11 December 2011

Stefano Ugolini: 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.

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. 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.

Conclusions

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. 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.

The key to success is not who runs monetary policy, but how credible they are.

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