By Pierre Ortlieb, s a graduate student, writer, and researcher based in London. He is interested in political economy and central banks, and currently works at a public investment think tank (the views expressed herein do not represent those of his employer). Originally published at Economic Questions
Donald Trump’s most recent feud with the Federal Reserve reached a new peak late last week as the U.S. President lambasted the institution’s policy stance. “I don’t have an accommodating Fed,” he noted. Commentary on Trump’s outburst is perhaps even more alarming than his words themselves. For instance, The Week noted that Trump’s encroachment on Fed independence was “essentially unprecedented”; imperiling the central bank’s status as a guardian of price stability was reckless, foolish. This reading of the history of central banks is misguided, however. Our current paradigm of independent central banks deploying their tools to maintain low inflation is a deeply contingent historical phenomenon and obscures central banks’ frequent role as publicly-controlled institutions and fiscal buttresses throughout their centuries of existence.
The contemporary notion of independent, conservative central banks was enshrined gradually over the 1990s, a decade in which over thirty countries – developed and developing – guaranteed the legal and operational independence of their monetary authorities. This institutionalization of inflation-averse central banks has come hand-in-hand with an aversion to “inflationary” deficit financing and fiscal expansionism, which has been restrained by an exclusive focus on price stability. This has come to be treated as the best practice approach to central banking, a paradigm which, until recently, was rarely questioned among policymakers. Reaction to Donald Trump’s comments has been emblematic of this.
Yet the history of central banks shows them to be far more intertwined with states and treasuries than current commentary or policy would suggest. At their founding, central banks frequently served not as constraints on the state, but rather as fiscal agents of the state. The inception of the Bank of England (BoE) in 1694, for example, was the result of a compromise that granted the state loans to finance its war with France, while the BoE was granted the right to issue and manage banknotes. As a result of this bargain, the market for public debt in the United Kingdom exploded in the 18th century, and government debt peaked at 260 percent of GDP during the Napoleonic wars. This both facilitated the expansion of Britain’s hegemonic financial position and enabled the industrial revolution, as borrowing at low risk made vast industrial development possible.
Direct state financing was, however, not the only means through central banks fostered favorable monetary conditions and growth during this era. The use of various “gold devices” to manage credit conditions from within the straitjacket of the gold standard was commonplace. The Reichsbank, for example, granted interest-free loans to importers of gold and inhibited gold exports to establish de facto exchange controls and some degree of exchange rate flexibility.
Various central banks also pursued sectoral policies, lending government-subsidized credit at lower real interest rates to key developmental industries. The 1913 Federal Reserve Act, for instance, was designed such that it would improve the global competitiveness of New York financial institutions. It is important to note that at the time, these central banks were largely established as private institutions with government-backed monopolies; yet this did not alter the fact that, in practice, they served as crucial instruments for the expansion and development of Western economies. Beyond the US and the UK, central banks across Western Europe, such as the Banque de France (1800), the Bank of Spain (1874), and the Reichsbank (1876), served a similar initial function as developmental agents of their respective states.
Nevertheless, this was not a uniform or constant system. The existence of the gold standard itself constrained the use of monetary instruments to foster growth across developed economies during the late 19th century. Furthermore, Victorian-era British policy came to revolve around sound finance and fiscal discipline, as the use of a central bank to finance the national state was increasingly in tension with Britain’s central position in the international trading system. Inflationary fiscal deficits were seen as inhibiting growth and dampening international investment. This “Victorian model” focus on price stability produced a paradigm shift in the UK away from expansionary deficit financing towards more restrained policy.
Despite interludes, the use of central banks as macroeconomic instruments endured and emerged reinforced in the aftermath of the Great Depression and the Second World War. After 1945, governments across the Western world adopted full employment objectives as part of the consensus of “embedded liberalism,” a practice which often also involved nationalizing central banks, so they could serve as tools of macroeconomic policy. Credit allocation came to serve social goals, and central banks were given additional tasks such as managing capital flows to maintain low interest rates. In France, the Banque de France was brought under the umbrella of the National Credit Council, the institution charged with managing financial aspects of government industrial and modernization policies. While other countries employed different mechanisms in implementing this consensus, the overarching aim of monetary institutions serving social goals was broadly shared across developed countries in the postwar era, as it had been during the 19th century during the infancy of central banks.
This consensus of central banks undergirding fiscal policy fragmented and fell apart from the 1970s onwards. The experience of stagflation, the increasing influence of financial institutions in policymaking, as well as a growing academic consensus on the dangers of central bank collusion with governments, dismantled both the expansionary fiscal state and the subservient central bank. The “Volcker revolution” in the United States was a first step in the gradual, post-Nixon institutionalization of a price stability-focused, independent central bank. The Bank of England was granted operational independence in 1997 by Labour Chancellor Gordon Brown, while the ECB has been independent since its inception in 1998.
The current paradigm of independent, inflation targeting central banks thus obscures the messy history of central banks as public institutions. Since their inception, monetary authorities have performed various different roles; while they served as guardians of price stability in Victorian England, they have originally served as developmental and fiscal agents for expansionary states, and have frequently continued to do so in the centuries since. Treating central bank independence as an ahistorical best practice approach is misleading, and we should recall that there have been alternatives to the current framework. As some have heralded the end of the era of central bank independence, while others have underscored the benefits of re-politicizing monetary policy, it is worth bearing this history in mind.