Origins, purpose of a central bank

12 Apr, 2019 - 00:04 0 Views

eBusiness Weekly

What was our goal as a civilisation when we created a central bank and set it to be an integral institution across our societies? This question, with seemingly obvious answers, may evoke ridicule than curiosity.

Be that as it may, tracing our steps back to the era when the institution of a central bank was conceived – listening to individuals who birthed it and reflecting on events that moved them to so-conceive – could be informative to Zimbabwe since the reform of key institutions is on the Government’s agenda. This article reflects on the origins of central banking and the bank’s purpose. The article deems ‘‘purpose’’ to be a higher-level assignment than a legislated mandate. To appreciate purpose, it is necessary to go back to the times when we humans put forth the idea of a central bank.

Some 150 years ago, a delicate little boy to be known as Paul was born in Hamburg, Germany. Paul’s family had a banking practice which his grandfather Gumpich Marcus had bequeathed to his two sons in 1798, not as a bank but a money-changing business. The sons, Moses and Gerson, grew the business and converted it to a bank. Their children expanded it to become one of the leading banks in the world. Interestingly, in 1965, Gumpich’s great grandson was appointed to the board of governors of the central bank of Rhodesia by British Prime Minister Harold Wilson. But let’s go back to Paul and leave his nephew who had a fleeting attachment to Ian Smith’s strange experiment.

Around 1890s, Paul joined the family bank after apprenticing in London and Paris. In 1895 at one of his brother’s wedding in America, he was smitten by the daughter of his brother’s boss. They married and settled in Hamburg for seven years before relocating to America where Paul joined the bank which had pulled his brother from Europe some years earlier.

Then came the 1907 financial panic. As with all financial crises, causes had been long in the making. They included high levels of debt collateralised by listed equities, low cash holdings by banks to meet clients’ demand and a speech by President Theodore Roosevelt threatening rich people. As the crisis deepened, the stock exchange was closed. Dr Woodrow Wilson, then president of Princeton University, set up a panel of intellectuals to work on solutions. Zimbabweans will relate to how Ron Chernow (on whose three massive books this article draws) describes the 1907 panic:

“The 1907 panic exposed many systemic defects. As people hoarded money and banks called in loans, there was no central bank to instil confidence or offset the sudden credit contraction. Sharp drops in the money supply then led to severe recessions. The country needed an elastic currency and a permanent lender of last resort.”

Paul had warned of the panic about a year earlier in a presentation to distinguished economists which had been convened by Professor Edwin Seligman of Columbia University. In attendance was a leading banker who sneered at Paul’s presentation. As J Pierpont Morgan was frantically raising bailout money from the likes of John D Rockefeller Snr., the leading banker who had sneered at Paul’s presentation now asked him for his paper.

Paul replied: “Too late now. What has to be done cannot be done in a hurry. If reform is to be secured, it will take years of education and work to bring it about.”

As panic subsided, Paul published an essay in the New York Times titled ‘‘Defects and needs of our banking system’’. The essay marked the beginning of the crusade to form the Federal Reserve Board of Governors (Fed). “Something has got to be done. We may not always have Pierpont Morgan with us to meet a banking crisis” warned Senator Nelson W Aldrich who would manage the politics for Paul to push forward the proposal of a central bank. The Fed was enacted by President Woodrow Wilson late 1913.

Paul Warburg. He was the foremost architect of the Fed. Not long after launch he said of the Fed, “it doesn’t take any degree of bold prophecy to foretell what the outcome must be. The United States now is and from now on will be one of the world bankers.” He was right.

Although Paul’s proposal of a national reserve fund backed by gold to anchor the financial system was revolutionary in frontier America, it was not a novel idea. Germany and Britain already had central banks. Because Paul had taken a scholarly approach to banking, he was more reflective than merely transactional and as an outsider, he easily spotted weaknesses.

What was the purpose of Paul Warburg’s proposed creation? It was for society to have a dedicated institution that would anticipate, avert and absorb financial panics. The Fed would pool reserves from all banks to ensure stability of the financial system – what we now call capital adequacy ratios. The matter of the Fed board composition caused tense debates. Paul wanted it to be run by bankers while President Wilson preferred political appointees. The debate on the independence of a central bank is still raging on.

The promoters of the Fed were keen to use it to assert frontier America as the top player in finance. They wanted to wean themselves off European finance. Thus, the purpose wasn’t just about having an institution to monitor banks, aggregate data and formulate monetary policy but for its activities to reinforce the nation’s international relations agenda.

A pressing motivation for the Fed was the need for a uniform national currency. The thinking then was that a gold-backed currency would foster trust and confidence. While still on trust and confidence, it is fascinating to note that at the height of the panic, Pierpont Morgan did not only convene a meeting of bank presidents, he also implored religious leaders to ‘‘preach calm in their Sunday sermons’’. The Archbishop held a special service for businessmen. Clearly, frontier America was as religious as modern-day Zimbabwe.

A further motivation of a central bank was to facilitate banks to trade their positions as opposed to always holding them to maturity, and so began the secondary bond market. The absence of a vibrant bond market is the most disconcerting gap in Zimbabwe’s capital markets.

Unlike frontier America, our financial market architecture was not birthed by our experiences and pressures. Yet, we hardly reflect on whether it fits our circumstances. Our debates on the Reserve Bank of Zimbabwe, the high priest in the financial market, begin and end on its policies and the conduct of its affairs.

But the debate needs to be broader because of the importance of the financial sector in facilitating delivery of a middle-income economy by 2030. In that regard, Zimbabweans could consider pondering on what would best suit the country’s circumstances and aspirations: a central bank as currently constituted, a central bank that doubles as a development bank or, a monetary authority overseen by a regional body. In debating these and other versions of the high priest, great realisations on institutional reform in the financial sector and the broader economy will emerge.

Alfred M. Mthimkhulu, PhD (Stellenbosch), Senior Lecturer, Graduate School of Business, NUST. Email: [email protected], Twitter: @mthimz

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