Early days of Central Banks

Most people would agree that it is all but impossible to imagine the modern world without central banks. It is noteworthy that the first prototypes for modern central banks were the Bank of England as well as the Swedish Riksbank, which date back to the 17th century.

What’s interesting, the Bank of England was the first to acknowledge the role of lender of last resort. For example, other early central banks, notably Napoleon’s Bank of France and Germany’s Reichsbank, were established in order to raise funds for the military.

It was principally because central banks made it easier for governments to grow, wage war, as well as enrich special interests that many of United States’ founding fathers opposed establishing such an entity in their new country.

In spite of these objections, the United States did have both official national banks as well as numerous state-chartered banks for the first decades of its existence until a “free-banking period” was established between 1837 and 1863.

One really interesting fact: The National Banking Act of 1863 created a network of national banks as well as a single U.S. currency, with New York as the central reserve city. The country subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907.

In response, several years later, the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the United States in order to stabilize financial activity and banking operations. The central bank helped finance World War I as well as World War II by issuing Treasury bonds.

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Central banks and military

As you might know, between 1870 and 1914, when world currencies were pegged to the gold standard, maintaining price stability was much easier because the amount of gold available was limited.

As a result, monetary expansion couldn’t occur simply from a political decision to print more money, so inflation was easier to control. As a reminder, the central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; the central bank issued notes based on a country’s reserves of gold.

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Nevertheless, at the beginning of World War I, the gold standard was abandoned. Importantly, it became apparent that, in times of crisis, governments facing budget deficits and needing more significant resources would order the printing of more money.

As governments did so, governments encountered inflation. After World War I, many governments decided to go back to the gold standard to try to stabilize their economies. Notably, with this rose the awareness of the importance of the central bank’s independence from any political party or administration.

During the Great Depression in the 1930s, as well as the aftermath of World War II, most governments favored a return to a central bank reliant on the political decision-making process.

This view emerged mostly from the necessity to establish control over war-shattered economies; furthermore, newly independent nations decided to keep control over all aspects of their countries.

What’s important, the rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macroeconomy. Eventually, nevertheless, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the best way in order to achieve a liberal as well as a stable economic regime.