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Posts Tagged ‘Gold standard’

Did you know that central banks have not always been State-owned banks? The vast majority of them were in the hands of the public before the wave of nationalisations that took place right after the end of WWII. And the system did not work bad at all; the record of both price stability and financial stability before 1913 was certainly impressive. True, bank panics also occurred but the different response taken to such crises is the key to understand the pros of a monetary system fully in the hands of the public and market participants. And, a regards price stability, from approx. 1870 to 1913 most developed (and other less developed) economies ran the gold standard as the rule to determine the amount of money in the economy; a standard which very much tied the hands of central banks and governments as regards money creation. The outcome of the running of a system which preserved monetary stability for a 50 year-time period limited was (not surprisingly for any monetary economist!) was true price stability (by true, I mean that the price level in 1870 was roughly similar to that in 1913), and a growing and rather stable financial system on the whole.

Why was such a ‘miracle’ possible? There is no mystery nor secrecy about it at all! It was the establishment of the right institutions and policies to discipline both the Treasury and a highly independent (actually privately-owned!) central bank what explains such a favourable outcome. And, did you know something even more striking? Several central banks are traded in the market in our days in different ways: the Swiss National Bank, Belgium Central Bank, Reserve Bank of South Africa, Greece Central Bank and Bank of Japan. Historically speaking as I said above this is not an anomaly but the norm before the 1940s. Given the poor record of our monetary authorities since then and the miss-management of the recent financial crisis, why not extending private ownership even further and thus mitigate the threats of a politically-exposed (some will say ultimately ‘controlled’) central bank?

In an interview with Standard and Poor’s, ‘New way forward or outdated anomaly? The future of publicly traded central banks’ (S&P Global. Market Intelligence), I advocate for central banks to return to the public and the banking sector, in order to guarantee their independence from governments and thus be able to achieve a more sound and stable monetary system. You will find the arguments in favour of a more independent central banks, owned by market participants in many references. Here I will just mention two of them, one written by Tim Congdon (Chairman of the Institute of International Monetary Research), Central Banking in a Free Society (IEA), and the other by myself with Pedro Schwartz (Visiting Professor, University of Buckingham), Central banks; from politically dependent to market-independent institutions (Journal of Economic Affairs); both pieces written in the midst of the Global Financial Crisis (2008-09) and the observed mismanagement of the lender of last resort function of central banks.

Find below an extract from the interview with my arguments:

‘Those in favor of privately owned central banks say such institutions would be better equipped to preserve market stability and could help prevent future financial crises.

“If publicly traded or owned by the banking sector … the market incumbents will have a genuine interest in setting clear … rules for the central bank to maintain financial stability over the long term,” said Juan Castañeda, director of the Institute of International Monetary Research at the University of Buckingham in England.

In the event of another financial crisis, a central bank would be fully independent to intervene at a bank in need, and any injection of capital would come from the banking or private sector, Castañeda said. Situations like the nationalization of Northern Rock by the Bank of England at the outset of the global financial crisis could be averted were central banks not in public hands, he argued.

“Those are the things that you can avoid if your central bank is publicly traded,” he said, citing the late 19th century example of U.K.-based Barings Bank, which faced bankruptcy but was saved by a consortium of fellow lenders, helping to stave off a larger crisis.

Oversight of a central bank would belong to the bank’s shareholders, although national authorities would also have a say because of the bank’s management of monetary policy and financial stability.’

It is not surprising Tim Congdon and myself advocate for more independent central banks (privately-owned) as a way to protect them from political interference in the development of its functions. I do believe this would contribute to a more sound running of monetary policy and to less financial instability in the future. If publicly-traded or owned by the banking sector (following the US Fed model), market incumbents will have a genuine interest in setting clear mandates/rules for the central bank to maintain financial stability over the long term. Should another financial crisis occur in the future (that it will), the central bank will have free hands to intervene promptly and avoid the contagion of panic in the market (by the application of its lender of last resort function). And if any injections of capital were needed, it would be the banking sector (or the private sector as a whole) which would bail-in the bank in crisis and, most likely, taxpayers’ money will not be needed again.

Of course this alternative arrangement is fully compatible with the central bank be given statutory functions (such as an inflation target for example) and be subject to parliamentary oversee; so the Governor will have to answer not just to the Bank’s shareholders but to Parliament as well in relation to the running of monetary policy and financial stability (find further details on these arrangements in Congdon’s 2009 work mentioned above).

Juan Castañeda

PS. An excellent narrative of the flaws of the current system can be found in Milne and Wood (2008)’s  analysis of Northern Rock bank crisis in the UK.

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Mr. Carney, the Old Lady is not for tying

I found this caricature in The Times last Saturday (see below) and I could not resist the temptation to write a post on it. With a blog like this one, with its name, I had no other choice but to welcome and echo this caricature and its message. As I already explained in more detail here, I do believe that a  course on money and central banking could be taught by using these classical (and contemporary) caricatures as the main material of the course. They provide the political and historical context needed to properly analyse how different constraints/events have affected the policies conducted by the central banks along the modern history.

As J. Gillray masterly did it two centuries ago, here you will find again the (poor) Old Lady screaming and fighting with the authorities; represented this time not by the prime minister but by the next governor of the Bank of England, Mr. Carney. There are some other differences of course. In this new version of Gillray’s “Political-ravishment, or the old lady of Treadneedle-Street in danger!” (1797), the new governor is not taking some gold coins from her pocket but trying to keep the Lady well tied up and under his control. The Lady is obviously protesting and is struggling to free herself from the new ties imposed in the last years; ties which represent the new and extraordinary lending facilities the Bank has had to implement since the outbreak of the recent financial crisis to assist the banking system and the Government. True, many will say that the central banks, wisely acting as the lenders of last resort of the financial system, had no other alternative but to support the banking system and maintain the proper running of the payment system. Fine, I agree to some extent since, in the face of a major financial panic, the central bank must act firmly and timely to avoid the collapse of the financial system. But at some point these extraordinary policies will have to cease and the central banks will return gradually to normality in the coming years; which certainly will mean the adoption of a more orthodox monetary policy, one committed to maintaining the stability of the financial system but also the purchasing power of the currency. Let’s see if the new governor of the Bank of England succeeds and is able to extend the existing “ties” or even adopt new ones: an expansionary nominal income targeting strategy?, the adoption of a new, higher of course, inflation target?

Nothing new at all. Under the gold standard there were clear rules which prevented the central banks from printing too much money. In our days, under a fully fiat monetary system, one in which money is created out of thin air (or ex novo), those rules are even much more needed (though become blurred many times …); so, yes, somebody must tie the hands of the Government and those of its bank (i.e. the national central bank) not to overspend and overissue respectively, in order to maintain monetary stability and the purchasing power of the currency in the medium to the long term. Until relatively recently (in the interwar years), it was in the very nature of the central bank to limit the amount of money in circulation to preserve the value of its own currency in the markets. It was a profit maximising institution for quite a long time and that was the best policy to increase the demand of its money and thus its revenues (the seigniorage). However, as depicted in this caricature, this time it looks like the world is turning upside down, since it is the (next) governor of the Bank of England, the “manager” of the bank, the one who wants to impose his own (new) ties to the Old Lady to keep on running extraordinary policy measures in the UK.

Future will tell which vision prevails in the UK and elsewhere, the classical one which defines the central bank as a bank which provides essential financial services to the banking system (a sound money amongst them) or the modern view of the central bank as a major policy actor committed to a time changing basket of macroeconomic goals, either given by the government or not.

Paraphrasing Mrs. Thatcher’s very famous quote (1980), The Time‘s cartoonist has chosen a very clever title for this satirical caricature: “the Lady is not for tying (see below). Enjoy it.

Juan Castañeda

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Published in The Times, 4th May 2013. Business section p. 51. “The Lady’s not for tying”. By CD, after Gillray.

After_Gilray_TheTimes2013

 

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A chat on fractional reserve and monetary competition

This video was originally recorded in Spanish and released on the 15th of March 2012 at Vimeo (Spanish version). Then it was very kindly supported by the GoldMoney Foundation, so we could release an English version of the video on July this year, entitled: “The Spanish economic crisis”. I would like to thank GoldMoney very much for their support.

You can also find below a summary of the content of the video, as quoted from the GoldMoney website (research section).

Enjoy it! Comments very much welcome.

Juan Castañeda

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The Spanish economic crisis: ‘Yo Invito – ¿Dónde está mi dinero?’

What caused the Spanish economic crisis, and how safe is your money in banks? Maria Blanco, economist and member of the Instituto Juan de Mariana; Doctor in Economics Juan Castaneda; Marion Mueller, founder of OroyFinanzas.com; and Expansion.com journalist Miquel Roig discuss this and more over coffee at Madrid’s Café Gijón.

Fractional reserve banking, sound money, and the prospects for monetary reform in Spain and the wider world are the broader topics of conversation. Though the quartet are heartened that more and more people in Spain are taking an interest in economics since the country’s debt problems became apparent, they doubt that the kind of radical monetary reforms they favour would win support among many Spaniards. They are heartened though that elsewhere in the world – notably an increasing number of US states – the sound money cause is gaining support, albeit slowly, among citizens and politicians.

This video was recorded on 10 March 2012 in Madrid.

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Article originally published in GoldMoney Research (15th May 2012)

Improving the banking system

Governments grant central banks a monopoly on the creation of hard currency. At the same time, we ordinarily make transactions with other means of payment supplied by commercial banks. This is possible because in our monetary system commercial banks are able to create so-called bank money. These means of payment consist of different banks’ deposits that can be used with cheques, bank transfers, credit or debit cards and direct billings, which make our lives much easier as we do not have to hold or carry bank notes or coins to make ordinary transactions.

However, commercial banks are not free to issue their own currency. Bank money has to be denominated in the currency issued by the national central bank and the banks are legally required to redeem their sight deposits in the currency of the central bank at any time. However, the need to back any single deposit of their clients does not necessarily mean that the bank is keeping all our money in their vaults at all times. According to current regulations, they just have to keep a tiny fraction of it. This is the legal reserve ratio. In the eurozone this is 2% of banks’ total deposits; and for this reason we call it a fractional reserve monetary system. This system allows for easy expansion of the money supply, but it also involves a significant risk: that of bank runs caused when depositors all try to take their money out of banks at once.

Banks started to operate under a fractional reserve system in the early modern era, when it started dawning on them that in ordinary times, few clients actually asked for the money kept on deposit. So they started to lend part of it out. By doing so, new deposits were created and hence new means of payments. Consequently, banks increased their balance sheets as well as their profits quite substantially, as the costs of backing their new deposits were much lower than the earnings coming form the new loans. Since the mid to late 19th century, with the expansion and development of modern banking, banks were able to offer these new means of payment more efficiently – which did not require the use of paper notes or coins. As a result, banks realised that their clients needed less and less physical currency, which resulted again in a reduction in reserve ratios.

But during the 19th century the gold standard regime – championed by the British Empire – was an effective means to limit monetary expansion, both from central banks and commercial banks, as they still had to keep gold in reserve to back their issuance of money and credit. However, with the abandonment of the classical gold standard during the First World War, banks no longer needed to keep valuable assets in their vaults as the new reserve money of the economy was the notes of the central bank; which, in theory, could be expanded overnight with no tangible costs. This new system, in combination with the running of purely discretional monetary rules, resulted in excessive money creation and, finally, in more inflation and output instability in the late 1960s and 1970s.

Consequently, fractional reserve systems based on fiat currency tend to over-issue money unless strictly controlled by the central bank, or by the emergence of free competition in money. With the former, the central bank commits to a sound monetary rule focused on maintaining the purchasing power of money. Under this rule, both the central bank and the commercial banks are able to create means of payments but are subject to restrictions.

As sight deposits are redeemable at very short notice, banks could be required to fully back all their sight deposits with an equivalent amount of notes. Hence, the reserve ratio would amount to 100% of all sight deposits. Under this regulation, banks could only create new means of payment by lending the money kept in their time or savings deposits. It would result in a more stable monetary system but at the cost of having a less developed banking system, and thus a much smaller money supply.

In my view we do not have to go all the way towards a 100% reserve ratio to preserve the stability of the monetary system, while allowing for the development of the banking system. The gold standard seen in Britain and other countries during the 19th century is a good example of a self-correcting monetary system that nonetheless operated on a fractional reserve basis.

However it is achieved though, greater recourse to preserving the purchasing power of money would go a long way to improving our current monetary system.

Juan Castañeda

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Gold standard under a competitive market scenario: a debate

 

Gold standard has been often claimed to be the liberal panacea as regard to monetary regimes. I myself believed it for quite a long time.  However,  the study of monetary history in a broader and longer perspective has made me change my mind on this question. In relation to the gold standard, Milton Friedman (1) made a very interesting critique from a liberal perspective in the paper presented at the Mont Pelerin Society in 1961. His work, “Real Versus Pseudo Gold Standards” is a true challenge for all those who beleive that the classical gold standard was (and still is) a panacea. As Friedman remarked, it is difficult for a pro free-market economy to put the label of “liberal” to a monetary regime in which the State fixed the price of one specific good (in this case, the covertibility rate between the bank notes and the gold held by the central bank). In his view, the belief of the classical gold standard as part of the main liberal body of theories is the result of the traditional involvement of the State in the monetary field; as a result, we cannot even think of a monetary system in which the price of gold were not determined by the State, but by the competitive dynamic of different issuers of bank money and money holders themselves.

And this is the sort of the debate that I introduced in the last meetting of the “ANR DAMIN” Project (coordinated by Prof. Georges Depeyrot, CNRS, Paris), entitled Silver Monetary Depreciation and International Relations, hold in Paris last January. It was an extraordinary  meeting with experts and very good colleagues in the area of contemporary monetary history; and my proposal to talk about a competitive gold standard monetary system was received with some surprise at first. Then, once the question was properly set and introduced, we did develop a very interesting debate on the feasability of a monetary regime not necesarilly monopolised by the State; one in which, different issuers of paper money, backed with gold, were able to compete to provide the best means of payment. Under this system, as Friedman masterly stated, there is no need to claim for a fixed priced for gold, as its price will vary in the market everyday according to its demand and supply(ies).

Let me clarify that, even though under the control of the State, I do take the classical gold standard as a stable monetary system, with a remarkable record of long term price stability and economic growth from 1870 to 1914. And this is much more the case in light of the much more discretionary monetary regimes  that we have experienced since the abandonment of the gold standard in the last century; under purely fiat monetary systems, we have seen during the so-called “Keynesian years” how money supply was taken as another tool in the hands of the policy-makers to finance excessive and recurrent fiscal deficits, with the expected and undesirable results in terms of higher and more volatile inflation, and thus more uncertainty in the markets.

The debate can be found in the following link: http://www.anr-damin.net/spip.php?article31#outil_sommaire_1

(please, go to the last Saturday video, “Final Debate of the Round Table”; the debate on this question is in the middle of the recording)

Juan Castañeda

(1) I am grateful to Prof. Pedro Schwartz for his suggestion to read it several years ago.

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