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Published by EH.NET (March 2004)

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David E. Altig and Bruce D. Smith, editors, Evolution and Procedures in Central Banking. Cambridge: Cambridge University Press, 2003. xi + 321 pp. 45? or $60 (hardback), ISBN: 0-521-81427-8

Reviewed for EH.NET by Stefano Battilossi, Department of Economic History and Institutions, Universidad Carlos III de Madrid.

This collection of papers was originally presented in May 2001 at the (then newborn) Central Bank Institute of the Federal Reserve Bank of Cleveland. The Institute’s aim is to promote research and education on central banking, combining the exploration of contemporary challenges with a strong sensibility to lessons that can be learned from the past (www.clevelandfed.org/CentralBankInstitute/index.htm). Not by chance the editors, David E. Altig (Vice President and Director of Research for the Federal Reserve Bank of Cleveland) and Bruce D. Smith (Hofheinz Regent’s Professor of Economics at the University of Texas-Austin), invited to the Institute’s inaugural conference a group of eminent monetary economists and historians to discuss the “origins and evolution of central banking.” Sadly, Bruce Smith, who also played a critical role in designing the research mission of the Institute (see www.clevelandfed.org/CentralBankInstitute/cbi.pdf), passed away only a few months later. The book is dedicated to his memory and pays a warm tribute to his intellectual legacy.

In spite of an apparently understated title, the volume raises challenging issues. In fact, the variety of approaches and themes makes it somehow a demanding read. However, Altig and Smith’s effective introduction takes up the common threads running through the papers and provides a most useful guide for readers.

The first big issue raised is: what explains the superior performance of central banks in attaining price stability in the 1980s and 1990s? Three competing explanations are offered. The consensus story, espoused by Charles Goodhart (“Whither Central Banking?”, pp. 65-81), goes that the eradication of inflationary biases from the economy goes hand in hand with the rise of inflation targeting and the spread of central bank independence as a commitment mechanism to address time-consistency problems. Once policymakers eventually accepted the existence of a natural rate of unemployment and of a vertical (rather than downward-sloping) Phillips curve in the long run, the pursuit of objectives other than price stability became futile and the delegation of monetary policy less controversial.

This “triumph of natural rate” story has been challenged at the end of the 1990s by Thomas Sargent in The Conquest of American Inflation [1]. His alternative interpretation is based on governments learning through an adaptive process in which policy functions are recursively modified — i.e. policymakers don’t know the true model but, behaving like econometricians, use a good fitting approximation to adjust their behavior rule. In his contribution to the volume (with Jasmina Arifovic, pp. 23-55), Sargent presents further evidence in support of his approach in the form of “laboratory experiments with human subjects” (i.e. undergraduate students) conducted in a Kydland-Prescott environment with an expectational Phillips curve. The results show, indeed, low convergence to a Ramsey-focal point of zero inflation, below the time consistent rate.

To these well-established interpretations, a novel and ambitious one is added by Randall Kroszner (“Currency Competition in the Digital Age,” pp. 275-296), who credits the decline of worldwide inflation to the gradual erosion of the base for seigniorage-motivated policy. His story is told in Hayekian fashion and points to the disciplinary effect on central banks’ behavior of increased currency competition from other central banks and the private sector, enhanced by the process of dollarization in a number of emerging countries, as well as by recent innovations in payments technology and information processing and dissemination.

Whatever the underlying driving force, there seems to exist little doubt about the practical effectiveness of going consistently for price stability — the so-called “just do it” approach. As Chris Sims argues in his commentary to Arifovic and Sargent, “policymakers believe that by persistently choosing a long-run, optimal, low-inflation policy, they can convince the public they are likely to continue doing so, and it seems both in reality and in these experiments that they are right” (p. 62). But, Altig and Smith hasten to ask, “what would lead a central bank to ‘just do it’?” (p. 14). And does it mean that price stability has come to stay for good?

These questions drive into an intriguing search for the ultimate sources of anti-inflationary convergence — a search that ends up bringing society and history into the picture. Factors such as uncertain inflation forecasts, long lags in the monetary transmission process, let alone mounting political pressures — Goodhart emphasizes — can still undermine the ability of central banks to deliver on their goal. Indeed, J?rgen von Hagen and Matthias Br?ckner, who review the experience of the European Central Bank in its early years (pp. 95-126), suggest that the ECB’s unwillingness to make an explicit choice between targeting inflation or the price level may reflect “a desire to leave room for a flexible choice of the distribution of monetary policy responses to fiscal and other shocks over time.” This would allow the bank “to pursue a more ambitious target with less political resistance,” though at the cost that “beneficial, stabilizing effects on inflation expectations will only come about once the public has fully understood the central bank’s true intentions through experience” (p. 102).

Moreover, Kroszner suggests that inverse causality possibly holds: central bank independence may have been not the prime driver of price stability, but “the result of a coalition of anti-inflation interests or a deeper political consensus against inflation” (p. 282), based on past experiences. This view has been expressed in other studies as well: for example, Pierre Siklos’ recent work [2] provides evidence that institutional arrangements implemented throughout the 1990s followed, rather that led to, the emergence of a robust anti-inflationary consensus. In the end we are driven into a reflection on the roots and resilience of social consensus about the non-desirability of inflation. Economic historians accustomed to think of monetary arrangements as “socially constructed institution[s] whose viability hinge on the context in which [they] operate” (to quote Barry Eichengreeen on the classical Gold Standard) [3] will immediately recognize a familiar landscape.

The second critical question raised in the volume is this: are central banks really necessary to improve the functioning of the banking and payments system, or are they “just one of many possible institutions that can (and will) arise in the course of economic development?” (p. 1). This issue is explored in multiple directions. Gary Gorton and Lixin Huang (“Banking Panics and the Origin of Central Banking,” pp. 181-219) present a model which disputes the assumption of Diamond and Dybvig that, due to moral hazard, banks are inherently unstable institutions prone to panics. Elaborating on a large historical literature that compares the experience of the U.S. and Canada in the nineteenth century, they argue that: (a) the emergence of a lender of last resort (and deposit insurance) is related to the industrial organization of the banking system, and developed as a response to systems (such as U.S.’s) with many small, undiversified banks; (b) the lender-of-last-resort function can be effectively performed by private bank coalitions of clearinghouses, as in the U.S. experience up to the early twentieth century; (c) government intervention, through central banking and deposit insurance, can be welfare-improving upon private arrangements only if its monitoring effectiveness is superior to that of private coalitions. In a similar vein, Arthur Rolnick, Bruce Smith and Warren Weber (“Establishing a Monetary Union in the United States,” pp. 227-262) analyze the historical experience of the Suffolk Banking System prevailing in antebellum New England — a private clearing arrangement operated by the Suffolk Bank of Boston in a framework where money supply consisted largely of privately issued notes — in order to question another widely held view: that a central bank is necessary to deliver uniform currency. Finally, Alberto Trejos (“International Currencies and Dollarization,” pp. 147-167), elaborating on the experience of small Latin American countries, suggests that, in a world of increasing openness, small economies will find it “undesirable and even unfeasible in the long run to maintain a central bank and an independent currency” (p. 147).

As a whole, the volume provides a refreshing survey of current leading issues in central banking, and belongs to the shelves of anyone who believes in the outstanding relevance of monetary and banking history for current challenges, both theoretical and practical.

References:

[1] Thomas J. Sargent, The Conquest of American Inflation, Princeton: Princeton University Press, 1999.

[2] Pierre L. Siklos, The Changing Face of Central Banking: Evolutionary Trends since World War II. Cambridge: Cambridge University Press, 2002: p. 269.

[3] Barry Eichengreen, Globalizing Capital: A History of the International Monetary System, Princeton: Princeton University Press, 1996: p. 30.

Stefano Battilossi is visiting professor at the Department of Economic History and Institutions, Universidad Carlos III de Madrid. Recent publications include European Banks and the American Challenge: Competition and Cooperation in International Banking under Bretton Woods (edited, with Youssef Cassis, Oxford: Oxford University Press, 2002) and “Financial Innovation and the Golden Ages of International Banking: 1890-1931 and 1958-1981,” Financial History Review, 7 (2000). Current research interests include the history of Eurocurrencies markets, corporate governance in universal banking, and the evolution of financial repression in Western Europe.

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