A Central Banking in the Twenty-First Century

The Bank of England’s objective is to ‘advance the good of the people of the United Kingdom by ensuring monetary and financial stability,’ according to the Bank’s website. As a statement of mission for a central bank, this statement isn’t particularly controversial. What is potentially contentious is how monetary and financial stability are viewed, how they enhance people’s well-being, how they should be accomplished, and whether they are achievable.

Given the problems posed by the constraints of central banking practice, we examine how far the prevailing thinking within central banking theory has altered in the aftermath of the crisis. The ramifications of an alternative, Post Keynesian, perspective are next examined.While the central banking theory is presented as universal on one level, the historical, political, legal, institutional, and cultural environment in which it is applied is significant (see Blinder et al., 2017). However, in order to make the debate more real, examples are presented, particularly from the UK experience.

Theory and practise of central banking

The theory of central banking is unique in that it has undergone a series of alterations over time, as evidenced by the shifting goals and functions of central banks. Because of its methodological shift, the transformation from the 1970s to the recent crises was particularly noteworthy. Until then, central banking theory was considered a branch of political economy. It looked at how central banks operate and the banks they work with, using a variety of sources and approaches and considering a wide range of central banking functions. While distinct theoretical viewpoints existed, the content of theory developed over time, reflecting real-world economic developments and power shifts.

However, in the post-war years, the mathematical formalisation of mainstream economic theory aided breakthroughs in macroeconomic modelling as the foundation for central banking, which were pursued at the expense of the less technical political economy approach. The prevalent perception of the central bank’s role shifted as a result, supporting a narrow technocratic approach to practise. As will be discussed more below, this development severely harmed central banks’ ability to respond to new difficulties, the most recent of which was the global financial crisis that began in 2007.

This ‘new consensus’ approach to central banking theory thus concentrated solely on monetary stability (Arestis and Sawyer, 2008; see further Arestis and Sawyer, 2010). Given the failure of attempts at money supply control, it indicated a shift from Monetarist to New Classical theory in its return to the old interest rate tool.

However, the ‘new consensus’ model shared a neutral-money (closed-system) ontology with its forerunners (Fontana, 2007). Money is merely a technical input into trade in this view, financial markets are efficient, inflation is a monetary event, and central banks have the capacity to manage it. To aid markets in generating financial and economic stability, monetary stability had to be pursued. The theory is full of conceptual distinctions.

Central banking after the crisis

According to Post Keynesian theory, the crisis resulted from central banks placing an undue emphasis on monetary stability at the expense of financial stability, which was backed up by theory that denied the latter’s relevance, as well as a lack of attention to bank (and central bank) governance issues. On a theoretical level, the crisis revealed a flaw in basing central bank policy on monetary stability as determined by quantitative modelling. When the financial crisis struck, central banks had no choice but to recognise the interdependencies and complexities that the modelling technique had overlooked. Those central banks who put their focus on inflation rather than financial stability were unprepared to deal with the crisis. The new mainstream attitude had become so established that when the threat of bank failure arose, the instinctive reaction was to refuse support on the grounds that it would promote moral hazard. Indeed, two months before the Northern Rock crisis, the Bank of England’s then-Governor had worried how central banks could respond to the mounting market instability that had (supposedly) stemmed from different market defects (King, 2007). He re-emphasized the inflation target and warned that shielding banks from the repercussions of their excessive risk-taking would just promote more of the same in the future, creating a moral hazard problem.

Principles Of Central Banking

Central banks keep accounts with commercial banks and, in most cases, their sponsoring governments, and extend credit to them, but they rarely do business with the general public. Most central banks function as their countries’ (or, in the case of the European Central Bank, multiple countries’) sole source of paper currency since they have the authority to print fiat money. The monopoly of paper money that results provides central banks with enormous market influence as well as a revenue source known as seigniorage, named after the mediaeval French lords or seigneurs who had the privilege of minting their own coins.

Modern central banks are responsible for a wide range of public functions, the first and most well-known of which is the prevention of banking crises. This role entails providing additional cash reserves to commercial banks that are at risk of failing due to large reserve losses. Managing the growth of national money stocks (and, indirectly, fostering economic stability by preventing large fluctuations in general price levels, interest rates, and exchange rates), regulating commercial banks, and serving as the sponsoring government’s fiscal agent—for example, by purchasing government securities—are among the other responsibilities.

Conclusion

We’ve addressed the topic of how central banking should evolve in the future by returning to the idea that central banks should provide a safe money asset. Rather than interpreting this principle in terms of a monetary theory of inflation over which the central bank has control, the Post Keynesian perspective sees it as a key component of a stable financial system that generates credit to finance real economic activity in order to support government policies aimed at achieving socio economic goals (such as reducing income inequality and conserving natural resources).