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What future for central banking? Insights from the past

While many central bankers feel they are now in unchartered territory, this column argues that history may provide guidance. Going back to a time before central banks, it argues that there are long-term cycles in the evolution of monetary policy – governments have alternatively internalised and externalised money creation. The key to success is not who runs monetary policy, but how credible they are.

For nearly three decades to 2007, the theory and practice of central banking have seen a remarkable convergence throughout the world. Yet the events of the recent years have marked a profound watershed. The pre-crisis consensus is now increasingly seen as inadequate, and changes to the central banker’s toolkit are being proposed (Eichengreen et al. 2011). The feeling is growing, however, that the required changes will pose considerable threats to the solidity of the institutional arrangements currently backing monetary authorities, thus creating new challenges to the proper conduct of policy (Borio 2011). In such “uncharted waters”, a look at the long-term evolution of central banking may provide valuable hints to where we should (or should not) focus our attention now.

Making a sensible use of history

A fundamental precondition to this exercise is, of course, not making an anachronistic use of the past. Unfortunately, this is what a good deal of economic historians have often being doing, just asking historical sources: “When did we learn to do it right?” Based on the assumption that today we are better than any of our ancestors at understanding the world, this teleological approach is what drove us directly into the crisis. The events of recent years suggest that a more neutral stance should be adopted. The kind of question we should rather ask sounds like: “What did we do, and did it work?”

Central banking before central banks

In a recent survey of the long-term evolution of central banking (Ugolini 2011), I ask this very question. To this aim, the paper takes a functional approach (Merton 1995). It does not look at what today’s central banks used to do in the past. Rather, it looks at what kinds of organisations used to perform, in the past, the very functions central banks perform today. This approach allows us to broaden considerably the scope of analysis, as it puts into comparative perspective a number of institutional arrangements – going back to as far as the Middle Ages.

Microfoundations of central banking: Managing a natural monopoly

My survey starts from the microfoundations of central banking. In any sufficiently advanced financial system, the need for the centralisation of interbank payments naturally arises. Proponents of free banking maintain that such demand can be adequately met by a private clearinghouse. A number of objections have been advanced against this idea. In particular, it has been pointed out that there exist scope economies in the clearing process, which lead to its concentration to a single intermediary (Goodhart 1988). Therefore, the payments system can be described as a natural monopoly. Because of their great liquidity, claims on the organisation sitting at the centre of the payments system tend to acquire the status of money – even when they are not granted legal-tender status. Thus, the intermediary dominating the clearing process becomes, de facto, a money-issuing organisation.

Deficit monetisation and the “printing press”

Money-issuing organisations seldom behaved like currency boards in the past. In fact, they almost constantly practiced fractional reserve banking. Any time they used reserves (gold or other legal-tender money) to purchase financial assets, they actually engaged in money creation in favour of some borrower. More often than not, this borrower was the government. Note, however, that money creation is not exactly the modern version of coin debasement. Debasements instantly reduce the real value of all money-denominated contracts. This is not the case with money creation, as long as confidence in the issuer’s ability to preserve the value of money is untarnished (Hicks 1969). That is why deficit monetisation cannot, as such, be equated to a debasement – or to its fiat money regime equivalent, i.e. the “printing press”.

Cycles in the evolution of money-issuing organisations

Over the centuries, governments have adopted different approaches with respect to the natural monopoly of the domestic payments system – and to the opportunity of using it to monetise deficits. Sometimes, they have kept the monopoly for themselves (as in the case of state-owned giro banks, like the Bank of Amsterdam); other times, they have entrusted it to a private corporation in exchange for direct financial support (as in the case of early banks of issue, like the 18th-century Bank of England). We can track cycles in the way the institutional arrangements backing money-issuing organisations have changed over time. Like “Coaseian” firms (Coase 1937), governments have alternatively “externalised” or “internalised” money creation according to changes in the relative efficiency of the two options.

In this respect, the long experience of the Republic of Venice (a core international financial centre in medieval and early-modern times) is telling. The Venetian government internalised money creation (to one of its departments, the Grain Office) as long as the domestic banking system remained underdeveloped (13th-14th centuries); then, it externalised it (to the Rialto clearing banks) when the banking system thrived (15th-16th centuries); then, it internalised it again (to the state-owned giro bank) after the banking system collapsed (17th-18th centuries). A similar process has taken place in the main Western countries in the last two centuries – formerly privately owned central banks became dependent on treasuries when the Great Depression bit, only to regain their independence since the 1980s. In these developments, governments always followed – rather than preceded – evolutions in domestic banking systems.


Should we conclude that a “subjugation” of monetary policy to fiscal policy must be expected in the near future? Not necessarily. What emerges from the past is that while the relationship between central banking and politics may have been dynamic, it has always been very close. It also comes out that deficit monetisation has very often occurred almost everywhere. Sometimes it ended in catastrophe, but on many other occasions, it did not. This suggests that the debate we should be confronted with today is not whether monetisation is admissible or not, but whether we can appropriately assess its long-term costs and benefits. In some circumstances, it may not be optimal for monetary authorities to guarantee government debts; in others, it may well be (Kocherlakota 2011). Similarly, we should not take an ideological approach to the question of central bank independence. Central banking is the outcome of collective bargaining. What history shows is that central banks did not derive their actual strength from formal independence, but from the credibility of the institutional arrangement in force. In order to prevent the equilibrium from being fragile, monetary and fiscal authorities must not be perceived as free-riding the one on the other. This would patently be inconsistent – after all, both are but the two sides of the same coin.


Borio, Claudio (2011), “Central Banking Post-Crisis: What Compass for Uncharted Waters?”, BIS Working Paper no. 353.
Coase, Ronald H (1937), “The Nature of the Firm”, Economica, 4:16:386-405.
Eichengreen, Barry, Eswar Prasad, and Raghuram Rajan (2011), “Rethinking Central Banking”, VoxEU.org, 20 September.
Goodhart, Charles AE (1988), The Evolution of Central Banks, MIT Press.
Hicks, John (1969), A Theory of Economic History, Oxford University Press.
Kocherlakota, Narayana (2011), “Central Bank Independence and Sovereign Default”, speech at the Sovereign Debt Seminar, CME Group-MSRI Prize in Innovative Quantitative Applications, Chicago, Illinois, 26 September 2011.
Merton, Robert C (1995), “A Functional Perspective of Financial Intermediation”, Financial Management, 24:2:23-41.
Ugolini, Stefano (2011), “What Do We Really Know about the Long-Term Evolution of Central Banking? Evidence from the Past, Insights for the Present”, Norges Bank Working Paper 2011/15.

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