CENTRAL BANKS



A central bank is a financial institution established by a national government for the purpose of regulating the monetary policies of that country. Responsibilities of central banks include: holding the reserves of commercial banks, controlling a country's monetary reserves, regulating a country's money supply, check collection, establishing interest rates, issuing legal tender, holding foreign currency reserves and monitoring exchange rates, and regulating governmental credit policies and government loans and borrowing. A central bank is often referred to as a "banker's bank" or the "lender of last resort" because most central banks are restricted to dealing solely with other banks or government agencies. The central bank of France is a notable exception and often conducts business directly with private citizens and companies. By the 1990s virtually every country had established a central bank, however, the specific functions of each respective bank may vary greatly from country to country. Central banks are usually fashioned after the European model that is typified by centralized operations and strict government control. The American model, especially when compared to the European model, is more decentralized and more independent of political control and pressure.

Two of the earliest central or government-sponsored banks are the Riksbank of Sweden, which was founded in 1668, and the Bank of England, which began in 1694. The Riksbank, which did not acquire its present name until 1867, did not originally function as central banks do today. It started as a public bank but one with a unique relationship to the Swedish state. The Swedish parliament in fact had sole governing rights over operations of the Bank of the Estates of the Realm, as it was then called. The Riksbank evolved, like many central banks of other countries, because the national government was its biggest customer.

The Bank of England was created solely to finance England's Nine Years' War with France. Instrumental in the creation of the bank was William Paterson (1658-1719), a man familiar with banking practices on the European continent. Paterson received financial backing for his plan to create a national bank from a group of wealthy London merchants. These merchants feared that their Protestant king would accede to Catholic France because of a lack of funds in the English war chest. Paterson arranged a loan to the government to finance the war effort and the merchants who subscribed to the loan incorporated as the Governor and Company of the Bank of England. This was the first bank to be capitalized by public subscription and was granted special privileges including handling of the government's financial accounts. The bank's charter went into effect on July 27, 1694, and the bank opened for business a few days later.

The United States was one of the last contemporary economic powers to found a central bank. The central banking authority in the United States is the Federal Reserve System, which wasn't founded until 1913. The present Federal Reserve System was preceded by two other government banks. The first Bank of the United States was the creation of Alexander Hamilton (1757-1804), the first secretary of the treasury. George Washington signed the 20-year charter for the bank and it was funded with capital of $10 million. One-fifth of this amount was subscribed to by the U.S. government and the other four-fifths came from individuals, businesses, and various partnerships. The bank was a depository for federal funds and a source of loans for both the government and private concerns through the issuance of banknotes. Hamilton's financial creation continued to operate until 1811 when its charter was allowed to lapse. Even though the Bank of the United States was involved in commercial transactions, it still operated as a central bank in that it regulated U.S. currency and wielded financial discipline over other banks. Although this first Bank of the United States operated successfully, there was much political opposition to it on a variety of grounds including its constitutionality, its monopolistic powers, and its impediment to the development of state banks. A bill that would have renewed its charter was defeated.

In 1816 Congress chartered a second Bank of the United States. Opposition quickly mounted to this bank from various coalitions of entrepreneurs, industrialists, and agrarians. They felt that the bank's fiscal responsibilities oppressively restrained their own financial and commercial activities. Constitutional issues soon arose over the bank's creation and Andrew Jackson, upon his election to the presidency in 1828, became a focal point for the bank's opposition. In 1832 Congress voted to renew the bank's charter, which was due to expire in 1836. Jackson, however, vetoed the congressional act and moved federal deposits from the federal bank and into various state-chartered banks, effectively ending the bank as a fiscal entity. The United States had the Independent Treasury System (1840-41, 1846-1921) and the National Banking System (1863-1913), but these were not central banks.

During the financial panic of 1907 J. P. Morgan in essence acted as a central bank and saved the nation's finances with a $40 million rescue. His actions, however, drove home two points: in a democracy no one man should have so much financial power at his disposal, and a central bank was again needed. In 1911 a National Reserve System was proposed by Republican Senator Nelson Aldrich. His plan, which was defeated, called for a central bank and 15 branches managed by a coalition of leading bankers, not the government. After the Democrats won the 1912 elections they adopted the framework of Aldrich's plan but Congress and President Woodrow Wilson rewrote the proposal so as to have new bank's board appointed by the country's president. The seven-man board took office on August 10, 1914, and the Federal Reserve Banks opened for business on November 16, 1914, finding its services badly needed because of the outbreak of World War I.

In the aftermath of the stock market crash in October 1929, 5,000 banks failed between 1930 and 1932 and another 4,000 failed in 1933. Because of the dire economic straits the nation found itself in during the Great Depression, Congress passed four laws in the mid 1930s that were designed to restore confidence in the banking system; strengthen the banks that survived the aftermath of the crash; discourage speculation; and increase the powers of the Federal Reserve System, especially its board. These acts were the Banking Act of 1933; the Securities Act of 1933; the Securities Exchange Act of 1934; and the Banking Act of 1935. The 1933 and 1935 banking acts established the Federal Deposit Insurance Corporation, which reduced and ultimately eliminated most bank failures.

The Federal Reserve Act mandated that the country be divided into Federal Reserve Districts, each with its own Federal Reserve Bank. This was at the insistence of Democrats who feared a single monolithic bank. There can be no fewer than 8 districts nor no more than 12. Each Federal Reserve Bank is named after the city in which it is located and the activities of the 12 regional banks are coordinated from a board in Washington, D.C. All national commercial banks in the United States must belong to the Federal Reserve System and state-chartered banks, although regulated by the "Fed," have optional membership. The Federal Reserve System is administered by the Federal Open Market Committee and the board of governors from which a member is nominated by the president of the United States to serve as chairman.

The world's newest central bank is the European Central Bank (ECB). The ECB was created to serve as the independent bank of the European Union. By 1998 the European Union had a membership of 15 countries joined together through a number of treaties for various far-reaching cooperative efforts. The Maastricht Treaty of 1991, officially known as the Treaty of European Union, called for an Economic and Monetary Union (EMU) and a single shared unit of currency now known as the euro. The European Central Bank's primary responsibility is to implement the EMU and regulate the euro. By May 1998, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain were chosen as the first 11 official members of the EMU. These countries qualified for membership because their economies, especially in terms of budget deficits and inflation, were under control. The ECB had the daunting task of creating a single monetary policy that all 11 nations could live with. This single monetary policy went into effect on January 1, 1999. Starting on that date, commercial and governmental financial transactions—such as the selling of bonds—were pegged to the euro, which was worth about US$1.14 in early 1999. National currencies were scheduled to remain until 2002 when euro coins and bills will begin appearing. The ECB also gained responsibility for setting interest rates across this European zone.

The ECB is not without its detractors. Some financial observers worry about a "dictatorship of the bankers." They fear that once the ECB begins setting fiscal policy for the many nations of the European Union, the setting of public and political policy on an EU-wide basis will inevitably ensue.

[ Michael Knes ]

FURTHER READING:

de Kock, M. H. Central Banking. London: Crosby Lockwood, 1974.

"EMU: An Awfully Big Adventure" (special section). Economist, 11 April 1998.

"Euro Countdown: One Size Fits All'?" World Press Review, May 1998, 19-21.

Glassman, James K. "New Coin of the Realm." U.S. News and World Report, II May 1998, 50.

Goodhart, C. A. E. The Central Bank and the Financial System. Cambridge, MA: MIT Press, 1995.

——. Evolution of Central Banks. Cambridge, MA: MIT Press, 1988.



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