There is worse: panic is contagious. When one bank fails, the depositors of the other banks begin to fear for their own money, and the run propagates from one institution to another, like a fire that leaps from one house to another. A crisis that starts from a single tottering bank can thus turn into a crisis of the whole banking system, in which even solid banks are overwhelmed by the general flight of depositors, credit seizes up, the enterprises that depend on credit fail, and the real economy plunges into recession. Bank panics, frequent and devastating in the nineteenth century and still in the early twentieth, were among the most feared economic calamities, capable of destroying in a few weeks wealth and work accumulated over years. The fractional-reserve banking system, which in normal times is a marvellous machine for creating credit and feeding growth, revealed itself in moments of panic a frighteningly fragile edifice, exposed to sudden collapse at the first wavering of trust. This was the problem that cried out for a solution, and the solution was the central bank in its new and decisive role.

The lender of last resort

The solution emerged gradually, learned in the field through a series of crises, and was theorised with definitive clarity in the nineteenth century. The idea is as simple as it is profound, and revolves around a question: what can be done to stop a bank panic? If the panic arises from the fear that there is not enough money to return all the deposits, then the way to stop it is to demonstrate that the money is there — to provide it, in case of need, in unlimited quantity. If depositors know that their bank will always be able to obtain the cash necessary to repay them, they will no longer have reason to run to withdraw, and the panic will subside of itself. But who can provide this unlimited money in the moment of need, when all the banks seek it together and none has it? Only an institution that stands at the top of the system, that can create money, and that is willing to lend it to the banks in difficulty: the central bank. So is born the function the English called that of the lender of last resort, the lender of last resort: the one to whom one turns when no one else lends any more, the ultimate supplier of liquidity that, intervening in the moment of panic, prevents it from overwhelming the system.

The classic formulation of this doctrine is owed to a nineteenth-century English writer and newspaper editor, Walter Bagehot, who in a famous book on the banking world of London fixed the rule that central banks would follow from then on. Bagehot’s rule sums up in a few clear principles. In a crisis, the central bank must lend freely, without stinting, to satisfy every demand for liquidity and so extinguish the panic. But it must do so at a high interest rate, so that the emergency credit does not become a gift and so that only those who truly need it have recourse to it. And it must lend only against good collateral — against assets of real value offered in pledge by the banks — because the aim is to succour the solid banks struck by panic, not to save those really failed. To lend much, at a high price, against good collateral: in this formula lies the secret of stopping a panic without encouraging imprudence. The central bank furnishes the money that prevents the collapse, but on terms such as not to reward those who have exposed themselves recklessly [Ferguson 2008].

There is, in this function, a paradox worth grasping, because it illuminates the deep nature of modern money. The lender of last resort stops the panic by creating money from nothing: in the moment of crisis, the central bank lends money that did not pre-exist, creates it with a bookkeeping entry, makes it appear because it serves to re-establish trust. It is the barest demonstration of the fact that, in a fractional-reserve system, money is in the last analysis a creation of trust and of authority, not a fixed quantity of metal. Precisely because money can be created, the panic — which is a crisis of trust — can be cured by creating the money that re-establishes trust. The central bank is, in this sense, the supreme guardian of that trust: the institution that, being able to create money without limits, can always guarantee the system the money it needs not to collapse. It is an immense power, and like every immense power it carries with it dangers and temptations, of which we shall speak.

The model spreads

The model inaugurated by the Bank of England proved so effective that, in the course of the nineteenth and early twentieth centuries, it was adopted by one country after another. Every nation that wanted a modern and stable monetary system ended by equipping itself with a central bank: an institution at the top of the banking system, with the monopoly or quasi-monopoly of the issue of banknotes, and with the function of lender of last resort. The great European powers equipped themselves with their central banks over the course of the century, and the model extended progressively to the whole world, until it became universal: today there is no country that does not have its own central bank, and the government of money through an institution of this kind is taken for granted everywhere. But this universality must not let us forget that it is a recent historical invention, matured by trial and error in little more than two centuries, and anything but obvious: for most of history, money did without central banks.

The most instructive and most tormented case of adoption of the model is that of the United States, and it deserves to be told because it belies the idea that the central bank is a natural and painless outcome. America, unlike Europe, was for a long time deeply distrustful of the idea of a central bank, for reasons rooted in its political culture. An important part of American opinion saw in a central bank a dangerous concentration of financial power, a threat to liberty and to democracy, an instrument through which a few bankers could dominate the economy and the politics of the country. This distrust was not a whim, but expressed an authentic and in part well-founded concern: the power to create and govern money is indeed an enormous power, and to entrust it to a single institution raises real problems of democratic control, which we have already glimpsed and which we shall meet again. Because of this distrust, the United States, throughout the nineteenth century, repeatedly made and then unmade attempts to equip itself with a central bank: two institutions that could have performed that role were created and then suppressed, victims of political hostility toward the concentration of monetary power. It is a point that must be underlined to avoid a widespread misconception: the Federal Reserve, the American central bank, was not born from nothing in 1913, but was the third attempt, after two earlier federal institutions later dismantled. The American road to the central bank was long, contested and marked by second thoughts, and this reminds us how much the question of the government of money is, and always has been, also and above all a political question [Davies 2002].

The panic that convinced America

What in the end overcame American distrust was, as often happens, a crisis. In the early years of the twentieth century the United States, by now a great industrial power, was still without a central bank and therefore without a lender of last resort, and this lack exposed it to recurrent and devastating bank panics, against which no systemic barrier existed. In 1907 a grave financial panic shook the country: banks and financial institutions of New York were overwhelmed by a run of depositors, credit seized up, and the whole system risked collapse. In the absence of a central bank, the crisis was stopped only thanks to the intervention of a great private banker, who used his own prestige and his own resources, and those he managed to gather among his colleagues, to serve as lender of last resort in place of a public institution that did not exist. The system was saved, but the very fact that its salvation had depended on the initiative and the goodwill of a single private individual appeared to many intolerable: it was absurd and dangerous that the stability of the whole American economy should rest on the shoulders of one man, however powerful. The panic of 1907 convinced even many sceptics that the country could no longer do without a public institution capable of stably performing that function.

It was from this conviction, matured in the trauma of the crisis, that the Federal Reserve, the central bank of the United States, was born in 1913. Significantly, its structure still bears the mark of the old American distrust of the concentration of monetary power: the Federal Reserve was not conceived as a single central bank centralised on the European model, but as a federal system, articulated into several regional banks coordinated by a central organ, precisely to disperse the power and prevent its concentration in a single place or in a few hands. It was a compromise between the necessity of having a lender of last resort and the fear of creating one too powerful: a typically American compromise, which sought to reconcile effectiveness with distrust of centralised power. Later history would see the Federal Reserve become progressively more centralised and stronger, until it became the most powerful central bank in the world; but its original structure still recalls its contested origins, and the old, never-extinguished American suspicion of whoever governs money.

Credit is money

We come thus to the conceptual heart of the chapter, to the idea that the central bank brings to its full evidence and that is one of the most important in the whole book: in a modern economy, most money is not created by the state that mints coins or prints banknotes, but by the banks that grant credit. We have met this mechanism, in embryonic form, speaking of the Renaissance bankers; now we must state it in its full reach, because it is the way money really works in the world in which we live.

When a bank grants a loan, in the overwhelming majority of cases it does not hand the borrower a pile of banknotes drawn from a vault: it merely records a sum in the client’s account, creates a deposit with a bookkeeping entry. That deposit is, to all effects, money: the client can spend it, transfer it, use it to pay, exactly as if it were cash. But that money did not exist before the loan was granted: it was created by the bank in the very act of lending, from nothing, with an entry in its own registers. It is the “value from nothing” that gives this book its title, and it is the ordinary, daily way in which most money comes into existence in a modern economy: not through the mints, but through bank credit. Every time a bank lends, it creates money; every time a loan is repaid, that money is destroyed. The mass of money that circulates in an economy is largely made of these deposits created by credit, and is therefore a magnitude that expands and contracts with the lending activity of the banks.

How, then, does the central bank govern this mass of money created by credit, if it does not print it directly? Its principal instrument is the interest rate. By regulating the rate at which it itself lends to the banks — and therefore, indirectly, the cost at which the banks lend to households and enterprises — the central bank influences the quantity of credit that is demanded and granted, and with it the quantity of money created. When it wishes to slow the economy and inflation, it raises the rate: credit becomes dearer, less is asked for and granted, the creation of money slows. When it wishes to stimulate the economy, it lowers the rate: credit costs less, more is demanded, money expands. The interest rate is therefore the fundamental lever of modern monetary policy, the wheel with which the central bank steers the economy by accelerating or braking the creation of credit. The history of interest rates, which runs through the whole story of money as we have seen since Mesopotamia, reaches here its mature form: from the price of a loan between private persons, interest becomes the instrument with which a public authority governs the entire monetary economy of a nation [Homer & Sylla 2005]. It is a subtle and formidable power, because it acts not by direct order but through incentives, orienting the decisions of millions of lenders and debtors with the simple variation of a number.

Here, however, prudence imposes an important clarification, because on this point misleading and opposing descriptions circulate, and it is well not to take an ideological side. A traditional representation, found in many textbooks, describes the creation of money as a mechanical process: the central bank injects a certain quantity of reserves, and the commercial banks multiply them by lending, according to a “multiplier” determined by the fractional reserve, in an orderly and predictable chain. A more recent representation, closer to how the system works, underlines instead that the banks, in granting credit, do not merely multiply pre-existing reserves, but create the deposits actively, in response to the demand for loans and to their own assessments of convenience and risk, while the central bank acts rather by regulating the cost of credit than by mechanically dosing the quantity of money. The difference between the two views is technical and debated, and this is not the place to settle it; what counts, and on which both agree, is the fundamental fact: that most modern money is created by the banks through credit, and not by the state through coinage. It is a fact with enormous consequences, because it means that the government of the quantity of money — and therefore, through the quantity theory we have met, of inflation and price stability — passes largely through the control of bank credit, and it is this, not the printing of banknotes, that is the principal instrument with which central banks govern money.

The power and its temptation

There remains to address the underlying tension that runs through the whole history of the central bank, and that makes of it one of the most delicate and controversial institutions of the modern world. The central bank has an enormous power: it can create money, govern credit, influence interest rates, stop panics, and through these instruments affect profoundly the economy, employment, prices, the wealth of all. So great a power inevitably poses the question: who controls whoever governs money? To whom must the central bank answer, and with what end must it exercise its power?

The fundamental tension is that between two potentially conflicting functions. On one side, the central bank was born, we have seen, also to serve the state, to finance its needs, above all in time of war: the original pact of 1694 was a loan to the crown. The state, which is always short of money, has a permanent temptation to use the central bank as a source of easy financing, having it create the money necessary to cover its expenses without having to resort to unpopular taxes. On the other side, the central bank has the responsibility of watching over the stability of money, of preventing inflation, of maintaining trust in money. And these two functions conflict, because to create money to finance the state means, beyond a certain limit, exactly what the quantity theory has taught us to fear: to increase the quantity of money more than wealth, and therefore to generate inflation, to debase money, to betray trust. Monetary history is full of cases in which the central bank, enslaved to the financial needs of the state, has printed money without restraint to cover its expenses, unleashing ruinous inflations: we shall see it in the chapters on the age of inflation, where this mechanism reaches its most extreme outcomes.

From this tension is born the idea, today largely accepted but historically recent and anything but peaceful, of the independence of the central bank: the idea that, in order to perform well its function as guardian of monetary stability, the central bank must be removed from the direct control of the government, so as to be able to resist the political temptation to print money to finance spending or to win electoral consensus. An independent central bank, it is argued, can pursue price stability in the long run without bending to the short-term needs of politics. But independence raises, in its turn, a democratic problem of no small weight: is it right that an institution endowed with so great a power over the economy and over the life of all should be removed from the control of the representatives elected by the people? To whom does an independent institution render account? The question of the right relationship between the central bank and political power — between the independence necessary to guarantee stability and the democratic control necessary to legitimise power — has no definitive solution, and is still today at the centre of heated debates, which reignite at every crisis. It is one of the great open questions of the government of money, and on it, consistently with the approach of this book, we do not claim to give an answer, but to show what is at stake [Eichengreen 2008].

There was, in the nineteenth century, a powerful brake on this temptation, and it is the thread that leads us directly to the next chapter: gold. So long as the banknote was convertible into gold on demand, the central bank could not print as much of it as it wished, because it had to keep a reserve of gold sufficient to honour the promise of conversion, and if it printed too much it risked everyone running to convert the notes into metal, emptying its vaults. Convertibility into gold was, in other words, a discipline, an external constraint that tied the hands of the central bank and of the state, preventing them from abusing the power to create money: the quantity of paper one could issue was anchored to the quantity of gold kept. This anchoring of money to gold — the gold standard — was the great monetary system of the nineteenth century and the early twentieth, and it promised precisely what the temptation to print put at risk: the stability of the value of money, guaranteed not by the virtue of rulers but by an inflexible metallic constraint. To keep the gold of the nation and to guarantee the convertibility of money became thus one of the central functions of central banks, and the gold accumulated in their vaults the ultimate foundation of trust in the system. But that golden constraint, which gave stability, had also a terrible cost, and concealed contradictions that would in the end bring it down. It is the story of the gold standard, of its apogee and its ruin, that the next chapter tells.

In this unresolved tension — between service to the state and the defence of money, between effectiveness and control, between independence and democracy — lies the essence of the central bank, the ambiguous and powerful institution born of that pact of 1694 to finance a war. It represents the attempt, never wholly successful and always to be renegotiated, to tame the power and the fragility of money created by credit: to enjoy its benefits — the credit that feeds growth, the liquidity that stops panics — while keeping in check its dangers — inflation, abuse, instability. It is an attempt that has had notable successes, and that has made the modern financial system far more stable than it was in the nineteenth century of recurrent panics; but it is an attempt that has never wholly eliminated the risks, as the great crises of the twentieth century and of our own would dramatically demonstrate. The central bank governs money, but does not wholly domesticate it; and the story that remains for us to tell — the age of gold and its collapse, the advent of fiat money, the great inflations and the great crises — is largely the story of this perennial, never-concluded struggle to keep under control the force that credit and paper have unleashed. It is to the first great chapter of this struggle, the epic and the ruin of the gold standard, that we now turn.