LECTURE 5:

THE EMERGENCE OF THE CREDIT CYCLE AND

CENTRAL BANKING

1. Introduction: financial globalisation

2. The emergence of modern credit
3. The U.S. Crisis of 1906
4. Implications for Monetary Policy
5. The U.S. and Central Banking.
6. Central banks & banking (macroeconomic) stability.

1. Introduction: financial globalisation

Globalisation and the ‘end of history’.
‘Neo-liberalism’ vs. Evolutionary/Marxist historicism.
The meaning of ‘globalisation’:
- global communication and travel?
- global media fostering common patterns of
consumption?
 - free trade (vs. new regionalism)?
- global (U.S.?) international finance
International finance as constraint on macroeconomic policy
vs. instability of liberalised markets
Capital flows and relative wages: Capital does not flow where
wages are lowest.

The First Globalisation:

The ‘gold standard’ (1870-1914) and its functioning.

International payments system (in gold/convertible currencies)

+ International capital movements
= financial globalisation

2. The emergence of modern credit

Inelasticity bank-note supply →
Emergence of interbank market using Treasury Bills (discounted
and payable on maturity at Bank of England – similarly in other
countries).
Interbank market used to regulate liquidity of commercial
banks.
Bank crises if other banks would not assist because central
banks (then ‘banks of note issue’) could not issue more notes
than they had gold reserves (small ‘fiduciary issue’)
→ Government forces ‘accommodation’ by issuing Treasury
notes payable at Bank, breaking central bank monopoly of note
issue (last time ‘Bradburys’ in 1914).

Bagehot doctrine (1873): If a bank could not obtain credit

(deposits) in interbank market (through selling bills), Bank of
England should lend freely at a penal rate;
i.e., Central Bank should buy in securities (bills) at large
discount, to assist with ‘illiquidity’ but not with ‘insolvency’.

With paper/commodity money, saving (deposits) create loans.

With credit (bank deposits as means of payment), loans
create deposits:
Banks ‘create’ deposits when advancing loans.

Use of long-term securities as security for loans brings credit

(liquidity) into long-term securities markets.
But repaying loans reduces credit and liquidity.

3. The U.S. Crisis of 1906

22 October 1906, Failure of the Knickerbocker Trust in New
York.
U.S. Banks suspend payments, due to exposures to
Knickerbocker through interbank market.
→ premium on gold emerges rising up to 4% (i.e., gold price is
4% higher than official price).
Gold premium drains gold from London: net exports of gold in
1st week of November reached £6.265m, leaving Bank of
England with reserve of £17.695m.
Bank of England raised Bank Rate up to 7% on 7 November
Gold came in from Germany, France (where Bank Rate was
kept at 4%) and India.

7. Implications for Monetary Policy

Rise in Bank rate in 1890 and 1906 associated with major fall in
stock market and economic recession.
Problem of using interest rates to maintain foreign convertibility
(gold reserves) vs. domestic need for low interest rates to ease
domestic investment:
High interest rates drain gold and money from normal industrial
circulation (‘real’ economy) to financial circulation.
Comparable to Argentine Crisis of 2001-2, and other emerging
market crises:
Currencies based on fixed conversion into foreign ‘global’
currency, i.e., US$ restricts note issue to amount of foreign
currency reserves (e.g., Argentina before 2001, Zimbabwe after
dollarization in 2009).
5. The U.S. and Central Banking.
In 1913, after 1907 stock market crash, the U.S. Federal Reserve
System set up;

13 Regional Reserve Banks owned by member banks,

Chairman appointed by U.S. Government and confirmed by
Congress.

Most important is New York Reserve Bank, because New York

city banks are most important international banks (e.g.,
Citibank) and investment banks (Goldman Sachs, J.P. Morgan)

Separate Comptroller of the Currency issues banknotes.

(i.e., US$ notes are liability of U.S. Treasury, not Federal
Reserve).
Main function: holding and regulating reserve accounts of
commercial banks (zero interest on reserves gives Fed income
from lending out reserves),
vs. Traditional role of central banks (Banque de France, Bank of
England, Bank of Sweden) to manage government debt.

6. Central banks & banking (macroeconomic) stability.

In crisis, banks need a ‘lender of last resort’.
European system, where central bank is the Government’s bank
(before European Monetary Union), socialises costs of crisis
through tax-payer (owner of central bank) guarantee.
Federal Reserve system socialises costs of crisis by sharing
costs among all banks (in theory).
In practice, Federal Reserve system always a Government
agency.

1990s doctrine of central banking: Risk is best assessed by

banks themselves in ‘money market’ (inter-bank market).
i.e. Central bank should provide or take out liquidity (reserves)
to/from money market if needed, to prevent interest rates
moving away from central bank policy rates.
But central bank should not provide liquidity to individual
banks, because that would involve setting a ‘risk’ margin for an
individual bank
→ stigmatisation of central bank discount operations: A bank
that goes to central bank to ‘discount’ assets does so because
cannot borrow from other commercial banks.
Interest rate used to regulate the economy

7. Targets and instruments.

Tinbergen Rule: for effective policy, government (central bank)
needs to have an independent instrument (not affecting
operation of other instruments) which can be assigned uniquely
to one target.
Targets for central banks:
Low inflation (maintaining value of money);
High level of economic activity/employment (in U.S.);
Financial stability;
Management of exchange rate (in some countries);
Management of government debt (? – the reason for establishing
Bank of England, but now contrary to Maastricht monetary
rules, see Greek problems today, so Treasury/Min. of Finance
does it, e.g., U.K. Debt Management Office).
Green transition
Instruments
Short term interest rates;
Open market operations (buying/selling securities to
increase/decrease bank reserves) or;
Repos: sale and repurchase, or purchase and resale agreements
to decrease/increase reserves temporarily;
Changing reserve ratios for banks (increase to decrease credit;
decrease to increase credit) (not widely used because difficult to
enforce);
‘Open mouth operations’ or ‘moral suasion’: issuing instructions
to banks.
Key operational problem open market operations/repos needed
to enforce short-term interest rates.
Hence, only one effective instrument: short term interest rates.
If exchange rate is targeted, short term interest rate is needed to
keep exchange rate stable (as under Gold Standard).
U.S. unusual in having 3 central bank short-term interest rates:
Prime rate (for best borrowers);
Federal Funds rate (for borrowing of reserves); and
Discount rate (for purchases of securities at ‘discount window’).