The (Pre)History of Central Bank Independence

This article was initially prepared as the author’s introductory remarks to the Nicolai Rygg 2021 virtual panel debate on Central Bank Independence – Lessons from History, hosted by Norges Bank on Thursday 8 April 2021, 17:00-18:30. You can see a video of the event here.

by Stefano Ugolini, University of Toulouse.

In book IV, chapter 4 of his treatise On Money (1751), economist Ferdinando Galiani (1728-1787) explained why the regulation of paper money by the Neapolitan banks of issue had proved so extraordinarily stable: “The credit of our banks has been maintained […] because the Court has behaved almost as though it were not even aware of their existence. Their management is in the hands of the most honest individuals who, in properly regarding the care of the public welfare as a pious and devout work, have demonstrated a total and, I should say, almost miraculous disinterest. Money deposited in them is kept religiously. And although the resulting immobility is harmful, failure of the banks would be even more harmful”. In writing these words, Galiani was directly taking aim at Charles de Montesquieu (1689-1755), who in The Spirit of the Laws (1748), book XX, chapter 10, had argued that a sound issuance of paper money could never take place in an absolutist monarchy. In Galiani’s view, even in an absolutist monarchy (as the Kingdom of Naples actually used to be) money could be safely issued if its management was delegated to independent, “conservative” bankers – although their conservative bias might have prevented them from acting proactively enough. It seems legitimate to say that Galiani’s quote already encapsulates, in a nutshell, the core of the subsequent debates about the benefits and costs of central bank independence.

This shows that talking about central bank independence before the appearance of modern central banks is, indeed, less paradoxical than it might appear at first sight. As a matter of fact, the question of the relationship between the monetary authority and the fiscal authority is a perennial issue of constitutional nature: it is therefore hardly surprising to find it treated by Montesquieu – i.e., by the jurist who is generally credited with the invention of the principle of the “separation of powers”. Yet, it appears that no unique optimal solution has been found to this problem over the centuries; and the principle of the “separation of powers” between the monetary and fiscal authorities has not always inspired the adopted solutions. In what follows, I will provide a very succinct sketch of the ways in which the institutional design of money creation mechanisms has evolved over the very long term. The survey is based on my book The Evolution of Central Banking: Theory and History (Palgrave Macmillan, 2017).

The prehistory of central bank independence can be tracked back to as far as the ancient civilizations of the Middle East. Many centuries before the invention of coins, the agrarian societies of Mesopotamia and Egypt were structured around central organizations (“palaces”) which provided a number of political, social and economic functions – including warehousing and banking. Landlords would typically sell their crops to the central warehouse and would be credited of the corresponding sum on their account, which they could then use to implement all kinds of payments. In this world, no “separation of powers” existed between the monetary and fiscal authorities, as both coexisted within the same governmental organization. However, because interests were aligned between money holders (aristocrats) and money issuers (aristocratic rulers), the risk that the money creation mechanism would be abused was actually quite limited.

Full-bodied coins were invented only many centuries later, in the politically fragmented Aegean region, as a device to remunerate mercenary troops rather than commercial services. At the time of their conquest of the Greek world, the Romans appropriated the invention, spread it westwards, and put it at the core of their legal system (probably their long-lasting legacy to Western Europe), thus fixing for centuries the notion that legal money is specie – i.e., “outside” money.

We therefore have to wait until the end of the Middle Ages in order to see the emergence of new mechanisms allowing for the creation of “inside” money. This took place in the context of the so-called “merchant republics” – i.e., city-states ruled by oligarchies of businessmen. It was in places like Venice, Amsterdam, and Hamburg that the first public banks were actually founded. As in the ancient centralized civilizations, also in merchant republics no “separation of powers” existed between the monetary and fiscal authorities: public banks were, indeed, mere divisions of municipal governments. But again, the risk that the money creation mechanism would be abused were limited, as interests were perfectly aligned between money holders (merchants) and money issuers (mercantile governments). This generation of public banks proved very resilient over time, and only disappeared when the polities that had created them were eventually dissolved.

The success met by merchant republics in putting into place efficient mechanism of “inside” money creation encouraged imitation by territorial monarchies. In this context, however, the alignment of interest between money holders (merchants) and money issuers (absolutistic monarchs) could hardly be taken for granted: monarchs naturally tended to have a spending bias, so that the risk that the money creation mechanism would be abused was indeed quite substantial. It is therefore not surprising that the principle of the “separation of powers” between the monetary and fiscal authorities became the norm in early-modern territorial monarchies. A variety of solutions were designed in order to externalize “inside” money creation to formally independent organizations: in the Kingdom of Naples, as recalled by Galiani, it was externalized to charities; in Sweden, to a bank controlled by Parliament; in the Austrian Empire, to a bank controlled by the municipality of Vienna; and in England, to a joint-stock company. All these different solutions worked rather smoothly until the Napoleonic Wars fragilized most of them, making the Bank of England the model for the creation of a new generation of European banks of issue – those which would eventually morph into present-day national central banks. By contrast, the territorial monarchy that tried to violate the principle of the “separation of powers”, i.e. Regency France (1715-1723), saw its ill-designed banks of issue collapse in the space of a few month. According to Galiani, it was precisely the failure of John Law’s companies that motivated Montesquieu’s unwarranted pessimism about absolute monarchies’ ability to design well-functioning money creation mechanisms.

This bird’s eye view over many centuries of history proves that the question of the relationship between the monetary and fiscal authorities is indeed a perennial constitutional issue, to which many different solutions have been designed over time according to the changing political equilibria. The relationship between the monetary and fiscal authorities is, indeed, a very dynamic and constantly evolving one. And, if we have to judge from the “revolving doors” between central banks and finance ministries, the separation between the two appears to have been rather porous also in recent times.

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