Banking on the Future: The Fall and Rise of Central Banking by Howard Davies

Chapter one
What Is Central Banking and Why Is It Important?
Societies become so used to the availability of stable currency, the ability
to make payments both domestically and internationally, and the exis-

tence of banks and other financial institutions through which to save
and borrow that it is easy to forget that each of these is a purely social
construct, fundamentally based on trust, albeit bolstered by legislation.
Occasionally, unpleasant reminders resurface abruptly that the financial
system is fundamentally fragile. It is rare, fortunately, that currencies
lose their value so fast that they cease to function—something that we
have recently seen in Zimbabwe and that happened in Germany in the
1930s—or that other payment mechanisms break down so that goods
and services can only be traded through barter. That tends to happen
only in wartime, as in Afghanistan in the recent past or, briefly, when
Iraq invaded Kuwait in 1991 and no one knew who controlled the Kuwaiti
central bank.
It is more common for individual banks or other financial firms to
fail. Banking is itself a fragile business because a bank depends on the
confidence of its depositors that it will be able to repay their deposits
whenever they want them, even though it has lent them out at longer
terms to borrowers. The maturity transformation that banks carry out
is in that sense a confidence trick.
All developed economic activity is dependent on this fragile financial
infrastructure, which requires its numerous constituent players to play
their parts as expected: the provider of currency must avoid issuing it
at such a pace that it is devalued; those making payments must deliver
them to the intended recipient ; savings should be made available to sus-

tain investment and loans provided to sustain business activity, house
purchase, or consumer spending.
Society looks to central banks to try to prevent these inherent fragili-

ties crystallizing or, if they do, to mitigate their repercussions. The
instruments at their disposal are quite limited and, in a sense, not very

sophisticated. Their main tool is their own balance sheet, as it is by
acquiring and selling assets and liabilities, borrowing and lending, that
they can seek to influence prices and interest rates in other markets. The
effectiveness of these actions is far from guaranteed—indeed the central
bank’s own balance sheet may well be constrained—and is dependent on
the wider economic climate in which they are operating. So the use of the
balance sheet has to be supplemented by suasion or guidance to the mar-

kets and to economic agents generally. Indeed it may be as much through
persuasion as through economic action that a central bank achieves its
aims. The combination of the two determines whether what the central
bank does makes any difference at all, given that its armory of tools
is essentially very limited. Changes in its balance sheet may be backed
up by an array of other controls, for which it may be responsible, on the
behavior of economic agents. These may be capital or exchange controls,
or controls on bank behavior, such as quantitative or price controls. But
in open markets such controls are of limited value in the long term.
Because the economic environment changes constantly, the way the
tools are used evolves. Political priorities change over time, sometimes
quite markedly and rapidly, with switches, even within a single country,
from ensuring credit is available to favored economic sectors to restrain-

ing inflation, and then, perhaps, to maintaining a particular exchange
rate.
Almost all countries now boast an institution called a central bank.
Central banking was not always so widespread, nor were its advantages
so widely acknowledged. In the United States, there were two unsuccess-

ful attempts to establish a “central” bank, in both cases called the Bank
of the United States, before the Federal Reserve System was set up in
1913. There was a strong strand of thinking in the United States at the
time in favor of “free banking,” and a fully competitive banking system,
without the intermediation of a state-owned or state-backed institution
at its center. Indeed, arguments about the merits of free banking still
rumble on in some academic and political circles.
Advocates of free banking argue that private monetary systems have
in the past been stable and successful, and that a competitive banking
system is less susceptible to bank runs, while the existence of central
banks has allowed political interference in the banking system, which
has had the effect of altering incentive structures and which has created
instability. These arguments have not, however, persuaded many govern-

ments. The balance of evidence appears to show that free banking leads,
instead, to systemic instability. So while arguments continue about the

Banking on the Future: The Fall and Rise of Central Banking by Howard Davies