What is the central bank doing


Simone Koehler

Oliver Mathis

Mark Kieferle

Michael Koschatzki

Wolfram Schubert


The history of central banking

The development of the central banking system was similar to the development of democracy in the western industrialized nations, albeit more slowly. Similar to the systems of government, the structures and functions of the central banks also differ greatly - from complete independence from state control (e.g. Deutsche Bundesbank) to complete dependence (e.g. Bank of England).

The differences between the banks are related to the economic development of the respective countries as well as to other cultural characteristics. Each state has created its own banking system according to its own interests - however, some models turned out to be superior.


With a focus on the Deutsche Bundesbank, the American Federal Reserve System and the Bank of England as well as a brief outlook on the future European Central Bank, 3 or 4 different (and very influential) banks in the world are considered in the following. The rise of these banks to the top three most important in the world followed the economic development of those countries.


While it is difficult to make a generally valid decision as to which banking system is ultimately the best and therefore preferable to the others, there are certain peculiarities in each system that are worth investigating.

Once the history, traditions and tasks of the various banks are known, it is easier to understand the actions and motives of these institutions.


The first central bank

When the mercantilist economic system developed in the 16th and 17th centuries, the need arose all over Europe to store money and gold safely. Moving significant amounts of valuable precious metals between countries became pointless as soon as there was an opportunity to easily transfer ownership of money and gold while keeping it in the same place.

Small banks already existed all over the European continent and minted their own coins. But in order to promote trade, the governments became increasingly interested in the introduction of single national currencies.


The first successful ancestor of a central bank as we know it today was established in Sweden. Stockholms Banco was approved by the Swedish government in 1656 as a private institution, but it was also state-controlled. The government placed most of its assets in the bank, which also accepted deposits from individual citizens, but demanded that any profits be shared with the state and the city of Stockholm.


The Stockholm Bank was not the first attempt by a government-backed bank. Rather, it was ultimately an image of the Bank of Amsterdam, which had been founded in 1609. This bank was tasked with managing the government accounts and savings of the Amsterdam merchants.

This system worked for more than 100 years. By 1819 the government's war debts and the insolvency of the Dutch East India Company led to the bank's failure.


In Sweden, on the other hand, in response to the increasing demand for money, the industrial banker, Johan Palmstruch, began issuing promissory notes backed by the bank's deposits. These promissory notes were interest-free and only intended for trading - comparable to today's banknotes. It was the first time such notes had been used and within 2 years it turned out that the bank was unable to maintain the supply of secured banknotes. In 1663 the government closed the bank for negligence and inattention.


In 1668 there was a renewed need for a central bank and Parliament founded the bank of the "Estates of the Realm". This institution was controlled by the government, which increased its usefulness for the political leadership: promissory notes with a fixed face value were issued. The government printed additional notes as soon as capital was needed. As a result, no loans had to be taken out.


Several cases of inflation occurred over the next 100 years, despite the fact that various laws had been passed to tighten control over the supply of money. The mistakes made in Sweden were repeated in other countries when they tried to set up their own banking systems. The structures we see today did not emerge until after World War II and they are still evolving.



The Bank of England (BoE)

Quoted in John Kenneth Galbraith, the Bank of England is "in all respects what St. Peter is to faith".

Like the British system of parliamentary government, the BoE was organized not from a single law but from a whole series of laws.

It was founded in 1694 by the Scotsman William Patterson and was the first bank in England in the form of a public company. Patterson had promised to lend money to the government should he get the concession.

The bank had a monopoly on trading in stocks and shares and managed all government assets. Particularly important is the fact that the bank began issuing promissory notes. It was authorized to issue notes equal to the amount it had borrowed from the government and was obliged to exchange the notes for gold as soon as a creditor requested it (an exception to this rule existed during the Napoleonic wars, such as the Exchange claims have been suspended for more than 20 years).


At the beginning of the 19th century, triggered by several inflations, there were a large number of bank failures in England as in Sweden. The parliament then passed 2 laws in the middle of the century, which should empower it to exercise more control - over the entire banking system but especially over the BoE.

The Country Bankers Act of 1826 broke the BoE's monopoly as a trading bank for securities, initially outside a 65-mile radius of London. After 1833 the monopoly ended completely. This prompted the bank to open branches in the initially unrestricted area in order to expand its influence.

The Bank Charter Act of 1844 forced the bank to use gold to support its bills. He asked for two-week reports on the bank's activities and money supply (these reports are still published weekly by Bank Return). He also restricted the ability of new banks to issue banknotes and let the power of attorney for bankrupt private banks pass to the BoE. Even with this law, it was not until 1921 that the BoE had complete control over the supply of money in England and Wales.


For much of the 19th century, the bank did not want to recognize its functions as central bank as such. It was only when Walter Bagehot, the editor of The Economist, proved in his book Lombard Street that the bank actually acted like a central bank, that its function was accepted as such.

In his book, Bagehot suggested very helpful procedures that could be used in the event of a crisis. He was an advocate of the bank as "monetary guardian in times of crisis" and hoped that this would increase people's confidence in the banking system.


In the course of this century, the bank began to develop further activities in the area of ​​more effective monetary policy: depending on the economic situation, the discount rate was increased or decreased. She also sold government bonds on the London Stock Exchange.

Eventually, given the primacy of Britain, the BoE became the bank of the world's banks.


Aided by laws allowing new securities trading banks to be set up, other British banks used the "old lady" to balance their accounts and store reserves. Banks in other countries also took advantage of the strength of the bank and deposited their reserves there as well.

By the First World War, beyond the UK, the BoE became a bank for the whole world.



The American Federal Reserve

Like the US Constitution, the Federal Reserve System (known as the "Fed") was created by a single act of Congress. The National Monetary Comission, a group of bankers and politicians commissioned by Congress, had carefully created a nationwide, centralized and federal system of payment transactions. The Federal Central Bank was established by the Federal Bank Act of 1913, which was signed by President Wilson.

Even before the Fed was founded, the Americans had had some experience with hyper-inflation. Even after the founding of the republic, attempts were made to establish a national bank (the first and second banks of the United States). The concession of the second national bank was not extended by President Jackson because he was of the opinion (like many Americans, by the way) that bankers were crooks.


America used an inefficient and confused system of state banks that had no preventive security reserves in place until the 20th century. In addition, there was no institution controlling the banks. US assets were allocated to accounts at various state banks and a system of debt securities was introduced. This happened shortly after the end of the civil war. The attempt to direct the banks became more and more difficult because the government had not exercised any influence over the state banks until then.

After the end of the economic crisis of 1907, the eighth and by far worst financial crisis in 100 years, private bankers and the government realized that the bank clearing house they had set up was not working. They founded 12 federal central banks, each responsible for a specific region. Each individual was granted almost complete autonomy. An umbrella organization, the Board of Governors (BoG), was established in Washington D.C. set up to coordinate the actions of the Bundesbanks and fulfill their commitments to Congress.


Just like the United States Constitution, some new ideas were put into law that had never been tried before. The Fed was created with absolute independence from political influence from the executive branch. It was required to provide Congress with regular reports on the state of the economy and expected short and long-term economic policies.


The best way to describe the Fed's level of independence is its "independence within the government". All private banks in a region are co-owners of the respective Bundesbank. They are considered to be a "quasi-state" organization because they have their own independent administration. The Bundesbanks are only allowed to serve other banks and the state, but not private customers. This fact is a clear delimitation criterion of the sphere of influence of the banks in the U.S. System and protects the interests of the private banks (they were concerned about a possible competition with the state banks). Initially, the 12 regional banks remained fairly unmolested except for minor objections from the BoG. They were allowed to set their own discount rates within a moderate range. Larger deviations from the BoG rate had to be approved by the BoG.


In the first seven years, the principle of independence from the executive was not fulfilled. Until 1920, a state secretary or other senior official in the finance ministry was a member of the board of directors. A congress investigation had shown that the Treasury Department had lobbied the board of directors to keep the discount rate stable so the government could borrow additional money as "World War I winners" bonus. In this way, Congress set a precedent in which the Fed and its chairman had to answer for the Treasury.


Although the Treasury Department and the Fed are in close contact these days, they are very cautious about the principle of central bank independence. In the early days of the Fed, the New York Federal Bank was more powerful than its parent organization in Washington. Because it was located in the world's second largest financial center, it played a bigger role than any other central bank. Its first president, B. Strong, became the spokesman for the entire Fed. The European central bankers of the time, especially the Chairman of the Bank of England, Lord Montagu Norman, knew that Strong was the most experienced man in the system. During his tenure, Strong began the first open market operations in which U.S. Bonds were bought and sold in connection with discountable commercial paper. He set up regular meetings of the BoG central bank governors, who formed the core of the Federal Open Market Committee. A body that still makes the most important decisions of the Fed today.


The influence of Germany and the wars on the central banks

Germany's current political institutions did not exist until the end of World War II. However, the origins of the banks go back to 1871, the beginning of the German state and later in the political and economic turmoil between the two world wars. When the nation was unified under Bismarck, a central bank, the Reichsbank, was set up at the same time.

It worked until the end of World War II, when control of the money supply was lost due to inflationary pressures caused by the war.


The government of the Weimar Republic founded a new Reichsbank with the help of other European central banks, but the demands on Germany after the war were too strict. In the Versailles Peace Treaty, the Allies demanded enormous reparations payments for the damage caused by the war.

Payments were made in gold bars, which the Reichsbank had only available in small quantities. Although it was impossible for Germany to meet the reparation payments schedule imposed by the other European countries, the government paid as much as it could. The money for the reparations payments "arose" from the revaluation of the currency. The small amount of gold reserves made the Reichsmark completely worthless abroad and at home it was not much more valuable.


The reparations payments plunged Germany into the worst financial crisis in the world this century. Prices in Germany rose to their peak in 1922/23. Between January and July 1922 they increased sevenfold. Between August 1922 and July 1923 they even rose 185 times, up to 1.5 million times the pre-war level. The Germans could only watch as all their private savings became worthless in an instant. Workers were paid twice a day so they could spend their money before it became worthless. The image of Germans using wheelbarrows to transport their money to buy bread burned itself into the minds of the nation.


After the hyperinflation crisis, the American banker Charles Dawes found a solution to Germany's problems. A new German currency, the Rentenmark, was issued.

The German population was told that the "soil" of the Reich was pledged in exchange for new money, because politicians feared that the public would otherwise lose confidence in the government's ability to support the currency in the normal way. One Rentenmark was equivalent to one billion Reichsmarks, so that it meant a new beginning for almost every German.


There were other changes to the Dawes plan. Following the example of the Federal Reserve Bank, the Reichsbank became independent from the government. Particularly important was the new credit system, which allowed Germany to take out a loan from the Allies in order to meet the reparation payments with them. While this significantly dampened the economic effect of the reparations payments, bankers like Norman and J.P. Morgan saw this as the only way to keep the country and the currency stable.


The Dawes Plan secured the German monetary system, but the global system was fraught with far greater problems. In 1924, the BoE set the price of gold at pre-war levels, despite claims by Keynes and other senior economists that the pound was overvalued. She reaffirmed her promise to exchange any money for gold if requested.

Many countries took advantage of the BoE's stability and exchange guarantee and transferred enormous amounts of gold. The bank quickly realized that these quantities could no longer be handled.

Attempts by Norman and Strong to resolve the situation were ineffective, and their adjustment to the U.S. discount rate was believed to be the cause of the stock market crash and the onset of the Great Depression.


The only bright spot in these turbulent times was the establishment of the BIS (Bank for International Settlements) in Basel in 1929. This institution was set up to promote cooperation among central banks and it still exists today.

The same group that set up the BIS also tried to solve the German debt problem.Led by Owen Young, a former chairman of General Motors, this group drafted an agreement between European governments to spread reparations payments over the next 59 years.


In the 1930s Germany was dependent on itself. Other countries were preoccupied with their own crises and could not provide assistance. Although all went well, the population had little faith in the Dawes plan. After experiencing hyperinflation, it was unlikely that the people would ever trust the banks again. The run on the Austrian bank quickly spread to Germany. The Germans were forced to exchange their London sterling reserves for gold and lost a third of their credit within a few days. In response, England admitted that their currency was overvalued and the gold standard was abandoned in September 1931.


The Bank of England after 1946

In the post-war period it became clear that many European central banks were in need of restructuring. The "Bretton Woods Agreement" brought the world back to the gold standard even though the dollar was in circulation as the world currency.


The British post-war parliament, which was dominated by the Labor Party, reformed the BoE through the Bank of England Act of 1946.

The bank was nationalized. Parliament got control of monetary policy and all economic affairs. The shareholders were compensated for the nationalization. The ordinance even gave parliament the power to designate all 16 bank directors and the governor and his deputy.

The bank was never independent from parliament, rather it became an agent of the government when the ordinance became law.


Another characteristic of the bank is its strongly centralized structure, which corresponds to the structure of the government. It has only 8 branches throughout the country, which are only responsible for processing payment transactions and distributing cash.

All major decisions are made in London.


Since the Banking Act 1979 was passed, the bank has become increasingly involved in the licensing and regulation of commercial banks.

But even with this legislation, the bank is largely dependent on auditing by independent firms when assessing financial institutions.

This practice has been criticized in light of the collapse of the Bank of Credit and Commerce International (BCCI) and Barings Bank and the difficulties at Lloyd's of London. It was then suggested that regulatory powers for financial institutions be transferred to the Ministry of Finance.



The Deutsche Bundesbank

Due to the immense destruction in World War II, the Allies realized that the Versailles Treaty was a mistake. They tried not to punish the loser states even further. Instead, they supported the defeated countries in creating a new democratic order.

In West Germany the Reichsmark was practically worthless. Therefore, a new currency, the German mark, was issued before the end of the occupation by England, France and the USA. The leader of this currency reform was Ludwig Erhard - Germany's first finance minister. A stable currency was to be created under his leadership. A situation that Germany has not known since the First World War. The Allies supported this goal. Fighting inflation at all costs became the primary task of the new system.


Since a federal system was planned for Germany, the central banks were organized in a similar way. The model was the Federal Reserve Bank of the USA, but with some serious "improvements". The Allies founded independent banks of the German federal states (BdL) in the capitals of the 11 federal states. The head office in Frankfurt a.M. was given the task of coordinating banking policy. It shouldn't get too much power though.


The German system was observed by the Allied powers until 1951. Control by the Banking Commission was then handed over to the government of the Federal Republic of Germany, which had been established by the Basic Law in 1949.


A central bank independent of the government was always intended by the Allies.

Between 1951 and 1957 there was a great debate in Germany about the degree of state control of the bank. The dispute ended with the resolution of the Bundesbank Act of 1957. The name of the bank was changed to Bundesbank and the Landesbanken became subordinate institutions of the umbrella organization.


The structure of the Bundesbank is comparable to that of the Fed. The Bundesbank, for example, also has a central management, the board of directors in Frankfurt. The members of the Governing Board are also members of the Central Bank Council. The other half of the members of the Central Bank Council are the presidents of the Landeszentralbanken (LZB), the successors to the banks of the German states.


The central bank's complete autonomy guaranteed by the Bundesbank Act made it easier for the bank to pursue policies that are not necessarily politically popular. The Bundesbank's management can be praised for their work. Nevertheless, it was mainly the high level of acceptance and popular support that made the Bundesbank so successful.


The bank has not lost any of its influence over the past 8 years, but the political necessities of German reunification created internal tensions. No new central banks were set up in the 5 new federal states, but the areas of responsibility were redistributed. There are now only 9 state central banks, some of which are responsible for more than one state. A smaller number of bank presidents facilitates the quorum within the Central Bank Council.

However, there have also been situations in which the advice of the Central Bank Council has not been implemented. Federal Chancellor Helmut Kohl deliberately disregarded the (retrospectively reasonable) recommendations of the Central Bank Council when he offered to exchange the worthless Ostmark for the Deutsche Mark up to a certain sum. Bankers were aware of the inflationary effects of such an action, but they had no way of preventing it.

This shows that there are times when economic consequences are not as important as political and psychological acceptance.




The tasks of the various central banks today

Although the organization of an institution is very important, its efficiency can only be guaranteed by a clearly defined objective. At the central banks, the question of goal setting is a political issue. Of the three mentioned so far, the Bundesbank was the most successful.

In each country, governments have set targets for economic growth and price stability. In the UK and USA, however, these goals were often not well defined. Due to the long-term success of the Bundesbank, we will consider these first in the following.




The Bundesbank Act of 1957 states that the sole aim of all banking activities is to create a stable currency. The Bundesbank regards this principle as its constitutional mandate. There is a great deal of trust in the Bundesbank's decisions among the population. The citizens saw how influential the Deutsche Mark has become on the world market and recognized that the success of the DM (and Germany) since World War II is due not least to the Bundesbank.


The law says that the function of the bank is to regulate the amount of money in circulation and the amount of credit to the economy. In doing so, it uses the instruments that the law gives it, with the aim of safeguarding and safeguarding the currency. The law describes the goals very clearly - but not how they are to be achieved. The decision-making power lies in the hands of the bank's board of directors.

By remembering the hyperinflation of the 1920s, Germany is particularly concerned about avoiding inflationary tendencies.


Two other laws regulate the influence of the bank. The 1961 Credit Act created a new body to oversee the banking world - the Federal Credit Regulatory Agency (CRA). The state central banks are still responsible for controlling their loans, but the CRA is an independent department of the Ministry of Finance that determines banking policy.

The second law passed by the Bundestag, which determines the tasks of the Bundesbank, is the Stability and Growth Act of 1967. It obliges the bank to pursue a policy that brings price stability, full employment and foreign trade equilibrium with constant and reasonable economic growth in line with the market economy . Up to this point, lawmakers and economists believed that it was possible to achieve these goals simultaneously if Keynesian policies were only followed consistently. Germany, like the rest of the world, learned very quickly, however, that the Keynesian model did not correspond to reality. The law has remained in force today, but it is now seen more as a directive than a requirement to be met.


There are different ways to secure the currency. The different options are often in conflict with one another. The main question is whether to maintain the value of the currency abroad or to keep prices stable.

This conflict has existed since the end of World War II, but it became increasingly important when the gold standard was abolished in 1973. The biggest problem is "imported inflation", i.e. when other countries fail to observe constraints in their monetary and fiscal policy actions that are important to control inflation. In Germany, this inflation, which mostly comes from France, Italy or the USA, causes higher import prices and an outflow of capital abroad. The result is a higher demand for money and a continuous rise in interest rates.


An increase in the money supply by the Bundesbank leads to an increase in prices. So far, the Bundesbank has not been ready to take responsibility for the mistakes made by other countries. But it is not strong enough to stop inflation on its own. This has a strong influence on the stability of the Deutsche Mark. Intervening in foreign currency markets used to be a way of controlling money movements. However, the transactions have become so large that intervention by a central bank (or group of central banks) is now showing little or no effect.


It is less the interventions than the Bundesbank's decisions that send out important signals. When the European Monetary System was founded in 1979 and the possible exchange rate fluctuations of most European currencies were limited, the other European central banks began to adapt their policies to the Bundesbank. Since the DM is so strong, the currencies of the other countries rose and fell depending on the difference in the inflation rates and interest rates between these countries and Germany.

In the developing Eastern European countries, the German mark is used as a second currency and the official currencies of the Czech Republic, Slovakia and Hungary are strongly linked to the DM.

The Bundesbank is often accused of neglecting Europe's needs in its decisions, but the bank's statutes say it should focus on what is best for the Federal Republic. This became most evident when England and Italy were forced to detach and revaluate the pound and lira from the European exchange rate system in 1992.

The Bundesbank's methods of managing the money supply do not differ significantly from those of the other central banks, but they are implemented more effectively.



Great Britain

Britain's monetary policy goals alternated with general political currents.

Since the government is responsible for politics, the BoE functions more like a cabinet department than an institution separate from the government, like the banks of the US and Germany.

The bank's mandate is also more focused. The number of its employees is a quarter as large as that of the Bundesbank (which has a branch in every major city) and allows the markets to regulate themselves to the greatest possible extent. This created many problems. Nevertheless, the spirit of Adam Smith and his "laissez-faire" still wafts through the halls of the "old lady of Threadneedle Street".


There have been some attempts in the past to make the bank independent, but no reforms have been implemented to date.

A small change was made in 1971 when the country changed its currency to the decimal system. At that time, the bank agreed to publish annual financial metrics that included the wages of all employees, as well as all income and expenses. In doing so, it joined the other major central banks around the world which publish annual reports on the state of the institutions.

Until a non-Tory government came to power, it seemed unlikely that the bank would be detached from government oversight. This was quite absurd in view of the support given to set up an independent European Central Bank.


When it comes to conducting monetary policy, the bank uses a number of methods that differ from those of other central banks.

For example, there is no minimum reserve for commercial banks. They are only required to invest 0.35% of their liabilities in order to generate income for the operating business.

Instead, the BoE relies on the balance of balance sheets that commercial banks must maintain to cover ongoing payments. The balance sheet should therefore remain positive. However, this is not controlled very closely. If a commercial bank cannot keep a positive balance sheet, the central bank acts as the final donor.


Although the banks have a board of directors whose members are all appointed by parliament, it has no power to make real political decisions.

It is only entitled to advise the finance minister, who himself had the last word, e.g. about when and to what extent the interest rate should be varied. This constellation has only worked unsatisfactorily since World War II.

The governments were only successful to the extent that they could maintain medium price stability.

However, following the latest developments, the BoE is already becoming increasingly independent. The level of short-term interest rates is now set by a nine-member BoE monetary policy committee. The independent banks fared far better in the absence of political pressure.


The United States of America

The Federal Reserve System was not that focused on a specific goal. Three laws govern the activities of the Fed: the Federal Reserve Act of 1935 and the Full Employment and Growth Act of 1978 ("Humphrey-Hawkins Act"). These three laws regulate the goals that the Fed is supposed to achieve, but under certain economic conditions these goals are contradicting each other. In the early years, the Fed focused more on overseeing other banks, as each bank was allowed to set its own interest rate. Open market operations were introduced early in New York, but not much use was made of them.



The tremendous changes that have occurred in political and economic organizations around the world in recent years have forced the central banks to change too.

The nations of Europe are preparing to set up a European central bank.

It will have its headquarters in Frankfurt - alongside the Bundesbank, whose structure and mode of operation it will also largely take over.

Real central banking reforms have not yet taken place in the big banks, but they have in countries like New Zealand and Chile, where governments have set up independent central banks and implemented currency reforms.


New laws and reforms are the one important thing. However, Marsh describes the other - most important - quality of a central bank as follows:

"No central bank, however independent it may be, operates in an environment that is completely free from political entanglements. Ultimately, the decisive condition for a successful monetary policy is that it is understood and supported by the population."

This largely applies to the banks under review.

Like state institutions, which they often emulate, central banks have evolved over long periods of time and have always been heavily influenced by national political culture.

They may differ in their direction and structure, but the ultimate goal remains the same for all - to maintain a stable economy that encourages growth and progress.

Overview of the European central banks