History of Finance

Lecture 3
Central Banking and Money in Modernity

02.03.2022

András Póra
pora.andras@gtk.bme.hu
 WARNING

"I believe that banking institutions are more dangerous to our

liberties than standing armies. If the American people ever allow
private banks to control the issue of their currency, first by inflation,
then by deflation, the banks and corporations that will grow up
around the banks will deprive the people of all property until their
children wake-up homeless on the continent their fathers conquered.“
Thomas Jefferson 1802

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 What is a Central Bank?
An institution that manages the currency, money supply, and
interest rates of a state or formal monetary union, and
oversees their commercial banking system.

FUNCTIONS
MICROECONOMIC MACROECONOMIC
(Financial Stability) (Monetary Stability)
• Payments System; • Issuing Money;
• Lender of Last Resort (LLR); • Monetary Policy and Its Implementation;
• Banking Supervision and Regulation • Bank of the State?
(Microprudential regulation). • Macroprudential regulation?

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 Medieval Roots (City States)
1401: Bank of Barcelona founded (first state
„bank” Taula del Canvi), current accounts and
overdrafts;
1403: The lawyer and theologian Lorenzo di
Antonio Ridolfi won a legal case which led to
legalization of the interest payments by the
Florentine government;
1407: The earliest known state deposit bank,
Ufficio di San Giorgio in Genoa (Casa di San
Giorgio);
1444: Fatih Sultan Mehmet’s debasement of
“akçe”. He was the first Ottoman Sultan who used
debasement to raise public revenue;
Venice: first payment systems
Quentin Massys (1514):The Moneylender and His Wife
• 1282 Grain Bank (state agency)  loans and
deposits  until it quasi defaults (mid-14th
century)  then private banks. 4
 Interest in the 16th Century
• 1515: John Egk (Bologna University): advocated the freeing
certain types of interest.
• His research financed by the rulers of Augsburg (FUGGERS!);
• Augsburg vs Florence in controlling trade in that region;
• 1526: Nicholas Copernicus published his Treatise on
Debasement.
• He argued that the buying power of currency depends on the total
number of coins in circulation rather than the weight of metal they
contain.
• 1536: John Calvin ended the discussion on prohibiting interest
by arguing: “If I buy a piece of land, isn’t it still true that money
will bear money?”
(BTW the statement is wrong: what bears money is the land and labor
not money. John Calvin won the case not because of his intellectual
superiority but because of the support from traders and his followers
military superiority)
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 16th Century Developments
1542-1551: Henry VIII (1509-47) debases the
coinage of England;
1545: Henry VIII legalizes interest charges on
loans (An upper limit of 10% per annum is set);
The first English joint stock company is
founded;
Queen Elisabeth I (1558-1603) recalled the
debased coins.
1524 Banco del Giro di Rialto (Venice)  loans
and payments for the merchants, „girobank”;
1587 Banco della Piazza di Rialto  public
concession and monopoly (bill of exchanges +
deposit)  deposits and clearing house as well;
[1637  merge into Banco del Giro (first
inconvertible money).
1590 Berenberg Bank was established in
Hamburg (still operating)  a „girobank”. 6
 17th Century
1609: Amsterdamsche Wisselbank (Exchange Bank of
Amsterdam)  a „girobank”, a precursor, creating „bank
money”  financing the Dutch East India Company ;
1615: Sir Lionell Cranfield and Mr. Wolstenholme made the
first balance of trade and balance of payments calculations
for England;
1619: Hamburger Bank  pegs the value of money to
silver ingots (first silver peg);
1661: Bank of Stockholm issued banknotes and became
first chartered bank in Europe to do so  Problems of
Centralized, Territorial Polities;
1668: Swedish Parliament established world’s first central
bank: Rikens Ständers Bank (today known as Sveriges
Riksbank);
1682: Sir William Petty published „Quantulumcuque
Concerning Money” that argues development of banking is
a major stimulus to the English economy and world trade;
1694: Bank of England is established as a quasi-central
bank. 7
 Bank of England (1694) and the 18th Century
1688: Glorious Revolution  William III of House Orange (1672-
Stadtholder in the Netherlands, 1689-1702 King of England, Scotland,
Ireland)  personal union + joint war against France  in need of
money  1690 naval defeat (new navy needed).
1694 BoE  private institution (members of the parliament!),
monopoly of issuing money (banknotes) in exchange for lending to the
crown (for government bonds  monetary finance)  easier and
cheaper  £1.2 million was raised in 12 days  11 years charter, but
stays!
1705: John Law (Money and Trade Reconsidered)  the banknotes
issued and managed by a public bank would remove the brakes on the
economy  Mississippi Company (paper money in France)!
1762: Baring Bank was founded  1995, bankruptcy (Rogue Trader), it
was the oldest merchant bank in Britain);
1768: Catherine the Great of Russia established two state owned banks
to finance the war against Ottomans. The Assignat Bank was entrusted
to issue paper money;
1776: Adam Smith (The Wealth of Nations)  defended paper money
on the ground that it stimulated business in Scotland and American 8
colonies.
 Begginings of Central Banking in the US
Colonial times: colonists used European coins like British shilling,
Austrian thaler, and Spanish peso (the most common, the silver
„dollar” was quasi world money)  the peso and thaler looked
similar  they were both called “thalers”  “dollars”.
1729: Benjamin Franklin (Modest Inquiry into Nature and Necessity of
Paper Currency)  he was awarded the contract for printing
Pennsylvania Land bank’s third issue of notes.
1781: The first American bank, Bank of North America, was founded 
the „Continental” a paper money (first US currency), funding the
revolution  finances are chaotic in the aftermath of independence 
hyperinflation.
“But Hamilton forgets
Alexander Hamilton (America’s first treasury secretary), an admirer of His plan would have the government assume state’s debts
the English system  a reformed financial structure, including a central Now, place your bets as to who that benefits
bank, would create a stable currency and a lower cost of debt, making The very seat of government where Hamilton sits.”
it easier for the economy to flourish.  but Federalist (Hamilton)  (Jefferson in Hamilton musical, 2015)
Anti-federalist (Jefferson) debate  Issues of Decentralized Territorial
Polities
1791: the first Bank of the United States (20 years charter)  ended in
1811.
1792: The Dollar is adopted as the money unit in the United States.
1816: a second bank was set up (it was resented by many)  Andrew 9
Jackson (a populist president) vetoed the renewal of its charter in 1836.
 19th Century
1800: Bank de France established as the central bank of France;
1816: Norges Bank (Norway);
1856: Bank-ı Osmani (Ottoman Bank) established  1863 central bank;
1857: The first Worldwide banking crisis started in the USA;
1861/62: „The Greenback”  paper money, funding the civil war (green ink);
1863: National Banking Act (USA): dual system of banks (state and federal) 
Federal banks started to print uniform US currency backed US government
bonds  until 1865;
1873 Walter Bagehot (Lombard Street: A Description of the Money Market) 
"Bagehot's Dictum„: „in times of financial crisis central banks should lend
freely to solvent depository institutions, yet only against sound collateral and
at interest rates high enough to dissuade those borrowers that are not
genuinely in need”  LENDER OF LAST RESORT function (in practice, BoE did it
anonymously!).
1876: Deutsche Reichsbank is established as Germany’s central bank (-1945);
1882: Nippon Ginkō (Bank of Japan) was established as Japan’s central bank;
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1893: Banca d’Italia (Italy).
 Lender of Last Resort Functions based
on Lombard Street
Lending by the central bank in order to stop a banking panic should follow two rules:

„First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on
unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it.
The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of
idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the
public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to
cause alarm. But the way to cause alarm is to refuse some one who has good security to offer... No advances
indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial
countries is an infinitesimally small fraction of the whole business... The great majority, the majority to be
protected, are the 'sound' people, the people who have good security to offer. If it is known that the Bank of
England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly
pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if
securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other
loans made will fail in obtaining their end, and the panic will become worse and worse.”
(Walter Bagehot: Lombard Street, Chapter 7, paragraphs 57–58) 11
 Silver, bimetallism, Gold Standard
1717 Newton (Royal Mint) devalues the silver against the gold (Gresham’s
Law): dominance of silver (but gold standard);
After 1790: French Revolution and Napoleonic Wars  inflation + silver
shortage  Gold convertibility was suspended during the Napoleonic wars 
government debt and inflation soared. Parliament restored it in 1819 
bimetallism, issuance of „gold sovereigns”;
1844 Bank Charter Act  BoE notes were fully backed by gold + legal tender
 full gold standard for the GBP  full convertibility;
The Bank of England as a model central bank:
1. Short-term funding of the government;
2. Money issuance, gold market making
3. Lender of Last Resort;
4. Official targets (e.g. exchange rate).
5. Payment system.
The good (stable) example spreads  1871 the unified Germany (fixed
exchange rate, France, USA only in 1900 etc.);
1880-1914: Classical Gold Standard  the rate of inflation is less than 1%!;
Problem: the WWI  shortage in precious metals  the countries abandon
it.
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 20th Century until 1945
• 1907 banking panics, bank runs  1913: U.S.
Federal Reserve System was established.
• 1918: Goldmark=Papiermark (no pegging to gold);
• 1923: Inflation in Weimar Germany reached to
3,25x106 %! October 1923 Rentenbank
(established for the new money)  Rentenmark
(Security Mark) = 1.1 Tr Papiermarks, pegged to US
Dollar with a parity of one USD= 4.2 Tr
Papiermarks! 1924 Reichsmark (-1948);
• 1929: Great Depression  1930 Bank of
International Settlements (BIS) was founded;
• Renewed Gold Standard between 1918-1939:
does not work. Causes:
• The Great Depression (i.e. 1931- Sterling Area);
• USA isolation (even in economic sense). 13
History of the Central Banking in the US

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Federal Reserve System

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 20th Century: 1945-1980
• 1944: Bretton Woods international monetary agreements  fixed exchange rates the USD, and
convertibility for $35 per ounce, but only for CBs  problem in the long run it was bad for the
economy of the US (trade deficit etc.)  too strong USD;
• 1946: Hungarian Hyperinflation world record  4.19×1016 %
• 1947: International Monetary Fund became operational;
• 1948-57 Bank Deutscher Länder  1948 Deutsche Mark (W Germany)  1957 Deutsche
Bundesbank;
• 1971: the Nixon-shock  United States devalues dollar and gold convertibility for all currencies
ends  Smithsonian Agreements: G10 currencies pegged to the US dollar ($35 per ounce)  +/-
2.25% against USD  does not work (it ends in 1973);
• 1971-73: Europe: „Snake in the tunnel” (Currency Snake)  bilateral agreements between
European central banks  1973: The US abandons the gold standard  collapsed (because of the
free float of the USD);
• 1979: European Monetary System (European Currency Unit: ECU+Exchange Rate Mechanism,
ERM) Adjustable peg system to the German mark (Largest member of the ERM).
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Gold price (USD)

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 Hyperinflation Ranking
Hungary  After WWII (economic devastation and political chaos. Effects of Hyperinflation:
Zimbabwe  Unrest + mismanagement. • People couldn’t afford basic goods.
Yugoslavia  Civil War; • No credit available.
Germany  After WWI (economic circumstances + fiscal and • Menu costs: always adjusting the prices.
monetary mismanagement). • Switch to a barter economy (and to USD).
Greece, China, Taiwan  WWII + political turmoil. • Lost savings.
Armenia  After the war for Nagorno-Karabakh; • Damage to business confidence.
Turkmenistan  dissolution of the USSR + mismanagement.

Hyperinflation is always partially a political phenomenon! 18

 Moments of hyperinflations

Germany 1923 Hungary 1946 Yugoslavia 1994

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 How to solve a hyperinflation
On the surface it is easy  Stop the money printing press.
BUT: on its own, this will not remove the underlying problems (political, fiscal, monetary).

First: political calm down + public faith (without it, no working solution). Political Stabilization
Quick wins (psychological stabilization):
• „Cutting Digits” (optical tuning);
• Introduce new money (if the public trust is strong enough);
• Increase the Central Bank reserves (gold and/or hard currency)  not easy (foreign loans
mostly, nowadays: IMF). Psychological
Some deeper solutions: Stabilization
• Stimulating real growth: easier to say than do, especially in the short run;
• Improving the tax collection system: a lengthy process which takes time to produce sizable
results;
• Cutting government expenditure: VERY unpopular measures such as wage-cuts (or nominal
wage freeze)  may not be feasible to implement;
• Increasing net external flows: through new loans or defaulting on foreign debt. If default is the Solving the underlying
only option, this relaxes the budgetary constraint, but comes at the cost of lower access to problems
foreign capital markets in the future (which may not be seen as a problem, since the current
government will most likely be gone by then)

Since the fiscal and monetary problems were often reflections of unresolved distributional
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conflicts, the policy mix also needs to be smart.
 1980-
• 1982: Mexican Debt Crisis  Crisis in South America;
• 1985 Plaza Accord (NY)  France, West Germany, Japan, the United States, United
Kingdom  depreciate the U.S. dollar in relation to the Japanese yen and German
Deutsche mark by intervening in currency markets;
• 1992: Maastricht Treaty  a future Eurozone  Maastricht Criteria (inflation, long term
interest rates, government finances, exchange rate)  is it an Optimal Currency Area?;
• 1992: GBP Crisis (out of the ERM, George Soros  short GBP, long DM, 1 Bn profit);
• 1994-97: European Monetary Institute  1997 Treaty of Amsterdam;
• 1998: European Central Bank (ECB) + European System of Central Banks (ECSB);
• 1999: 11 European countries introduced Euro as an accounting currency  ERM 2 
virtual Eurozone;
• 2002: Euro banknotes and coins  real Eurozone;
• 2010: the Eurozone Sovereign Crisis starts  what about the Eurozone?
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 Black Wednesday 1992:
The Context
The day when Soros (Quantum Fund) broke the GBP
1979: European Exchange Rate mechanism (ERM) currencies fixed to each other, the most
important fix is to the German Mark (Deutsche Mark:DEM)  +/-6% band.
1990: the UK joins ERM at 2.95 DEM/GBP (the lower band is at 2,773).
1990: the costs of German reunification are huge  German austerity + higher interest rates
 the DEM weakens then strengthens.
1992: Maastricht Treaty + Danish rejection  pressure on the ERM.
The UK’s macro figures are relevantly worse than the Germans (inflation etc.)  the
fundamentals do not support the exchange rate.
The Actions (with only $1 Bn as collateral!) of George Soros (Quantum Fund)
Short the GBP in the value of $7 Bn  dropped 10%.
Long DEM in the value of $6 Bn and the French franc (to a lesser extent)  both gained 7%.
Buy $500 M worth of British stocks (equities often rise after a currency devalues)  gained
7%.
Long German and French bonds, while shorting those countries’ equities  the expecting
declining stock exchange and lowering yields (strengthening bonds)  bonds upped by 3%,
stock rallied for a while but then remained flat.
The Results
The market weighs in  the Bank of England tries to maintain the band (buying GBP and
raising the base rate)  the Sterling breaks, leaving the ERM  it costed 3.3 Bn GBP to the UK
Treasury.
Soros closes most of his positions in early October, earning $1.1 Bn profits. 22
 Solutions for Centralizing Payments
through history
1) Legal Restrictions: Establish a legal monopoly of some crucial
service like deposit collection or the encashment of certain
payments (e.g., Amsterdam’s and Hamburg’s giro-banks);
2) Scope Economies: Build on the role of the state as the biggest
domestic financial actor (e.g., Venice’s Banco del Giro);
3) A Blend of the Two: Combine some restrictions (like the
monopoly of joint-stock banking) with scope economies (like
the concentration of the state’s payments, e.g., the Bank of
England).

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 Monetary Policy in History
Strategies Implementation: Policies
1. Internal inconvertibility: a device 1. Quantity policies as long as usury
for sheltering the value of CB laws were in force (until the mid-
money from the fluctuations of 19th century);
legal money  CB money typically 2. Price policies during the first wave of
traded at a premium with respect to globalization  Gold Standard;
domestic legal money! i.e.
Amsterdam or Genoa; 3. Quantity policies (stabilization of
money supply) in the age of capital
2. External convertibility (needs controls  Bretton Woods;
external „high power money”)  a
device for limiting CB’s discretionary 4. Price policies (stabilization of
power (instead of independence); interest rates) during the second
wave of globalization  inflation
3. Inflation targeting  defending the targeting.
international purchasing power
parity of CB money.
Goal: The defense of the long-term value of CB money! 24
 Central Banking Independence?
Case for Independence Case Against Independence

• Political pressure  inflationary bias; • Anti-democratic;

• Independence of political business • Unaccountable;
cycle; • Difficult to coordinate fiscal and
• Should not be used to facilitate Treasury monetary policy;
financing of large budget deficits (it is • Has not used its independence
prohibited now in the developed world); successfully in the past – present???
• The principal-agent problem is worse for
politicians (popularity, party-discipline
etc.).

The mainstream in the developed world: CB Independence is a must, a basic criteria.

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 Reading
Required Reading:

Raymond de Roover: The Medici Bank Financial and Commercial Operations. The Journal of
Economic History, Vol. 6, No. 2 (Nov., 1946), pp. 153-172.

Kenneth Ng: Free Banking Laws and Barriers to Entry in Banking, 1838–1860.
The Journal of Economic History , Volume 48 , Issue 4 , December 1988 , pp. 877 – 889.

Some viewpoints:
• In what way did the Medici bank operate? What were the main business lines/assets,
what caused problems, how did they solve it? How was the relationship with the Papacy?
• What are the pros and contras pf the free banking? Did it work well?

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