History of central banks

Eric Monnet (EHESS, Paris School of Economics & CEPR)

March 2023

Forthcoming in Oxford Research Encyclopedia of Economics and Finance

Preprint version (may contain typos, errors and omissions)

Summary

The historical evolution of the role of central banks has been shaped by two major
characteristics of these institutions: they are banks and they are linked—in various legal,
administrative, and political ways—to the state. The history of central banking is thus an
analysis of how central banks have ensured or failed to ensure the stability of the value of money
and the credit system while maintaining supportive or conflicting relationships with
governments and private banks. Opening the black box of central banks is necessary to
understanding the political economy issues that emerge from the implementation of monetary
and credit policy and why, in addition to macroeconomic effects, these policies have major
consequences on the structure of financial systems and the financing of public debt. It is also
important to read the history of the evolution of central banks since the end of the 19th century
as a game of countries wanting to adopt a dominant institutional model. Each historical period
was characterized by a dominant model that other countries imitated - or pretended to imitate
while retaining substantial national characteristics - with a view to greater international political
and financial integration. Recent academic research has explored several issues that underline
the importance of central banks to the development of the state, the financial system and on
macroeconomic fluctuations: (a) the origin of central banks; (b) their role as a lender of last
resort and banking supervisor; (c) the justifications and consequences of the domestic
macroeconomic policy objectives - inflation, output, etc. -of central banks (monetary policy);
(d) the special loans of central banks and their role in the allocation of credit (credit policy); (e)
the legal and political links between the central bank and the government (independence); and
(f) the role of central banks concerning exchange rates and in the international monetary system;
(g) production of economic research and statistics.
Keywords: central bank, central banking, monetary policy, credit policy, central bank
independence, international monetary system
Central banks have become essential parts of modern states. Their monetary policy
announcements are seen as major elements of macroeconomic policy and have tangible effects.
However, their role is not limited to changing the cost of credit in order to influence consumer
prices and economic activity. They play a major role in organising and regulating the payment
system, to ensure that means of payment, whether paper or electronic, can be used throughout
a country in a secure manner. They are also concerned with financial stability. Their role in
financial stability concerns banking supervision, for which many central banks are responsible.
But it is also about acting as a lender of last resort during banking crises to prevent crises from
spreading and the financial system from collapsing. Finally, they are also vigilant to ensure that
their monetary policy decisions do not encourage speculative bubbles or, on the contrary, create
liquidity crises in the financial markets. This can be done in consultation with other institutions
in charge of financial regulation or policy, and thus articulated in the form of what is called –
since the 2010s – macroprudential policy. Another raison d'être of central banks in many
countries is the commitment to maintain a fixed exchange rate, i.e. the guarantee that domestic
currency can be exchanged into foreign currency at a constant value. Historically, the exchange
rate was usually fixed against a metal (gold or silver), and this has gradually evolved into a
parity against dominant international currencies such as the dollar or the euro. Governments
decide on the official value of the exchange rate (or its degree of flexibility) and central banks
are then responsible for selling or buying foreign currencies to limit fluctuations in the value of
the currency as much as possible.

If these main functions (monetary policy, financial stability, payments system stability,
exchange rate management) are well known and present in all economics textbooks, central
banks have played other roles historically, which are often underestimated: public debt
management, management of the Treasury account or accounts of other major financial
institutions, production of statistics, research and financial information, sectoral credit policy
aimed at favouring certain sectors or companies, direct loans to non-financial companies in
normal times or in times of crisis, etc. In many countries (especially those called “advanced
economies”), these other functions have been reduced over time - especially since the 1990s -
except for central bank economic research, which has increased. This was accompanied, in
these same countries, by a reduction in the role of central banks in managing the exchange rate
(due to the choice of floating exchange rates) and in dealing with financial stability issues
(including banking supervision). However, this development only concerned a small number
of countries in the world and, moreover, the financial crisis of 2008-2009 brought about a
reversal in these same countries, particularly on the issues of financial stability, public debt
financing (in Europe, Japan or North America) and, in some cases, foreign exchange reserves
(Switzerland and Scandinavian countries). These central banks bought massive amounts of
government debt to fight economic deflation and support government spending - and again
during the covid pandemic - while becoming responsible for banking supervision and getting
involved in macroprudential policy (Siklos 2017, Monnet 2023).

The roles of central banks have often tended to expand historically because of their two
major characteristics: they are banks and they are linked - in various legal and administrative
ways - to the state. The name of a central bank has a literal meaning. It is a "bank": its main
activity is therefore to lend. It is “central” in the sense that it is through it that other banks can
interact, both in normal times and in times of crisis. The fact that the central bank is the bank
of the banks tends to increase its activity if banking stability or development are seen as
important policy objectives. It also necessarily creates moral hazard, implied by central bank
support to the banking sector. But the fact that it is a bank also means that it can substitute for
the banking sector in some cases (and not just provide liquidity to banks) to lend to companies
or the state. In many countries the central bank was initially the main bank of the country and
thus assumed a lending role, similar to that of a private bank or a public investment bank. The
fact that the central bank is also linked to the state also implies that the latter may tend to entrust
it with more and more tasks, including public service tasks that have nothing to do with
financing or monetary policy, such as the production of statistics or financial information. There
may also be a strong temptation for the State to use the central bank not only for the
management of the Treasury account but also for the direct or indirect financing of the public
debt.

The history of central banks can therefore be read through the prism of the very special position
that these institutions have between the banking system and the state. They exist only in relation
to them but also emancipate themselves from them. There is therefore constant tension to
prevent central banks from being too subservient to the banking system and the state, or, on the
contrary, from becoming too powerful vis-à-vis one or the other. There is always the possibility
that some of the functions of a central bank could be taken over by private banks or by the
Treasury. History reminds us that this has been the case and that there is nothing obvious in the
fact that central banks have become, over time, the pivot of the state and the financial system.

This particular position raises tensions because, ultimately, the central bank is seen by both
sides as the guarantor of the stability of money. Private banks and states, as well as individuals,
have an interest in this. But many would like to benefit in the short term from the unlimited
power of money creation. The monetary system is indeed a public good. This means that
everyone benefits from it without individual use compromising the uses of others. Society as a
whole will suffer if money is worthless, if it is no longer accepted as a means of payment, if it
is impossible to borrow temporarily to solve cash flow problems. The role of a central bank is
ultimately to guarantee the stability of this monetary system against the two main risks it can
generate: high inflation and financial crisis. Inflation reflects the loss of confidence in money
as a medium of exchange and a store of value (at the international level, this means the loss of
value vis-à-vis a foreign currency). Anticipating that money will soon be worthless, everyone
tries to get rid of it as soon as possible. The value of money thus collapses. Unlike inflation, the
financial crisis is the loss of confidence in credit, which is normally only the counterpart of
money. A crisis occurs when banks or other borrowers (companies, households, governments)
are expected to default and are refused credit. It is possible that a financial crisis will also lead
to a loss of confidence in money and thus to hyperinflation. But the opposite is actually more
common: during a banking or financial crisis, savings accumulate in the only form that will be
deemed sufficiently safe (paper or metallic money, public debt, foreign currency, as the case
may be) and the system freezes, leading to a fall in credit creation and deflation. Deflation
characterises a situation where economic activity - and therefore prices - fall and unemployment
rises.

The history of central banking is thus an analysis of how central banks have ensured or failed
to ensure the stability of the value of money and the credit system - which has practical
consequences for all - while maintaining supportive or conflicting relationships with
governments and private banks. It is impossible to present the full history of central banking
around the world over several centuries. I thus will limit itself to highlighting new research in
this area, written in the last decade. After a short reminder of the institutional evolution of
central banks over time, the article will proceed in a thematic way, insisting on points that still
raise questions in academic research. Thus, it will address the issues of 1) the origin of central
banks; 2) their role as lender of last resort and banking supervisor; 3) the justifications and
consequences of the macroeconomic policy objectives of central banks (monetary policy); 4)
the special loans of central banks and their role in the allocation of credit (credit policy); 5) the
legal and political links between the central bank and the government (independence); and 6)
the role of central banks in the international monetary system.
The global development of central banking

The history of central banks follows that of the evolution of capitalism, the banking system and
the development of bureaucratic rationality of modern states. Since the beginning of the modern
era, it has been linked to the history of money, but is nevertheless a distinct development. Until
the beginning of the 20th century, central banking was mainly an almost uniquely European
phenomenon, while, in contrast, money had been used throughout the world since antiquity.
The Bank of Japan was founded in 1882 on the model of European central banks. The same is
true for the US Federal Reserve in 1913, which was created after an in-depth study (National
Monetary Commission) of European central banks and the banking systems of those countries.
During the 1920s and 1930s, most Latin American and Commonwealth countries also created
a central bank, again modelled on those of the main European countries and the United States
and advised by economists from these countries, the money doctors (Flores Zendejas 2021).
The number of central banks thus doubled between the end of the 19th century and the end of
the 1930s, from about twenty to forty (Marcussen 2005). The trend continued after the Second
World War, driven by two new factors (Singleton 2010): the increase in the number of
sovereign countries following the end of the colonial period, and the financial multilateralism
created at Bretton Woods. Having a central bank is a guarantee of participation in the
international financial system and thus a mark of both political sovereignty and international
integration. The European central banks continued to represent a model, but the central banks
of the 1950s and 1960s were also created in the spirit of the developmental state, where the
state plays an important role in developing industry and the banking system (Epstein 2006).
The central bank was therefore particularly integrated into the state apparatus. The number of
central banks increased continuously from 1945 to the 1990s. There were about 100 central
banks in the 1970s and about 180 since the 1990s, i.e. almost all the countries in the world.

Over time, two main institutional changes have affected central banks. The first is the shift from
private ownership to integration within state administration. Even though most central banks
were created at the instigation of the state and were entrusted with "public service" missions in
exchange for the privilege of issuing money, they had private shareholders, and therefore had
to pay dividends to them (Capie et al. 1994). This situation lasted until the 1930s-1940s, when
most European central banks were nationalised and integrated into the government. A few
central banks retained private shareholders, but these no longer had any power (Bartels et al.
2017). The end of private shareholding was often seen as a break with the vested interests of
bankers and central bank shareholders (Mitchener & Monnet 2023).

The second major institutional metamorphosis concerns the legal independence of central banks
from governments, which developed from the 1980s onwards and became more pronounced in
the 1990s (Siklos 2002, Garriga 2016). The reality of this independence in practice must be
qualified (see section “Central bank independence”), but it is undeniable that most central banks
made a shift in the 1990s towards a legal regime where direct lending by the central bank to the
Treasury is generally banned and the central bank management cannot be instructed by the
government or removed from office before the end of the term. This move towards
independence was a reaction to the very strong integration between the state and the central
bank that had developed after the Second World War. It was justified by economic research
stressing the need for central bankers to be independent of government and committed to a
long-term target to keep inflation low (e.g. Barro & Gordon 1983). The move towards legal
independence of central banks has been mainly a way for countries to show their international
integration and compliance with the rules of the gamepromoted by international financial and
political institutions (Polillo & Guillén 2005). Yet, forms of central bank independence - and
the debate around this issue - had existed since the 17th century (Capie et al. 1994, Blancheton
2016, Bindseil 2019, Mee 2019, Murphy 2019, Martín-Aceña et al. 2020). Although the
definition of legal independence that emerged in the late twentieth century is specific, the issue
of the balance of power between central banks and government is as old as central banking
itself.

It is therefore important to read the history of the evolution of central banks since the
end of the 19th century as a game of countries wanting to adopt a dominant institutional model.
Each historical period was characterized by a dominant model that other countries imitated in
order to send a signal about their good monetary and financial management, with a view to
greater international political and financial integration (Bordo & Siklos 2017). At the end of the
19th century, having a central bank and adopting the gold standard regime was a way of showing
membership in the international financial world (Bazot et al. 2022). Having a public, state-
owned central bank was a sign of sovereignty and integration in the mid-20th century, further
reinforced by the multilateralism of Bretton Woods (Singleton 2010, Flores 2021). From the
1990s onwards, the legal independence of the central bank played this role and became a
guarantee of membership in the international financial community. Thus, there is strong
imitation between the practices and institutional models of central banks, a deep professional
integration of central bankers at the international level, but also significant differences between
the rule (which aims to show a good international image) and the practices, which often
continue to depend on national political and financial specificities.

What is the origin of central banks?

The question of the origin of central banks has recently given rise to renewed debate among
economic historians. For a long time, the prevailing thesis was that the birth of modern central
banks could be dated to the end of the 19th century, at a time when the banks of issue, that is
the private banks that had the privilege of issuing banknotes (and had private shareholders)
became aware of their role in financial stability (lender of last resort) and in the management
of the exchange rate within the framework of the gold standard. In other words, according to
this view, it was only in the 19th century that banks that printed banknotes on behalf of the state
became true central banks (Goodhart 1988, Bordo 1990, Capie et al. 1994, Grossmann 2010).
This perspective, however, recognises a gradual evolution that began with the establishment of
the Bank of England and the Royal Bank of Sweden (Riksbank) in the 17th century, which were
the first banks to issue banknotes on a large scale in Europe. It also emphasizes – based on the
Bank of England model – that central banks were created with a clear objective of supporting
the financing of public debt, either by lending directly to the sovereign or by making public
debt markets liquid (Desan 2015, Murphy 2019).

A body of work has recently criticised this perspective. Although the existence of other large
public banks in Europe since the 16th century, other than in England and Sweden, had been
known for a long time, new research has shown that several of these banks performed a central
banking function before the 19th century (Roberds & Velde 2014; Ugolini 2017, Bindseil 2019).
Bindseil (2019) has taken this revisionist view the furthest. He attacks the idea that a central
bank can be defined by a monopoly of issuing coins and banknotes, or as the main lender to the
government. Instead, he defines a central bank as an institution that issues "financial money of
ultimate quality ". The central bank's "centrality" in the financial system requires it to produce
the safest (highest quality) asset that is used by other institutions. It primarily takes the form of
deposits of other banks at the central bank. There is no central bank without a credit system.
Credit relationships create debts, i.e. promises to pay (IOUs or "I owe you"). As long as these
debts circulate in the form of financial assets, their settlement becomes more complicated and
riskier. The central bank creates a form of financial debt (its liabilities), i.e. financial money,
which is different from material money (notes and coins). This financial money allows private
credit relationships to be settled, overcoming the disadvantages of cash and fiat money and the
risk associated with the credit system.

According to Bindseil's definition, all banks that centralised other banks' deposits (what
Roberds and Velde call 'ledger public banks') thus played a role similar to modern central banks,
not least because this allowed them to act as lenders of last resort, well before the 19th century.
Roberds and Velde (2014) were the first to comprehensively examine the financial activities of
these banks in Europe and, like Bindseil, they highlighted their role in producing a safe and
liquid asset that could be accepted by other financial agents. However, they were still reluctant
to call them central banks (they preferred "early public banks") because these banks did not
have a monopoly on the control of a nation's monetary base. Indeed, it was only in the 19th
century - especially after the Napoleonic wars - that central banks were established throughout
the territory of countries in order to unify the monetary system, notably by facilitating payments
from one city to another, anywhere within a country. Their role in inter-bank transfers was thus
linked to the construction of a national credit market (Bazot 2014, Ugolini 2017, Klovland &
Øksendal 2017).

These debates show that there is more continuity in the history of central banks than has long
been assumed in the literature, particularly with regard to their ability to provide a safe asset to
all other banks. Much remains to be written about how central banks shaped credit systems in
the 19th century and how their role was not limited to providing banknotes to citizens, lending
to governments or intervening in banking crises. Bazot (2014) has thus shown in the French
case how the development of central bank branches in the late 19th century had favoured the
development of bank credit at the local level. Likewise, Sissoko (2022b) argues that the Bank
of England’s new discount policy, as early as the late 18th century, transformed a select category
of commercial bills into ‘safe

assets which facilitated the development of local lenders.

These controversies about the origin of central banks are far from being unique to Europe. It
also shows how there can be a difference between the political birth of a central bank, as
presented as a political symbol by the government, and the birth of central banking functions.
In the case of Latin America, several contributions have shown some important continuities
between the large national banks (i.e. the main banks of the country, with the privilege to print
banknotes) created in the 19th century and the actual central banks created by governments in
the 1920s and 1930s (Tedde de Lorca & Marichal 1994). The former may have had a link with
the state (collecting taxes and financing public debt) but were often created by private investors,
including foreign ones. Thus, it is more accurate to speak of a "transition from the first to the
second generation of Latin American central banks (those established in the 1930s)" (Flores
2021) rather than to date the creation of central banks in Latin America to the interwar period.

There have been similar debates about whether clearing houses played a role similar to that of
a central bank, notably in the US before the creation of the Fed in 1913. While there is no doubt
that clearing houses provided liquidity to banks, including in times of crisis, it is clear that they
did not have sufficient credit capacity to smooth out all the shocks faced by the banking system
(Moen & Tallman 2013, Hanes & Rhode 2013, Bindseil 2019, Bazot et al. 2022). Yet, it is
unlikely that the US financial system could have functioned without clearing houses in the 19th
century.

Lender of last resort and banking supervision

The question of the role of central banks as lender of last resort continues to give rise to a very
large historical and theoretical literature. It is known that central banks played this role very
early, at least as early as the 18th century in England, Amsterdam or Hamburg (Quinn & Roberds
2015, Bindseil 2019, Kosmetatos 2019). But it is also clear that this was not the case during all
crises. For example, the Bank of England - which had previously rescued banks and become
aware of its role in the money market (Kosmetatos 2019, Sissoko 2022a) - rationed credit in the
1847 crisis (Rieder et al. 2022). More importantly, it is also known that central banks did not
play the role of lender of last resort during the crises of the 1930s, even when they had lent to
banks in crisis in the past, including in the US (Carlson et al. 2011). Thus, there was probably
no linear pattern of learning the lender-of-last-resort function, but reactions depending on the
type of crises and the type of financial institutions requesting liquidity in a crisis.

Understanding the different reactions of central banks to crises over time therefore remains an
active field of research, with many case studies conducted on different countries. Thanks to the
digitisation of archives, many of these studies can exploit very detailed data on central bank
lending to banks. Rieder et al. (2022) focus on the Bank of England in 1847, highlighting the
constraint of convertibility of the currency into gold that weighed on the central bank. Jorge-
Sotelo (2019) comes to a similar conclusion about the inability of the Spanish central bank to
rescue banks in 1931. On the Fed's reaction in 1930, Richardson & Troost (2009) insist instead
on the liquidationist ideology of central bankers, according to which bank failures were
necessary for the proper functioning of the economy. In the case of France in 1930-1931,
Mitchener and Monnet (2023) show that the central bank preferred to lend to the banks that
were its shareholders rather than play the role of a genuine lender of last resort. Connected
lending especially emerged during the crisis, together with the rise of uncertainty.

The ways in which central banks intervene in a crisis have also received a lot of attention. The
studies cited above all make a link to economic theory, in particular to understand how central
banks could limit moral hazard (see Ugolini 2021, Schneider 2022, Sissoko 2022a, Rieder and
Jobst 2022 for a summary of 19th century debates and practices, as well as Nishimura 1995 and
Okazaki 2007 for earlier contributions). They highlight that as early as the 19th century central
banks introduced a system of risk management to avoid incurring losses and lending to banks
that were structurally insolvent. Recent research has focused on the details of these techniques
and the operations of central banks. However, while this literature often tends to show the
ingenuity of central banks and the richness of their control procedures, it only provides evidence
of the absence of financial loss by central banks. It is much more difficult to conclude that there
was no moral hazard. The mere fact that crises recurred until the 1930s may suggest that moral
hazard had not completely disappeared and lender of last resort was not yet a fully established
doctrine in a systemic banking crisis. (Bordo 2014, Mitchener and Monnet 2023).

Some studies have shown other ways in which central banks could limit moral hazard. Rather
than lending to all banks indiscriminately with good risk management, they organised a
coalition of private banks (syndicate) to lend to a failing institution, and possibly manage its
liquidation. This system worked relatively well in France in 1889 and in England the following
year during the Baring crisis (Hautcoeur et al. 2014), but was insufficient to stop the French
banking panic of 1930 when it was used again (Mitchener and Monnet 2023). These systems
are similar to the resolution mechanisms set up by states and central banks after the 2008
financial crisis to involve private creditors in the liquidation of banking institutions.

Banking regulation has been used both to prevent crises - and thus as a substitute for the lender
of last resort - and as a way to limit moral hazard by serving as a threat to financial institutions
tempted to take too much risk. The period when banking regulation was most restrictive, from
the 1930s to the 1970s, is known as the period when banking crises were almost non-existent
(Bordo & Meissner 2016). Before the 1930s, there was no banking regulation (except in the
US) and thus there was some substitution between the role of central banks and regulation.
Central banks therefore exercised informal banking supervision, checking the quality of banks
that borrowed money from them, but without formal regulation (Nishimura 1995, Grossman
2010; Jobst & Rieder 2022). This system did not survive the devastating banking crises of the
Great Depression. The following years were thus marked by the emergence of banking
regulation at the international level. This had major consequences for central banks, both
because they used banking regulation instruments as a monetary policy tool (in particular
reserve requirements) but also because most of them became in charge of banking supervision
(Goodhart & Schoenmaker 1996). Banking supervision – as distinct from banking regulation -
by central banks has been little studied and new works have only recently shed light on this still
relatively unknown function (Drach 2020; Hotori et al. 2022, Molteni, & Pellegrino 2022)

Monetary policy

It was not until the second half of the 20th century that central banks played a full
macroeconomic role with the intention of influencing business cycles. Before that, their
objectives were mainly financial stability or maintaining the parity between the value of money
and the value of a metal. This does not mean, however, that central bank interest rate changes
or lending did not have a macroeconomic effect. Lennard (2018) shows that changes in the
Bank of England's discount rate at the end of the 19th century had a strong impact on prices and
employment. Jorda et al. (2020) also show that exogenous shocks to central bank interest rates
since the end of the 19th century have had a strong impact on the business cycle.

Many studies have attempted to measure the impact of monetary policy over time. This often
requires a “narrative” approach, i.e. using the archives to identify the intention of central
bankers and the information available to them. The narrative approach allows both the
identification of causal changes in policy (Cloyne et al. 2022). It is also very useful for historical
analysis that seek to to take into account the variety of instruments used by central banks, and
in particular the techniques of direct credit control (Monnet 2014, Aikman et al. 2016, Döme et
al. 2016, Galati et al. 2021), which were notably predominant from the 1930s to the 1970s, or
special asset purchases (Jaremski & Mathy 2018). The historical analysis of monetary policy
has therefore long been accustomed to dealing with cases of that were called "unconventional"
monetary policy after 2008, as well as studying the interactions between banking regulations
and monetary policy (Monnet & Vari 2022). However, much remains to be written on the
history of the set of banking regulation instruments that were used by central banks for
monetary policy or macroprudential policy purposes. The assumption that the interest rate
reflected the monetary policy stance is questionable for many historical periods and central
banks.

The study of monetary policy has not been limited to its effects but also to understanding the
objectives of central bankers. The many central bank monographs (which are too numerous to
cannot be cited here) often devote whole pages to explaining why central bankers have decided
to restrict credit by raising interest rates or, on the contrary, to have a more expansionary policy.
Many papers have pursued a statistical approach by estimating monetary policy reaction
functions, i.e. an econometric equation that explains the change in interest rates by
macroeconomic variables. During the gold standard, interest rates are thus mainly changed by
central banks in response to changes in the exchange rate and gold reserves (Morys 2013,
Lennard 2018), and this in a non-linear way (Bazot et al. 2016).

Similar methods have been used to determine whether a central bank was giving priority to
inflation or other macroeconomic variables, especially after the Second World War, when
central banks started to change their interest rates in line with macroeconomic objectives. Based
on estimates of reaction functions - and often more narrative approaches - there has been much
debate about whether over-expansionary monetary policy may have been one of the causes of
the 1970s high inflation in the US (Bordo & Orphanides 2013). The results of these estimates
depend to a large extent on how the central bank's objectives are measured and with what data.
According to Orphanides (2002), the 1970s Fed is found to be no less responsive to inflation
than to output if contemporary data are used. Romer and Romer (2002) find that the central
bank paid less attention to inflation in the 1970s, but explain that this was due to the poor
estimation of the output gap.

Credit policy and government financing

Economists generally distinguish between monetary policy, which is supposed to affect only
the business cycle, and credit policy, which has more distributive effects across economic
sectors or groups of individuals (Goodfriend 2014, Monnet 2018). Historically, many central
banks have claimed to use credit policy to favour certain activities deemed to be priorities (and
insufficiently financed by the market). What has been called macroprudential policy since 2010
does the same in the name of financial stability (by assuming to restrict some types of credit to
avoid too much leverage). In an ideal world, central banks can decouple monetary policy from
credit policy, but in reality, even measures aimed at influencing the business cycle can have
different effects on different sectors and individuals. I focus on cases where credit policy was
voluntary and asserted by the central bank, rather than on the unassumed distributive effects of
monetary policy (which is still little known in historical perspective).

The credit policy of central banks and its effects on the economy remains an understudied issue.
There are many studies on the lender of last resort in the 19th century which analyse in detail
central bank lending to banks during crises, but very little is known about central bank lending
to non-financial companies during this period, even though this was often a very important part
of central bank lending. Milton Friedman (1969) argued that discounting commercial bills – the
main operation of central banks in the 19th century - was indeed a credit policy because it
amounted to choosing activities considered safe or useful, in the same way as a commercial
bank does. It is also known that many central banks during this period, especially in
Scandinavia, were engaged in long-term mortgage lending (Klovland and Øksendal 2017,
Bazot et al. 2022). Given the state of the research, it is still difficult to say whether 19th century
central banks were making economic choices when they lent, favouring certain activities
deemed particularly important, or whether they followed a purely financial approach based on
the quality of the borrowers. Sissoko & Ishizu (2021) reveal the importance of the Bank of
England in financing the colonial trade, with loans of last resort for slave-trading enterprises. It
is known that, as Nishimura (1995) shows in the French case, many non-financial companies
renewed loans to the central bank to finance long-term projects. It is also known that most
central banks at the time were not very supportive of discounting agricultural loans, which was
sometimes seen as unfounded discrimination.

However, it seems that it is only during the inter-war period that a truly proactive credit policy
of central banks to favour certain sectors or companies appears. Several studies have shown
how the Bank of England began in the 1920s to buy shares in industrial companies, not only to
save them from bankruptcy but also to restructure them and organise mergers (Bowden &
Collins 1992). In Italy, the central bank's credit policy was important in magnitude but mainly
limited to providing financial support to funds created by the Italian state to support industry
(Cerretano 2013). In Germany, the Reichsbank also began in 1932 to accept securities of a
company specially created by the government to boost industrial employment and lending to
municipalities (öffa bills) before similar techniques were used to finance the government
directly in a disguised way from 1934 (mefo bills). In the rest of Europe, as well as in other
continents, this type of policy developed mainly after 1945 and was based on direct loans to
certain large financial and non-financial firms or, above all, on exemptions from quantitative
credit controls for certain loans or sectors (Monnet 2018). In the US, the Fed was given the
legislative capacity to make direct loans to firms during the New Deal (in addition to those of
the Reconstruction Finance Corporation) and this function remained in place until 1958 (Sablik
2013).

Little is known about the extent of such central bank policies in comparative perspective and
their persistence over time, especially in many emerging countries. Much also remains to be
written about their economic (sectoral) effects as well as the political economy of such loans.
How are the companies and sectors favoured by the central bank chosen? In some cases,
research has shown that these choices were made in line with the government's industrial policy
and had a positive impact on economic development (Cerretano 2013, Monnet 2018) but this
does not mean that they were not influenced by private interests either. On the contrary, the
central bank’s involvement in industrial policy could be a way to avoid nationalization of large
companies by the government (Bowden & Collins 1992). In another context, as Jorge Sotelo
(2022) shows in Spain before the proclamation of the Second Republic in 1931, it is clear that
the central bank's credit policy was essentially used to favour political connections, without an
industrial focus.

Direct lending by the central bank to the government can also be seen as a form of credit policy.
While today the majority of central bank financing of public debt is done through the purchase
of securities on the secondary market, the dominant form of financing in the past was direct
loans from the bank to the government, subject to parliamentary approval (Monnet 2018, Allen
2019, Bateman 2021, Garbarde 2021). The literature on the history of central banking has
mainly studied this issue through the lens of fiscal dominance and its effect on inflation (see
Ferguson et al. 2015 and Bordo & Levy 2021 for recent summaries of the comparative historical
literature on the link between government debt, central banking and inflation). A more limited
number of studies have attempted to understand how this mode of financing was able to persist
in several countries without being inflationary for decades, in part because of strict
parliamentary control that significantly limited the government's ability to borrow from the
central bank in peacetime (Ryan Collins 2017, Monnet 2018).

Central bank independence

The issue of public debt financing is partly related to, but not limited to, the issue of central
bank political and legal independence. The empirical and theoretical literature on central bank
independence in economics and other social sciences is immense (see Fernández-Albertos 2015
and Garriga 2016 for recent summaries) and has of course influenced economic history (Bordo
& Siklos 2015, 2017, Bindseil 2019). However, despite its abundance, this literature has
difficulty in formulating clear conclusions. This is due to three problems. First, the definition
of independence changes dramatically over time, depending on the institutional context of
central banks. Thus, on the model of the Bank of England created in the 17th century, and until
the middle of the 20th century, private shareholding largely guaranteed independence in the
eyes of contemporaries, unless the State granted itself all the powers of appointment of the
central bank's directors. But this was not seen as contradictory to direct government financing
by the central bank. Today, this second criterion is, on the contrary, seen as a complete break
with independence even though central banks are owned by the state..

Second, it is very difficult to distinguish between correlation and causation between the legal
independence of a central bank and macroeconomic variables. This is partly due to the fact that
legal independence only imperfectly reflects the power relations between a central bank and a
government. Independence is therefore often a reform that comes after a stabilisation allowed
by a government that considers monetary stability to be an overriding objective and central
bank independence an institutional reform necessary to guarantee this stability, or an important
signal sent to the international community or to the population.

Third, history shows that the difference between rule and practice is often very large. Laws
differ between countries, but practices differ even more, as laws governing central bank actions
are subject to different interpretations. They reveal national traditions, but they are also highly
sensitive to personalities. The case of the United States in the 1970s is often taken as an example
in this respect (Weise 2012). Richard Nixon appointed Arthur Burns, who had previously been
his economic adviser, as head of the central bank in 1970. Burns was both a renowned academic
economist and author of influential work on business cycles, and had been involved with the
Republican Party since the 1950s. Burns' personal and ideological closeness to Nixon, however,
led to a total submission of the former to the latter's orders, with explicit pressure that was
unopposed. From a strictly legal point of view, however, the Fed was no less independent than
it is in the 21st century. At the same time, Nixon had passed a law, the Credit Control Act of
1969, which allowed the President of the United States to use banking regulation to limit credit
(especially consumer credit) in order to fight inflation. It thus copied (albeit to a lesser extent)
measures that were being applied in other countries at the same time but were elsewhere decided
and implemented by the central bank, or by agreement with the central bank and the government
(Monnet 2018, chp.7). This example illustrates how the political relationship of the central bank
to the government can change profoundly without any change in legal texts but only because
of personalities, political convergences between governments and central bankers, or because
of the possibility offered by the government to use other legislative tools to regain control over
the macroeconomic policy controlling credit and inflation.

Open conflicts between governments and central banks are rare. In Germany, the central bank
was formally independent during the hyperinflation of 1922-1923, and again during the massive
financing of the public debt from 1933 onwards (by means of MEFO bonds, Metallurgische
Forschungsgesellschaft). It was not until 1939 that the members of its board resigned in protest
against Hitler's inflationary policy (Mee 2019). Disinflation policies in the US and then in other
countries in the early 1980s were done with government support, not in opposition.

There are, however, a few examples of central banks showing their frontal opposition to a
government policy, to the point of delegitimising the government. In France in 1952 - at a time
that many people often wrongly associate with the absence of central bank independence - the
governor of the Banque de France made a harsh indictment of the government's inflationary
policies and announced his refusal to lend to the central bank under these conditions (Monnet
2018). The central banker obviously had no direct power over the government and his
indictment was limited to inflation. But it had enough resonance with the parliamentarians that
they demanded and obtained a change of government.

The practice of independence is thus contextual and depends mainly on the strength or weakness
of the governments in place. Paradoxically, it may even be thought that de jure independence
has led governments to appoint central bankers with views closer to their own. This is shown
by the recent work of Adolph (2013) and Ioannidou et al (2022). The latter, in a comparative
approach on a panel of countries since the 1980s, observe that the appointments of central bank
governors have become more politically motivated, in particular after important legislative
reforms on central bank independence. Because of this, they find that there is no link between
de jure central bank independence and actual independence of the central bank from the
government. Their study is based on biographical information, reading the press and interviews
with economists.

This type of approach suggests a return to qualitative historical analyses to identify real power
relations rather than relying on quantitative comparisons based on legal documents. They
encourage opening the black box of central bank decision-making and taking into account how
central banks are influenced by the political context, but also by different economic doctrines
and even the personal experience or ideology of central bankers. The analysis of the
backgrounds of US central bankers since 1945 by Adolph (2013) and Bordo and Istrefi (2018)
shows the extent to which their previous professional trajectories influence the positions taken.
Similar conclusions have been drawn by recent economic studies that highlight the influence
of the corporate culture of central banks and the singular trajectories of their leaders. In the
1950s-1960s, central bank governors who had had longer professional experience of the gold
standard before World War II were less likely to abandon the reference to gold (as a guarantor
of the value of money). In practice, the continued to back the money base with gold reserves
until 1971. The institutional and personal history of the gold standard weighed on the shoulders
of central bankers even though the post-war Bretton Woods system had normally broken the
links between gold and monetary policy, and strengthened the political links between
governments and central banks (Monnet and Puy 2020).

These findings will come as no surprise to central bank historians who have long shown how
the corporate and ideological culture of institutions matters and survives institutional change,
while evolving over time (see for example James 2018 and Mee 2019 on the transition from the
Reichsbank to the Bundesbank in Germany, or Capie 2010 and James 2020 on the Bank of
England). The research continues along these lines and focuses on trying to measure the
economic effects of these cultural and organisational factors, which cannot be reduced to the
legal framework.

International Monetary System

To what extent does the international monetary system constrain the actions of central banks?
This question continues to be the subject of a large number of historical studies. The theoretical
framework usually used to answer it is the "impossible trinity" of international finance, or
trilemma (Obstfeld & Taylor 2004). In this perspective - with very old theoretical foundations
- a central bank has no monetary autonomy if it operates under a fixed exchange rate regime
with free movement of capital. If it decides to lower its interest rate below the rate prevailing
on the international markets, this will provoke a capital flight and thus a depreciation of the
exchange rate, incompatible with the official parity. Economists and historians have always
recognised that central banks actually have more room for manoeuvre than theory predicts.
Extreme cases are rare. Recent research has clarified the extent and functioning of this room
for manoeuvre.
During the 1990s, historical economists made extensive use of the "target zone" theory to
explain how central bank rates could differ, even in regimes with fixed exchange rates and
financial openness such as the gold standard (Eichengreen & Flandreau 1996; Bordo and
MacDonald 2005). According to this theory, the expectations of financial agents allow for
temporary rate differentials if the fixed exchange rate target is credible (via uncovered interest
rate parity). New work has supplemented this approach by showing that these adjustments are
not based solely on the free play of the market but on central bank interventions. In practical
terms, this implies a focus of analysis on central bank operations rather than simply interest
rates and exchange rates. In their study of the gold standard and central bank balance sheets
before 1914, Bazot et al (2022) show that central banks were able to absorb international interest
rate shocks (and thus prevent them from spilling over into the domestic market) by a
combination of foreign exchange intervention, restrictions on the convertibility of banknotes
into gold and countercyclical lending to domestic banks. All these techniques – whose extent
differed from country to country - made it possible to maintain relatively stable interest rates at
the national level without conflicting with financial openness and the gold standard. In contrast,
US interest rates and asset prices were much more sensitive to exogenous changes in the
international interest rate since the US did not yet have a central bank. The response of the
money market rate in New York to an increase in the Bank of England's interest rate was about
three times greater than that observed in European countries that had a central bank. This
finding shows that the US Treasury and the New York clearing houses could not play a role
similar to that of a central bank. It is consistent with studies that concluded that the creation of
the Fed reduced the seasonality of US interest rates and that the prior absence of a central bank
in the US had a negative impact on the volatility of agricultural markets and increased the
likelihood of financial crises (Hanes & Rhode 2013). With regard to the 1930s, Bordo,
Choudhri & Schwartz (2002) and Hsieh and Romer (2006) had shown that the Fed had the
ability to intervene in the markets in 1932 without creating an exchange rate depreciation that
threatened the country's adherence to the gold standard.

Several recent country case studies confirm these conclusions for the classical gold standard
and the interwar period (e.g. Ögren & Øksendal 2011). They also show that autonomy was far
from complete as central banks' ability to intervene depended on otherwise binding monetary
and fiscal constraints. Bazot et al (2016) and Fliers & Colvin (2022) show that - for France
before 1914 and the Netherlands between the wars - autonomy depended on large gold reserves
that exceeded the requirements of the gold standard. Fliers and Colvin (2022) also conclude
that the departure from the gold standard was eventually beneficial for the Dutch economy. The
Spanish case studied by Jorge Sotelo (2019) shows how it was impossible to maintain an
autonomous monetary policy when a country suffered from abrupt capital flight. Concerning
Italy before 1914, Di Martino (2022) confirms the importance of foreign exchange interventions
but also how they were dependent on the credibility of the Italian public debt, which ensured
the stability of the money market. Studying how foreign exchange intervention and cooperation
between central banks succeeded for several years in maintaining the gold parity of the pound
sterling and the dollar during the 1960s – the pillars of the international monetary system - ,
Bordo et al. (2019) also show that these measures were ultimately insufficient because financial
markets did not believe in the ability of governments to balance their budgets. Central bank
cooperation through credit lines or reserve pooling can reinforce the ability of monetary
authorities to react against adverse international financial shocks (Bordo & Schenk 2016,
McCauley & Schenk 2020). It is nevertheless difficult to tell if the value of cooperation should
be assessed in light of actual economic effectiveness or because of their deeper geopolitical
role.

Central banks do have the capacity to intervene, which allows them to be relatively autonomous
and to limit the impact of international shocks on the domestic economy. But it should not be
concluded that financial globalisation and fixed exchange rate regimes are without constraint
for countries. The constraint is, however, general and relates in particular to fiscal policy and
public debt, when the latter is financed by international markets. Eichengreen's (1992) famous
conclusion about the gold standard constraint thus remains valid, but it involves more complex
policy mechanisms than suggested by the theoretical framework of the trilemma (which
Eichengreen already recognised). This still opens the way for future research to fully understand
the interactions between public debt, fiscal policy and central bank policy, and how they
constrain each other.

Conclusion

This article has proposed a selective and subjective review of the literature on the history of
central banks and monetary policy, with an emphasis on references to recent works written
within the last decade. Only a small part of it is cited here; in particular, I have not been able to
do justice to all the monographs that have dealt with the history of a central bank. The
abundance of recent references shows that central banking history is an active field of research,
bringing together economists, historians and other social scientists, and from which useful
insights are often drawn for discussing current policy issues. It is also clear that much remains
to be written. In particular, recent work has challenged certainties about theoretical frameworks
that were taken for granted and thus opens up new avenues for research. It is no longer possible
to write the history of central banks on the assumption that the policy of these institutions has
been restricted to the manipulation of interest rates and the monetary base, or that their evolution
has been a linear progression towards independence from the government and learning to be a
lender of last resort. In particular, a broader view of central banking activities is needed to
understand the entire policy of these institutions around the world since the mid-20th century.
The history of central banking is still too often written from a European and American
perspective.

Many of the works cited here have gone down to the micro level to understand the details of
the financial operations of monetary policy or the lender of last resort. In this respect, there has
been a revolution in the quantitative history of central banking, linked to the ease of digitising
data and a rapprochement of financial and macroeconomic theories. Economic historians have
opened the black box of central banks and found that understanding implementation is as
important as understanding objectives in discussing the macroeconomic and financial impact
of central bank policies. It is also at this level of detail that political economy issues emerge and
reveal that the choices made by central banks have major consequences on the structure of
financial systems and the financing of public debt.

Further reading:

Bindseil, U. (2019). Central banking before 1800: a rehabilitation. Oxford University Press,
USA.

Desan, C. (2014). Making money: coin, currency, and the coming of capitalism. Oxford
University Press, USA.

Friedman, M., & Schwartz, A. J. (1963). A monetary history of the United States, 1867-1960,
Princeton University Press.

Goodhart, C. (1988). The evolution of central banks. MIT Press

James, H. (2012). Making the European monetary union. Harvard University Press.
Johnson, J. (2016). Priests of Prosperity: How Central Bankers Transformed the
Postcommunist World. Cornell University Press.

Mehrling, P. (2010). The New Lombard Street: How the Fed Became the Dealer of Last Resort.
Princeton University Press.

Monnet, E. (2018). Controlling Credit: Central Banking and the Planned Economy in Postwar
France, 1948 1973. Cambridge University Press.

Siklos, P. L. (2002). The changing face of central banking: Evolutionary trends since World
War II. Cambridge University Press.

Singleton, J. (2010). Central banking in the twentieth century. Cambridge University Press.

Schenk, C. R. (2010). The decline of sterling: managing the retreat of an international

currency, 1945–1992. Cambridge University Press.

Murphy, A. (2023). Virtuous Bankers: A Day in the Life of the Eighteenth-Century Bank of
England. Princeton University Press.

Smith V. C. (1936). The Rationale of Central Banking and the Free Banking Alternative,
Liberty Fund.

Straumann, T. (2010). Fixed ideas of money: Small states and exchange rate regimes in
twentieth-century Europe. Cambridge University Press.

Tedde de Lorca, P., & Marichal, C. (1994). La Formación de los Bancos Centrales en España
y América Latina: Siglos XIX y XX. Banco de España. Servicio de Estudios.

Toniolo, G., & Clement, P. (2005). Central bank cooperation at the Bank for International
Settlements, 1930-1973. Cambridge University Press.

Ugolini, S. (2017). The evolution of central banking: theory and history. London: Palgrave
Macmillan.

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