The Evolving Role of Central Banks
Chapter

8 Role and Independence of Central Banks

Editor(s):
Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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Author(s)
ANTONIO FAZIO

Toward the end of 1962, when the “monetarist controversy” was raging in academic circles, I was attending classes at the Massachusetts Institute of Technology. The graduate course of Monetary Theory was taught by Professor Samuelson, with the assistance of Albert Ando. One day a student came into class with a mimeographed copy of Friedman and Schwartz’s A Monetary History of the United States, 1867–1960.1 The manuscript was several inches thick. Professor Samuelson looked at it, weighed it in his hand, and said (more or less literally, I quote from memory): “Milton, Milton, we set up the Fed to adjust the quantity of money to the needs of the economy.” It was a critique, but also, in a nutshell, a philosophy of central banking. I will return to this point later, at greater length.

Having implicitly declared my exposure—and my affiliation—to a vision of the economy that can be broadly defined as “Keynesian,” let me nevertheless immediately state my conviction regarding (1) the importance of nominal quantities of money and credit (and not only of their relative prices with respect to other financial assets and liabilities, in other words, interest rates); and (2) the distrust of excessive activism in monetary intervention.

These two positions, together with the revival of the importance of monetary policy for the control of both output and prices, are certainly a product of what we may call a monetarist vision of the economy. I shall be more analytical and define the points I want to discuss and the arguments.

What Is Money?

Let me begin by discussing what money is (not only what money does) in an analytical model, in which there are an independent state, a fiscal activity, a market, and a banking system. Modern economic theory has taught us that in such a context money may be a good that has no intrinsic value.2 The amount of fiduciary money must be determined by forces that are outside the market. This requisite is necessary for units of money to have a determinate value.

Fiduciary money, circulating in the economy, embodies a credit on the authority that issues it. There must be reliance on some economic entity that is absolutely secure, that guarantees the value of money, or that has the authority to issue it. This requisite is necessary to ensure its general acceptability, in other words, to ensure its absolute or perfect liquidity. Since every private agent in a market economy can fail, the only authority that can guarantee all its debentures is the state—thanks to its power to levy taxes.

In ancient societies and early political organizations, money often circulated that had only conventional value.3 It was when the authority of the state was not sufficiently strong that the circulating medium needed to have an intrinsic value (although even then the weight generally had to be certified by a sovereign). Within the state, money possessed clearly fiduciary characteristics. It was issued by the sovereign and circulated on the basis of confidence in his authority. It embodied a claim on the authority that issued it (to finance public expenditure), and accepted it back for tax payments. In this interpretation, there appears to be a close connection between public expenditure and money circulation and between sound fiscal policy and the value of money. (I am aware of the danger of simplifying complex historical phenomena by using modern analytical instruments, but I am confident that the interpretation is basically correct.)

In medieval times, there are instances of bankers issuing notes that were the certification of given quantities of precious metals deposited with them, first in Italy, and then in other important markets and cities in Europe.4 In the loose institutional settings of the time, precious metals were the only internationally accepted medium of exchange. But, gradually, bankers’ notes representing the value of the deposited metals began to circulate; they generally paid no interest and served as the basis for exchange and credit operations between different places. Bankers then experimented with the issue of notes that were backed not by deposits of precious metals but by credits on merchants or, in some instances, on kings and foreign states.

The modern concept of banking activity began to emerge. Some credits to monarchs proved ruinous, both for the bankers and for their depositors. Modern states, which began to emerge in the seventeenth century with stronger institutional arrangements, “invented” the banks of issue. Some have evolved into what we now consider modern central banks.

The general acceptability of a medium of exchange can be established by decree. In this case, bank notes are raised to the status of legal tender for all payments, public and private. The imposition of the medium must be well received by the market and will become effective if there is confidence in the final debtor.

The Emergence of Central Banks

The origin and use of the expression “central bank” in academic literature goes back to the early decades of this century. In actual legislation, and in the usage of practical men and politicians, the term is a rather recent one. One definition describes the central bank as the “bank of banks.” Other definitions are the bank of the treasury and the bank for the external sector of the economy, that is, the custodian of a country’s foreign currency reserves.

If a central bank were only a bank of the banks, independence or degrees of autonomy would not be issues. Indeed, commercial banks are independent in their actions, subject only to legal limitations related to their special activity. For a central bank, the issue of independence arises when it is required—by law, by tradition, by the development of monetary theory, or by public opinion—to perform tasks that are considered to be of public interest. The institution charged with pursuing these particular public objectives is a bank of the banks, an institution that was historically generated by market forces. It would be difficult, I venture to say impossible, to assign those functions to a public body that was not so intrinsically linked with, and involved in, the working of the financial system.

The Bank of England during the nineteenth century emerged as a lender of last resort for the London bill market and progressively assumed the functions of a central bank.5 Together with a response to the needs of liquidity control, there was, from time to time, the need to stabilize the value of the pound in terms of gold. All this presupposed and required a growing involvement of the bank with the market.

The status of bank of issue was essential in performing these functions. Bank notes were considered a substitute for specie for certain classes of payments; the value of the bank notes was guaranteed by the gold reserve. When liquidity was tight, the government or parliament authorized, and basically guaranteed, an expansion in the volume of bank notes in circulation in excess of the rigid limits set by the gold reserve. The value of the bank notes, their liquidity, and their acceptability therefore rested ultimately on the existence of a gold reserve and on credit to the private sector, but in stringent periods an authorization and a guarantee from the political authority were also deemed necessary.

The U.S. Federal Reserve System was created in 1913 to act as a clearing house for the financial system and to provide liquidity to commercial banks under strain for cyclical or seasonal reasons by means of rediscounting. In practice, the system was also charged with the pursuit of public interest tasks of control over the circulation of the currency and of some operations of the banking system. Some of these functions had been previously performed by the U.S. Treasury.6

In Europe, several of what we now consider, and call, central banks were established as banks of issue: their bank notes had the status of legal tender and rigid provisions linked the volume of bank notes in circulation to the gold reserves; they also had special relationships with the treasury and the government.

Growing Need for Regulated Financial Systems

Financial crises that affect other economies and burgeoning financial markets have made authorities realize that financial systems need to be regulated.

Financial Instability

The Great Depression of the 1930s, with all its appalling social and political consequences, was partly due to a series of mistakes, lack of coordination, and rigidities in the conduct of monetary policy by the authorities and the central banks of the principal countries.7 The restrictive impact of each reduction in bank credit, as a consequence of the crisis, on investment and production was amplified by the multiplier and by international trade.8 In every country, the crisis led to, and was amplified by, bank failures. The close relationship between economic and financial crisis and between macroeconomic regulation and banking stability became more evident.

The first consequence was the tendency of various economies to close their frontiers to international economic and financial dealings. Banking and financial legislation was adopted that regulated intermediaries and markets in a much more penetrating and detailed manner than ever before. Banks of issue acquired new powers; new government bodies were created to supervise and regulate the banking sector.

An unstable money supply, which included not only specie and bank notes but also banks’ checking accounts, also emerged.9 It became clear that the credit policies and behavior of banks affected and could upset monetary policy. Hence the dramatic proposal, coming from such a free-market-oriented center as the University of Chicago, of a 100 percent reserve requirement on checking accounts and the suppression of certain operations of private banking.10

Since World War II, growth and stability have been unprecedented. International trade has been liberalized and has become an engine of growth; it benefitted from the new monetary order provided by the Bretton Woods agreements. Public expenditure has grown considerably, even too much, providing a built-in stabilizer for the economic cycle. These conditions have drastically reduced financial instability by comparison with both the interwar period and the early years of this century.

Certainly, the economic environment and new international monetary arrangements have had a decisive effect on the performance of the financial systems, but monetary authorities and central banks have made good use of the expertise gained from earlier disastrous experiences.

Expanding Financial Markets

There are two macroeconomic aspects of the financial performance of national economies and of the international economy to which I want to draw attention.

First, the degree of financial deepening of the industrial economies has increased steadily over the last fifteen years. Table 1 shows how the volume of financial assets owned by the domestic private sector has evolved in relation to gross domestic product in six leading industrial countries. In all the countries, the ratio has increased considerably, and constantly. In other words, the quantitative importance of the balance sheets of banks and other financial intermediaries has increased, and the financial markets have developed. This means that the expenditure behavior of households and firms is now dependent on the composition, nature, and yield of financial assets more than in the past.

Table 1.Ratios of Domestic Financial Assets to GDP
1975198019851988
United States
Households2.22.42.52.6
Firms11.92.12.42.7
Total4.14.54.95.3
Japan
Households1.11.31.82.2
Firms12.93.24.05.1
Total4.14.65.97.3
Germany
Households0.91.01.21.2
Firms13.33.74.54.6
Total4.24.75.75.9
France
Households1.021.01.21.3
Firms12.522.73.44.2
Total3.523.84.55.5
United Kingdom
Households1.31.31.82.0
Firms11.51.52.12.6
Total2.82.73.94.6
Italy
Households0.90.91.11.3
Firms11.91.92.22.1
Total2.82.83.33.4
Sources: Organization for Economic Cooperation and Development (OECD); Financial Accounts, for the United Kingdom; CSO Financial Statistics, for Italy, Bank of Italy.

Firms include nonfinancial enterprises, banks, insurance companies, pension funds, and other financial institutions.

Data are for 1977.

Sources: Organization for Economic Cooperation and Development (OECD); Financial Accounts, for the United Kingdom; CSO Financial Statistics, for Italy, Bank of Italy.

Firms include nonfinancial enterprises, banks, insurance companies, pension funds, and other financial institutions.

Data are for 1977.

The second aspect concerns the international economy. The size of the international financial markets, in relation to the world economy, as measured by available indicators, also grew dramatically in the last fifteen years. International banking activity, measured in terms of banks’ total external assets, almost doubled. The international Eurobond market grew even more rapidly (Table 2).

Table 2.Growth of International Financial Intermediation
YearPercentage Ratio of Banks’ External Assets to GDP1Percentage Ratio of International Bonds to GDP2
197510.60.53
198017.02.23
198530.96.3
1990433.68.4
Source: Bank for International Settlements (BIS).

All banks in BIS reporting countries plus some offshore markets; end-of-the-year data. OECD area GDP at current prices and exchange rates.

Total outstanding international bonds; end-of-the-year data. OECD area GDP at current prices and exchange rates.

Estimates.

Estimates based on second-quarter figures.

Source: Bank for International Settlements (BIS).

All banks in BIS reporting countries plus some offshore markets; end-of-the-year data. OECD area GDP at current prices and exchange rates.

Total outstanding international bonds; end-of-the-year data. OECD area GDP at current prices and exchange rates.

Estimates.

Estimates based on second-quarter figures.

International banking activity is, as a first approximation, outside the monetary control of central banks. The performance of financial markets can be influenced only indirectly by the action of central banks and national regulatory agencies. All other things being equal, the growth of domestic and international financial markets increases the importance of, and the need for, financial regulation and control.

The “Weight” of Central Banks

If a central bank is to influence the behavior of financial aggregates and rates of interest, starting from its position in the market, one necessary condition is that its balance sheet be sufficiently large with respect to the dimension of the economy.

Assets

For various countries and periods, Table 3 shows the ratio of the total assets of the central banks to the money supply (a measure of the consolidated balance sheet of the banking system) and annual national product. Both ratios are significantly higher in Italy and in France, and lower in the United States and the United Kingdom. The ratios for Germany are between the two extremes. The situation does not change over time, except in the case of the United Kingdom, where the ratio of money to gross national product doubled in the second half of the 1980s, and the importance of the central bank remained unchanged in relation to the gross national product.

Table 3.Central Bank Assets, the Money Supply, and GDP: Selected Ratios(Percentage ratios of annual averages)
M2GDPM2/GDP
1980/831984/871984/87191980/831984/871984/87191980/831984/871984/8719
Italy36.2034.3031.7025.7022.8021.3070.9066.3067.30
United States9.509.209.506.106.005.9064.3065.0062.60
Germany21.0019.9021.9011.6011.6013.2055.0058.5060.10
United Kingdom19.9010.509.408.709.6043.7090.90
France35.2030.5027.5018.5016.2013.4053.0052.6048.90
Sources: Central bank bulletins; and International Monetary Fund, International Financial Statistics, (IFS).
Sources: Central bank bulletins; and International Monetary Fund, International Financial Statistics, (IFS).

Table 4 shows the weight of different categories of central bank assets and liabilities with respect to gross domestic product (GDP). On the assets side, it is evident that more than half of the high ratio found for the Bank of Italy is due to its financing of the treasury; the reserves of gold and foreign currencies are also remarkably high.11 On the liabilities side, a large proportion is accounted for by the deposits of the banking system, that is, essentially compulsory reserves; given the amount of financing to the treasury and the amount of gold and foreign exchange reserves, these deposits increase the demand for monetary base and make it possible to maintain a minimum amount of refinancing to the banking system.

Table 4.Central Bank Balance Sheet Aggregates and M2: Selected Ratios, 1989(In percent)
ItalyUnited StatesGermanyUnited Kingdom1France
Assets
Foreign11.621.657.425.0514.05
Treasury17.857.561.043.181.34
Financial system0.670.0813.010.118.45
Other assets1.130.571.431.213.01
Total31.279.8622.899.5426.85
Liabilities
Currency8.927.8311.173.558.52
Bank deposits14.121.244.960.342.68
Treasury0.080.200.453.15
Capital and other liabilities8.150.596.315.6412.50
Total31.279.8622.899.5426.85
Sources: Central bank bulletins; and International Monetary Fund, International Financial Statistics, (IFS).

The monetary authorities’ foreign assets and liabilities are based on those reported in IFS.

Sources: Central bank bulletins; and International Monetary Fund, International Financial Statistics, (IFS).

The monetary authorities’ foreign assets and liabilities are based on those reported in IFS.

Other high figures on the assets side are the amount of treasury debentures of the U.S. Federal Reserve System and the refinancing of the private financial system for the Deutsche Bundesbank and the Bank of France. One tentative conclusion for such high figures is that in Italy and the United States, influence on market conditions is mostly transmitted via open market operations on, and financing of, the public debt. In Germany and France, there is a more direct influence on the financial sector, via lending to the banking system and the supply of liquidity to the private financial sector.

Liabilities

The central bank is part of the financial system; it intermediates a part of the flows of saving going through the same system. But the liabilities of the central bank are quite special; they are the money par excellence, or monetary base. Because of their intrinsic qualities, legislative prescriptions, and long tradition, these liabilities have the features of absolute liquidity and general acceptability, and serve as means of payment, not only among individuals and firms but also among banks and financial intermediaries, which are, in turn, themselves creators of money.

Here again we meet the fundamental characteristic of the central bank as the bank of banks, and thus a natural candidate to influence their operations. This influence can be reinforced by obliging the banks to make special deposits, in other words, by imposing compulsory reserve requirements, which are now mostly enshrined in law. The reserves strengthen the link between the size of the central bank’s balance sheet and that of the consolidated balance sheet of the banking system. The link would be perfectly rigid in the famous 100 percent reserve requirement proposed by the Chicago School in the 1930s. Worried by the excessive oscillations in the amount of money provided by the banking system and the disturbances to the economic cycle induced by banking activity, the Chicago School also proposed the abolition of private banking activity, in some extreme formulations.12 Private banks have not been abolished; they are useful institutions; they behave as free enterprises in their own field of activity. They are subject to special banking laws.

The point is that one can apply to banking activity, in order to preserve the value of banks’ deposits, the same type of analysis that requires an outside limit on the amount of bank notes, in order to preserve their nominal value. The volume of banking activity, the output of the banking system as measured by the amount of credit and deposits, is not limited by the availability of some primary resource, as is the case with all other productive activities. In a closed economy, credit produces deposits, and deposits allow for further expansion of credit. This process affects real variables and prices.

Central banks did not fail during the Great Depression because they had sufficiently large gold reserves. Some analyses consider that it was precisely their sticking to the rules that was at the root of the crisis. Central banks were also mostly creditors of the state—which cannot fail—and had a sort of state guarantee.

A relation similar to that existing between the central bank and the banking system exists between banks and the financial system. This is made up of intermediaries that extend credit and collect liabilities that we do not generally consider as means of payments. The system also includes markets where debtors and creditors, investors and savers, meet directly. A bank can provide investors directly with means of payment, because its liabilities are considered as such. Other intermediaries, and financial markets, need at least a temporary credit, and then the money provided by the banking system. Expenditure by debtors stimulates economic activity and saving. Saving takes, in part, the form of bank deposits and financial assets, thus closing the financial circuit. The central bank, because of its special nature and position in the market, can understand what is happening in such a circuit and the velocity at which it operates, and can strongly influence its operation.

Discretion in Central Bank Action

In order to influence the volume, composition, and cost of financial transactions, the central bank needs to be able to manage the size and composition of its balance sheet, as regards both assets and liabilities. Because it has the monopoly of monetary base creation, it can set the nominal interest rate at which the monetary base is lent to the system.

In the monetarist approach to monetary policy, the central bank only needs to influence the amount of money, via the supply of monetary base and the money multiplier. It is assumed that the amount of money can be more or less perfectly controlled on the supply side. The demand for money is stable in the long run; the underlying development of real variables is considered, per se, regular and stable. Prices are assumed to be sufficiently flexible; consequently, they respond to the quantity of money.

In a more realistic—and less doctrinaire—approach, monetary policy has a scope that is, in a certain sense, wider, though perhaps less definite and exclusive, less sharp edged. Monetary policy in this view can and has to affect first the behavior of the banking system, that is, bank credit, deposits, and the money supply. Specifically, by supplying the monetary base, the central bank will affect banks’ willingness to lend, in other words, the supply of bank credit. This will be matched in the market with the demand for credit—for investment, for the financing of current production and sales, or even for the hedging of financial operations. All these uses of credit and the resulting amount of money affect the domestic economy in various ways, directly or indirectly, as well as the relationships with the foreign sector. The volume of foreign reserves held by the central bank will consequently be affected. And most important of all, so will the exchange rate.

The process I have just described is by no means a mechanical one. The reactions of different variables to the stimuli of monetary policy may vary considerably from one situation to another. Good qualitative and quantitative analyses can provide reliable indications of the effect of policy actions. It is not possible, however, at least in my view and experience, to cover all of this with simple rules, for example, merely by fixing the rate of money expansion.

Returning to what I said at the beginning, I believe that quantities of credit and money expansion have to be defined ex ante. The quantities can also be announced to provide markets with correct indications. But I do not think that there exist simple quantitative rules by means of which the price level can be controlled.

A lax monetary policy will certainly result in inflation. But monetary fine-tuning cannot be relied upon for close inflation control. Fine-tuning is difficult and probably impossible to achieve in such matters, mostly because of incomplete information, lags, and uncertainties regarding the size of the effect of the various instruments.

There is thus a grain of wisdom in the monetarist prescription of not seeking continuous correction of the economic cycle and avoiding over-activism in the use of monetary instruments.

Effectiveness of Central Bank Action in Italy

At the Bank of Italy, long experience has taught us to rely on a complex econometric model of the economy to understand how monetary policy affects all the variables we want to influence. The model is particularly detailed for the monetary and financial sectors. Numerical results provided by the model are only a basis for decisions. Judgment and other empirical evaluations complete the assessment of situations and influence decisions.

Technically speaking, reliance on the estimated coefficients of different equations of the model is limited to providing a starting basis for decisions. What is implicitly relied on, always, is the model, that is, the logical interconnections of all the variables. What the model, or more correctly the structure, says is that variables, such as internal demand, prices, employment, and the balance of payments, can be affected significantly, though not very much in the very short run, through the use of ordinary monetary policy instruments, such as open market operations, bank reserves, rediscount rates, and the like.

In some periods of high inflation, large balance of payments deficits, or exchange rate crises, it was necessary to resort to extraordinary administrative policy instruments, namely, credit ceilings and portfolio requirements, for which the Italian banking law provides. These extraordinary and harsh restrictive interventions were devised and graduated on the basis of the econometric model. They proved quite effective in stabilizing the economy.

Similar conclusions can be applied to all systems that find themselves under exceptional strain because of accelerating inflation, a balance of payments crisis, or rapid exchange rate depreciation. I have to remember, however, that in Italy, the adoption of direct or administrative methods of monetary control hindered, among other things, the efficient allocation of credit resources.

In conclusion, the central bank can and must first use its tools, its instrumental variables, to pursue the smooth and regular development of the economy, or, to paraphrase Professor Samuelson, to adjust the quantity of money to the needs of the economy, not merely to the demand of the economy.

Indeed, the behavior of real variables (including prices), that is, those variables that have a more or less direct impact on social welfare, could be unsatisfactory. In such cases, the central bank can use its instruments to correct the situation, via the supply of credit, interest rates, and bank money supply. In a deeper sense, if the correction is in the direction of stability, for the common good, it is an adjustment of the quantity of money to the more profound needs of the economy. We thus have a complete philosophy of central bank action.

Let me now turn to another more theoretical issue: whether it is the central bank that moves the economy or vice versa. From what has just been said, it is clear that over the long run a close correlation exists between the behavior of the economy and the evolution of the monetary aggregates. The parallelism, which is the result of close links between monetary, financial, and real variables, is for some periods the result of an adaptation of financial variables and monetary guidance to a satisfactorily smooth behavior of the economic system.

From time to time the system needs correction. The central bank has the power to enforce such corrections. The parallelism is now the result of active monetary policy intervention. In these cases, money and credit determine the evolution of the system. On such occasions, the quantitative relationships between real variables and financial variables are usually altered—a problem for the econometrician, but also for the central banker who has to use judgmental evaluation to graduate the strength of interventions. In this discussion, I have in mind mostly cases of restrictive monetary policy. Perhaps I continue to be influenced by the dictum that monetary policy is like a rope that you can pull but not push.

Economic Objectives of the Central Bank and the State

The central bank must coordinate its action and its economic policy interventions in the general context of the state’s economic policy. Given the macroeconomic objectives of the political community, which can be defined, depending on the level of generality and constancy over time, either by law or by the government, the central bank has to deploy all its tools to achieve those objectives. Some are more immediately within the reach of the central bank; others require the central bank to cooperate with other institutions or agencies. Ensuring financial stability and the proper functioning of the financial system is certainly a primary duty of the central bank. When stability depends on an adequate supply of liquidity, the central bank is endowed with all the necessary powers.

Regulation of the structure of the banking system and achievement of a good performance by that system generally require powers that go beyond those relating to the supply of liquidity. These powers are granted by banking legislation, which recognizes the particular character of banking activity, within the institutional system. The central bank is at the center of the system; it understands and participates in the working of the system. It is natural to use its status and technical skills to enact banking legislation and to discipline the behavior and working of this important sector of the economy.

Within the banking sector, important pieces of information are necessarily possessed only by individual banks; consequently, their assets are not marketable. So the working of competitive markets can be relied upon only within certain limits. The central bank is then empowered with supervision and inspection duties and possibilities of intervention in order to prevent instability.

In current macroeconomic policy, maintaining the purchasing power of the currency is the primary duty assigned naturally to central banks. As I said before, to do this the central bank must control, in complete freedom, the size and composition of its balance sheet. The pursuit of macroeconomic objectives must be related to the overall economic policy. As far as monetary matters are concerned, the ways and means of achieving the objectives should be, and generally are, left to the judgment of central bankers. Central banks themselves can help define some of the economic objectives of the nation. An executive power of the state that affects directly the process of money creation generates a conflict of interest between different powers of the state. The executive power does not have to interfere with the process of money creation. This does not mean that the central bank cannot facilitate the financing of the treasury, in ways that do not conflict with the stability of the currency. Indeed, one traditional and fundamental task of central banks is to cooperate actively in the management of the public debt.

Managing Public Debt: Inflation Control

The mere existence of a budget deficit, and of a public debt, means that parliament has chosen not to cover a part of public expenditure through taxation. This can be done for structural, redistributive, or allocative reasons, or even just for cyclical reasons. Such a superior will of the parliament is, at least in the short run, a dictum for all public bodies and institutions within the state.

I have examined the operations of the central banks’ of all the main industrial countries: all of them have special arrangements with the treasury for the placing and management of the public debt. There are functional and historical reasons for the central bank to perform such a role. In the first place, an important part of monetary control is implemented via purchases and sales of government paper and, as I said before, government debentures constitute an important component of the central bank’s assets. Moreover, in a system where fiduciary money is the norm, confidence in central bank money is in some fundamental way related to the authority of the state. It would be difficult to think of sound money in a fiscally bankrupt state, unless we assume, for example, a money circulation strictly related to gold or foreign assets.

Sound money cannot exist without a sound fiscal system. In countries where most of the tax revenue comes from seigniorage, money is deprived of its most intrinsic features. In a hypothetical, unsound fiscal system, one could imagine, for a while, a monetary system based directly or indirectly only on credit to the private sector. Such an equilibrium is illusory, and at best temporary. In such circumstances, the bad government debt might take on some of the functions of a monetary standard and tend to displace the sound money. More realistically, the crisis of the state would entail that of the private sector.

The question is sometimes discussed whether the central bank, or more generally monetary policy, can be assigned the objective of absolute price stability. It is certainly true that good monetary management is a necessary prerequisite for price stability. However, our knowledge of the working of modern economic systems suggests that in some cases an objective defined in precise quantitative terms, for example, zero price growth, can be difficult or even impossible for the central bank to achieve.

In an open system, central banks may have considerable scope for influencing the external value of the currency—in the short run, through intervention on foreign exchange markets and, more basically, by controlling the expansion of credit and money. The external value of a currency is, in turn, an important component of the currency’s domestic value, its internal purchasing power.

In a large and complex economic system, the level of prices is strongly affected by other variables and circumstances, first of all fiscal policy and labor costs. In such cases, relying solely on monetary policy to achieve monetary stability can be extremely costly in terms of other economic objectives. Monetary policy, including exchange rate policy, can make a large and essential contribution to the achievement of price stability. Other policies, namely fiscal and wage policies, have to join forces in the same direction.

Institutional Status of the Central Bank

One fundamental issue remains to be discussed, namely, that of the institutional setting of the central bank in relation to other powers of the state.13 Is there room for defining, within the state organization, a money-regulating power that flanks the traditional powers: the Legislature, the Judiciary, and the Executive?

The problem did not arise in the past, because the purchasing power of money was usually thought of as being anchored by law to a circulating medium having an intrinsic value, namely, gold. But, over the last sixty years or so—especially over the last ten or twenty years—the value of money has relied only on the limitation of its nominal quantity and on its good management by central banks and monetary authorities.

I confess my difficulty in deciding on the basis of economic analysis alone what is the appropriate solution for the institutional position of the central bank in the state organization. The solution has to be sought with reference to social and constitutional theories of political organization. The existence of international treaties conferring monetary powers on international or supranational organizations complicates the problem, or, perhaps, just adds another dimension to it. Economic analysis, nonetheless, has a duty to suggest some guidelines, or at least minimum prerequisites, for the appropriate institutional setting.

First of all, there must exist, at the constitutional level, a broad, explicit or implicit, delegation of authority by a sovereign state, which has the power to levy taxes, to the central bank, to provide the fiduciary standard for the economy. Second, there must be independence from other powers of the state in the process of money creation and control, in the sense that the amount of money and the channels of creation have to be decided only on the basis of the achievement of the general objectives of economic policy. Within this framework, the central bank will seek the best ways to achieve those objectives.

A closely correlated proposition is the implausibility of creating a system separated from the fiscal authority and the value of the public debt. The points of contact and the degree of involvement in this field are a very delicate issue. I simply wish to express my fears about the emergence, where there is absolute separation, of a sort of parallel monetary system in the event of an uncontrolled public debt; as Gresham said, bad money drives out good.

Finally, there must be a functional, legally sanctioned connection between official money, created by the central bank, and the money produced by the banking system. In effect, central banks and monetary authorities control money creation indirectly, on the basis of banking legislation giving central banks powers to exercise wide control over banking activities. This amounts to recognition, at the institutional level, that money is a component of the financial process. It is also an indispensable element for the correct and stable unfolding of the whole process. Given all these conditions, a bank of issue becomes the central bank of the system.

The International Dimension

Up to now I have made reference to economic systems that are independent of each other, not only politically but also to a large degree economically. I would like to add a few considerations about a central bank’s position in the international economy.

As I have already indicated, in the last few years a feature of the evolution of the international economy has been the rapid development of banking and financial activities outside national boundaries. Underlying this development has been a steady growth of international trade in goods and services, but more important still has been the rapid growth in transactions for purely financial purposes. Industrial countries, during the 1980s, removed many restrictions on such transactions, and on capital movements in general; stable exchange rates are once again being valued, after the skepticism of the 1970s; and computing and communication costs have fallen dramatically. These factors have created favorable conditions for the expansion of international financial transactions.

The implications and advantages of this development in terms of economic growth, employment, and economic stability are not yet clear; however, this trend, given the fiduciary character of money in circulation, poses formidable new problems for the regulation of the economic cycle and for international, financial, and economic stability.

Central banks and national monetary authorities find themselves rather disarmed in this field. In some respects, a sort of free banking exists in international markets, in a context in which there is no reserve having an intrinsic value and no lender of last resort. Freedom of capital movements and relatively stable exchange rates tend to create an international monetary system that is deprived of overall quantitative limits. Until now, risks of various kinds have somewhat checked the expansion of the markets—but at a cost.

Central banks are in the market. By virtue of their participation in the foreign exchange markets, in particular, they are in a position to perfectly understand what is happening in the international banking and financial markets. Since the abandonment of the Bretton Woods system in the early 1970s, national monetary authorities have been trying to restore their control of the international monetary order by means of closer cooperation and various reform proposals at regional or world level.

Summary

Central banks emerged, with their present role and functions, from the tormented political and monetary history of the twentieth century. In the great economic and financial crisis of the 1930s, the close connection between financial stability and economic activity became dramatically apparent. Problems have persisted and reappeared at various times since then, though less dramatically.

Solutions included imposing restrictions on international trade and finance, introducing banking legislation, engaging in more active central bank intervention, and, after World War II, establishing a new monetary order. The Bretton Woods system stressed new aspects of the importance of the objective of the external value of the currency.

The development of unrestricted international banking activity and the more recent reciprocal opening of financial systems, in a context of money circulation based on purely fiduciary standards, pose new problems for national central banks and national monetary authorities. They are being attacked through closer cooperation and projects of reform.

Central banks play an important and sometimes exclusive role in preserving the value of currencies and in ensuring the overall stability of banking and financial systems; they contribute to the achievement of governments’ economic objectives. The central bank’s ability to preserve the value of the currency rests, explicitly or implicitly, on a delegation of powers by the political authority. Central banks are to be credible and trustworthy. In a regime of fiduciary money, the sound operation of the fiscal authority is a necessary condition for guaranteeing the value of the currency. The central bank can achieve the aims assigned to it, by law and by the state, by freely maneuvering the items of its balance sheet. The central bank derives the effectiveness of its action from being part of the financial system; however, it must also be enabled, by banking and financial legislation, to control certain operations of banks and financial markets. The juridical status of central banks, with special reference to their role and powers, is sometimes not clearly defined in the institutional framework of modern industrial economies.

A central bank has to be accountable for its actions and policy. Whether it is accountable to public opinion, to parliament, or to the executive power is a constitutional problem to be solved on the basis of political, social, and juridical analysis. Economic analysis provides some indications and minimum requirements to be observed for the correct and effective performance of the central bank’s role.

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*The author is Deputy Director General of the Bank of Italy.
1See Friedman and Schwartz (1963).
2See Patinkin (1956). For what money does, see Modigliani (1944) and (1963).
7See Friedman and Schwartz (1963); Hawtrey (1932); and League of Nations (1944).
9See Keynes (1930). An explicit definition, the first to my knowledge, of the total quantity of money, as we usually consider it today, was given by Keynes in the Treatise, in particular, Volume I, The Pure Theory of Money, Book I, “The Nature of Money,” p. 9, see Keynes (1930).
11The balance sheet shown here is the consolidation of the balance sheets of the Bank of Italy and the Ufficio Italiano dei Cambi.
13See, for example, Friedman (1962).

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