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2

If the evolutionary criterion of success for an entity is to spread around the world

through proliferation and adapt to changes over time, central banks definitely

succeeded in this perspective.

(Capie et al, 1994: pp.91)

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Mehmet Akif Ersoy

If the evolutionary criterion of success for an entity is to spread around the world

through proliferation and adapt to changes over time, central banks definitely

succeeded in this perspective.

(Capie et al, 1994: pp.91)

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Mehmet Akif Ersoy

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3

¾ The fundamental rationale behind the emergence of central banks:

Necessity to have a “lender of last resort” in a paper-money system.

¾ The core motive of establishing central bank for governments is the desire

to finance budget deficit by monetization. Several central banks like in England,

France, Finland, Netherland and Portugal were established during the war

times.

¾ Private commercial banks were held responsible for preventing economic

downturn by playing role in credit market and financial system during crisis

period. These banks turned into leading position concerning balance of

payments and placed in the core of banking systems.

¾ The fundamental rationale behind the emergence of central banks:

Necessity to have a “lender of last resort” in a paper-money system.

¾ The core motive of establishing central bank for governments is the desire

to finance budget deficit by monetization. Several central banks like in England,

France, Finland, Netherland and Portugal were established during the war

times.

¾ Private commercial banks were held responsible for preventing economic

downturn by playing role in credit market and financial system during crisis

period. These banks turned into leading position concerning balance of

payments and placed in the core of banking systems.


4

¾ Central Bank independence have emerged as a major point of discussion in

economic policy globally during the last 25 years.

¾ Furthermore, this concept has a background up until the beginning of the

19th century sharing a background equivalent to the history of the central

banking.

¾ Concept and implementation of independence have followed a course

depending upon the current economic conditions and conjunctural cycles and

not a linear and uninterrupted one.

¾ Although it has been widely accepted by most experts in academic and

practical fields, Central Bank independence is still criticized both explicitly and

implicitly while proposals to limit independence come to order.

¾ Central Bank independence have emerged as a major point of discussion in

economic policy globally during the last 25 years.

¾ Furthermore, this concept has a background up until the beginning of the

19th century sharing a background equivalent to the history of the central

banking.

¾ Concept and implementation of independence have followed a course

depending upon the current economic conditions and conjunctural cycles and

not a linear and uninterrupted one.

¾ Although it has been widely accepted by most experts in academic and

practical fields, Central Bank independence is still criticized both explicitly and

implicitly while proposals to limit independence come to order.

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5

¾Recessions and crises during late 1700s, 1820s and 1860s called for a stable

international monetary system.

¾Central Banks have gained credibility and the concept of independence have

strengthened.

¾ “If Government wanted money, it should be obliged to raise it in the legitimate way; by taxing the people; by the issue and sale of exchequer bills; by funded

loans; or by borrowing from any of the numerous banks which might exist in the

country; but in no case should it be allowed to borrow from those who have the

power of creating money.”

Ricardo, 1824

¾Recessions and crises during late 1700s, 1820s and 1860s called for a stable

international monetary system.

¾Central Banks have gained credibility and the concept of independence have

strengthened.

¾ “If Government wanted money, it should be obliged to raise it in the legitimate way; by taxing the people; by the issue and sale of exchequer bills; by funded

loans; or by borrowing from any of the numerous banks which might exist in the

country; but in no case should it be allowed to borrow from those who have the

power of creating money.”

Ricardo, 1824

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6

¾ 1870s-1900s: Belle Époque, Monetary laissez-faire , Central Bank

Independence “Status Naturalis”

¾Bagehot says (1873) “Bank of England is the most isolated bank in the world

from the influence of politics and finance.” Lévy (1911) mentions “the theory of

decoupling of central banks and governments”.

¾ 1920s: Second Gold Standard, Fundamentals of Modern Central Banking.

Gold Standard (“Great Depression” due to Central Bank independence and

fixed exchange rate regime)

¾ 1870s-1900s: Belle Époque, Monetary laissez-faire , Central Bank

Independence “Status Naturalis”

¾Bagehot says (1873) “Bank of England is the most isolated bank in the world

from the influence of politics and finance.” Lévy (1911) mentions “the theory of

decoupling of central banks and governments”.

¾ 1920s: Second Gold Standard, Fundamentals of Modern Central Banking.

Gold Standard (“Great Depression” due to Central Bank independence and

fixed exchange rate regime)


7

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8

¾ 1950s-1960s: Keynesian Economics, Managed Accommodative Monetary

Policy. Inflation, stagflation, Demise of Bretton-Woods system

¾ 1970s: Floating Exchange Rate Regime, Monetary Targeting, Economic

Crisis

¾ 1980s: Rise of Neo-liberalism, Market Fundamentalism (Reaganomics,

Thatcherism), Internationalism, Combat against Inflation

¾ 1990s: Washington Consensus, Globalization, Central Bank Independence

and the end of Cold War have contributed to lowering budget deficits and

stronger central bank independence.

¾ 1950s-1960s: Keynesian Economics, Managed Accommodative Monetary

Policy. Inflation, stagflation, Demise of Bretton-Woods system

¾ 1970s: Floating Exchange Rate Regime, Monetary Targeting, Economic

Crisis

¾ 1980s: Rise of Neo-liberalism, Market Fundamentalism (Reaganomics,

Thatcherism), Internationalism, Combat against Inflation

¾ 1990s: Washington Consensus, Globalization, Central Bank Independence

and the end of Cold War have contributed to lowering budget deficits and

stronger central bank independence.

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¾Price stability’s being as the main and primary objective of central

banks is one of the rare cases that economists agree upon.

¾The hypothesis of “the only sustainable contribution of monetary policy

to the public prosperity in the long term is through price stability”, is

considered as a basic creed by “new consensus macroeconomics”

which is the monetary policy views of the synthesis of neoclassical

school and new Keynesian school.

¾Great Moderation proved the legitimacy of “single-mandate” central

banking

¾Price stability’s being as the main and primary objective of central

banks is one of the rare cases that economists agree upon.

¾The hypothesis of “the only sustainable contribution of monetary policy

to the public prosperity in the long term is through price stability”, is

considered as a basic creed by “new consensus macroeconomics”

which is the monetary policy views of the synthesis of neoclassical

school and new Keynesian school.

¾Great Moderation proved the legitimacy of “single-mandate” central

banking

11

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¾³« WKH�JHQHUDO�YLHZ�QRZDGD\V�LV�WKDW�FHQWUDO�EDQNV�VKRXOG�QRW� WU\� WR�XVH�LQWHUHVW�UDWH�SROLF\�WR�FRQWURO�DVVHW�SULFH�WUHQGV�E\�VHHNLQJ�WR�EXUVW�DQ\�EXEEOHV�WKDW�PD\�IRUP��7KH�QRUPDO�VWUDWHJ\�LV�UDWKHU�WR�VHHN��ILUPO\�DQG�ZLWK�WKH�KHOS�RI�D�JUHDW�YDULHW\�RI�LQVWUXPHQWV��WR�UHVWRUH�VWDELOLW\�RQ�WKH� IHZ�RFFDVLRQV�ZKHQ�DVVHW�PDUNHWV� FROODSVH�´ Ms Kerstin Hessius,

Deputy Governor of the Sveriges Riksbank, October 1999 (BIS Review).

¾Asset price cycles and the role of monetary policy ?

¾³« WKH�JHQHUDO�YLHZ�QRZDGD\V�LV�WKDW�FHQWUDO�EDQNV�VKRXOG�QRW� WU\� WR�XVH�LQWHUHVW�UDWH�SROLF\�WR�FRQWURO�DVVHW�SULFH�WUHQGV�E\�VHHNLQJ�WR�EXUVW�DQ\�EXEEOHV�WKDW�PD\�IRUP��7KH�QRUPDO�VWUDWHJ\�LV�UDWKHU�WR�VHHN��ILUPO\�DQG�ZLWK�WKH�KHOS�RI�D�JUHDW�YDULHW\�RI�LQVWUXPHQWV��WR�UHVWRUH�VWDELOLW\�RQ�WKH� IHZ�RFFDVLRQV�ZKHQ�DVVHW�PDUNHWV� FROODSVH�´ Ms Kerstin Hessius,

Deputy Governor of the Sveriges Riksbank, October 1999 (BIS Review).

¾Asset price cycles and the role of monetary policy ?

12

¾Boom and bust cycles: Asset prices soar, first rally in bullish markets, finally

the bubble bursts, asset price reversals are followed by crises and protracted

recessions

¾Tightening monetary policy in an asset market boom Insurance against the

risk of real and financial turmoil (obviously not free)

¾Kaminsky and Reinhart study a wide range of crises in twenty countries,

including five industrial and fifteen emerging ones. A common precursor to most

of the crises considered is financial liberalization and significant credit

expansion.

¾Demirgüç-Kunt and Detragiache study fifty-three countries during the period

1980-95. They find that financial liberalization increases the probability of a crisis

by stimulating credit growth.

¾Boom and bust cycles: Asset prices soar, first rally in bullish markets, finally

the bubble bursts, asset price reversals are followed by crises and protracted

recessions

¾Tightening monetary policy in an asset market boom Insurance against the

risk of real and financial turmoil (obviously not free)

¾Kaminsky and Reinhart study a wide range of crises in twenty countries,

including five industrial and fifteen emerging ones. A common precursor to most

of the crises considered is financial liberalization and significant credit

expansion.

¾Demirgüç-Kunt and Detragiache study fifty-three countries during the period

1980-95. They find that financial liberalization increases the probability of a crisis

by stimulating credit growth.

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13

The General Crisis of the Seventeenth Century: A movement from feudalism to

capitalism; from the political and economic ascendency of the South to that of

the North; from a "natural economy" based on the self-sufficient household and

barter to the use of markets and money; from separate deals to continuous trade

on bourses. The crisis was particularly acute between 1619 and 1623. Following

a sizeable monetary expansion during sixteenth century due to the influx of large

quantity of Spanish-American silver, the fall off of silver imports to Europe from

Spanish America after about 1600, inadequately compensated for by the

gradual rise of credit. This resulted in a series of debasement in order to extract

more seignorage. Finally From 1618 to 1623 average price of cereals raised

seven folds.

The General Crisis of the Seventeenth Century: A movement from feudalism to

capitalism; from the political and economic ascendency of the South to that of

the North; from a "natural economy" based on the self-sufficient household and

barter to the use of markets and money; from separate deals to continuous trade

on bourses. The crisis was particularly acute between 1619 and 1623. Following

a sizeable monetary expansion during sixteenth century due to the influx of large

quantity of Spanish-American silver, the fall off of silver imports to Europe from

Spanish America after about 1600, inadequately compensated for by the

gradual rise of credit. This resulted in a series of debasement in order to extract

more seignorage. Finally From 1618 to 1623 average price of cereals raised

seven folds.

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15

In the 17th century, Amsterdam merchants could establish control over the

financial flows of the world- economy because of their monopoly over Baltic

supplies and fine Asian spices through which they appropriated the bulk of

precious metal coming into Europe from Iberian America. Sitting on of such

magnitude, Amsterdam became the major entrepot of precious metal. Merchant-

bankers established the Wisselbank, the institution that controlled monetary

flows.

A new asset in Dutch markets, along with the dramatic extension of practices of

shareholding and trading and the associated influx of new investors led to the

speculative boom

Monetary expansion + Structural shift / financial innovation

Price increase Crisis

In the 17th century, Amsterdam merchants could establish control over the

financial flows of the world- economy because of their monopoly over Baltic

supplies and fine Asian spices through which they appropriated the bulk of

precious metal coming into Europe from Iberian America. Sitting on of such

magnitude, Amsterdam became the major entrepot of precious metal. Merchant-

bankers established the Wisselbank, the institution that controlled monetary

flows.

A new asset in Dutch markets, along with the dramatic extension of practices of

shareholding and trading and the associated influx of new investors led to the

speculative boom

Monetary expansion + Structural shift / financial innovation

Price increase Crisis


16

The South Sea Company’s planned conversion of government debt from a mass of highly illiquid

annuities into modern securities along with the influx of a mass of investors were both quantitatively and

qualitatively a new phenomena

the French and British governments sought to swap the bulk of their outstanding debt for equity in large

joint-stock trading companies with monopoly privileges – the Mississippi Company (Compagnie des

Indes) in France and the South Sea Company in Britain. Both efforts had the full support of the

government currently in power, and both were successful ultimately in reducing the respective debt

burdens, at the expense of debt holders who delayed converting their debt holdings or who failed to sell

out

Law (1705) sketched a monetary theory in an environment of unemployed resources. He argued an

emission of paper currency would expand real commerce permanently, thereby increasing the demand

for the new currency sufficiently to preclude pressure on prices. To finance a great economic project, an

entrepreneur needed only the power to create claims which served as a means of payment. Once

financed, the project would profit sufficiently from the employment of previously wasted resources to

justify the public's faith in its liabilities.

The South Sea Company's planned conversion of government debt from a mass of highly illiquid

annuities into modern securities along with the influx of a mass of investors were both quantitatively and

qualitatively a new phenomena

the French and British governments sought to swap the bulk of their outstanding debt for equity in large

joint-stock trading companies with monopoly privileges – the Mississippi Company (Compagnie des

Indes) in France and the South Sea Company in Britain. Both efforts had the full support of the

government currently in power, and both were successful ultimately in reducing the respective debt

burdens, at the expense of debt holders who delayed converting their debt holdings or who failed to sell

out

Law (1705) sketched a monetary theory in an environment of unemployed resources. He argued an

emission of paper currency would expand real commerce permanently, thereby increasing the demand

for the new currency sufficiently to preclude pressure on prices. To finance a great economic project, an

entrepreneur needed only the power to create claims which served as a means of payment. Once

financed, the project would profit sufficiently from the employment of previously wasted resources to

justify the public's faith in its liabilities.


17

¾1873 crisis in US railroad securities. The railroads, which had previously

provided only locally integrated systems of transportation, were being forged into

a nation-wide network. Railroads were the most visible industry in the economic

expansion and stock market between 1867 and 1873. Railroad investment hit a

peak in 1871-72, as did stock prices.

¾The Great Contraction in the U.S 1929-1933 is often associated with a classic

boom and bust episode in the stock market. The boom, focussed on the ‘new

economy’ stocks such as GE and RCA, according to legend began in 1926,

turned into a bubble in March 1928 which burst on October 24, 1929

¾The Japanese boom- bust cycle began in the mid 1980’s with a run-up of real

estate prices (see figure 4) fueled by an increase in bank lending (figure 6) and

easy monetary policy.

¾1873 crisis in US railroad securities. The railroads, which had previously

provided only locally integrated systems of transportation, were being forged into

a nation-wide network. Railroads were the most visible industry in the economic

expansion and stock market between 1867 and 1873. Railroad investment hit a

peak in 1871-72, as did stock prices.

¾The Great Contraction in the U.S 1929-1933 is often associated with a classic

boom and bust episode in the stock market. The boom, focussed on the ‘new

economy’ stocks such as GE and RCA, according to legend began in 1926,

turned into a bubble in March 1928 which burst on October 24, 1929

¾The Japanese boom- bust cycle began in the mid 1980’s with a run-up of real

estate prices (see figure 4) fueled by an increase in bank lending (figure 6) and

easy monetary policy.


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UNCONTROLLABLE FACTORS

1. Globalization Capital flows may weaken the effects of

domestic monetary policy

2. Financial Innovation Less effects of MP on structured

products, private (outside) money

UNCONTROLLABLE FACTORS

1. Globalization Capital flows may weaken the effects of

domestic monetary policy

2. Financial Innovation Less effects of MP on structured

products, private (outside) money

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TWO LAYERS CONCEPTUALIZATION

1. Globalization global infrastructure.

2. Mechanisms national superstructure

TWO LAYERS CONCEPTUALIZATION

1. Globalization global infrastructure.

2. Mechanisms national superstructure

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First introduced by, Fleming (1962) and Mundell (1963)

Developed and applied to international trade theory by Obstfeld

and Taylor (1998)

Frankel (1999) systematized and baptized as “impossible

trinity” or “trilemma”

Under free capital movements

Either interest rate policy (independent monetary policy) or

exchange rate policy (fixed FX regime) is feasible

First introduced by, Fleming (1962) and Mundell (1963)

Developed and applied to international trade theory by Obstfeld

and Taylor (1998)

Frankel (1999) systematized and baptized as “impossible

trinity” or “trilemma”

Under free capital movements

Either interest rate policy (independent monetary policy) or

exchange rate policy (fixed FX regime) is feasible

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Rodrik (Feasible Globalizations, 2002) established a similar

methodology in order to discuss the problematic structure

observed in global economic order.

Under the global economic integration

It is not possible to have both

full national independence/sovereignty and

democratic domestic policies

Rodrik (Feasible Globalizations, 2002) established a similar

methodology in order to discuss the problematic structure

observed in global economic order.

Under the global economic integration

It is not possible to have both

full national independence/sovereignty and

democratic domestic policies

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0RQHWDU\�3ROLF\�0HDVXUHVAdvanced economy central banks introduced a wide range of intervention measures including not just substantial interest rate cuts but also “balance sheet policies.”

44

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46

¾ Historically just like the present time, demands to limit independence of

the central banks did not come only from politicians but also from

financial sector, other market players and business world who seek to

benefit from short term effects of the monetary policy.

¾ When we scrutinize the past episodes, we see that certain developments

and economic conditions have gathered public and political support to the

proposals to limit independence and led to compromises on the central

bank independence

� Political tensions and time of war

� Times when protectionism was on the rise and policy makers endeavor to artificially maintain unsustainable economic imbalances engendered by structural weaknesses

� End of irrational financial euphoria and deflating financial bubbles,

could be counted as a number of cases.

¾ Historically just like the present time, demands to limit independence of

the central banks did not come only from politicians but also from

financial sector, other market players and business world who seek to

benefit from short term effects of the monetary policy.

¾ When we scrutinize the past episodes, we see that certain developments

and economic conditions have gathered public and political support to the

proposals to limit independence and led to compromises on the central

bank independence

� Political tensions and time of war

� Times when protectionism was on the rise and policy makers endeavor to artificially maintain unsustainable economic imbalances engendered by structural weaknesses

� End of irrational financial euphoria and deflating financial bubbles,

could be counted as a number of cases.

&21&/86,21

47

¾ Past experiences have shown that receding from central bank independence

and attempting to change real variables through monetary policy amplifies the

problems and deepens the crises. Covering out of control public spending

through central bank resources leads to hyperinflation, efforts to solve

recessions caused by real or structural setbacks through countercyclical

monetary policies lead to more instability (Friedman, 1953), using monetary

policy to correct imbalances those should be dealt with fiscal policy in order not

to upset the voters causes foreign exchange crisis, supporting asset price

bubbles with monetary policy leads to moral hazard and adverse selection and

thus growing systemic financial crises.

¾ Past experiences have shown that receding from central bank independence

and attempting to change real variables through monetary policy amplifies the

problems and deepens the crises. Covering out of control public spending

through central bank resources leads to hyperinflation, efforts to solve

recessions caused by real or structural setbacks through countercyclical

monetary policies lead to more instability (Friedman, 1953), using monetary

policy to correct imbalances those should be dealt with fiscal policy in order not

to upset the voters causes foreign exchange crisis, supporting asset price

bubbles with monetary policy leads to moral hazard and adverse selection and

thus growing systemic financial crises.

&21&/86,21

48

¾ The current period resembles to some extent with the past episodes when

rising trends impaired central bank independence.

� The global disparity in north-south axis, climate of conflict based on “clash of civilizations”

� Saving-investment imbalances between advanced and emerging economies

� Efforts to meet public demands in election periods, protectionism (Demands to leave European Monetary Union is voiced over in Italy and France, who are founding members of the European Union)

� Derivative products, soaring commodity prices and accommodative monetary policies implemented after 1999 to counter the recession and deflation threats have generated ample global liquidity. Recently, we see a contraction in the global liquidity conditions.

¾ Central Bank independence is at stake!

� Bank of England, FED, and last but not the least ECB.

� Either periphery or the independence of the ECB will be sacrificed. ECB may

soon have to purchase worthless government securities.

¾ The current period resembles to some extent with the past episodes when

rising trends impaired central bank independence.

� The global disparity in north-south axis, climate of conflict based on “clash of civilizations”

� Saving-investment imbalances between advanced and emerging economies

� Efforts to meet public demands in election periods, protectionism (Demands to leave European Monetary Union is voiced over in Italy and France, who are founding members of the European Union)

� Derivative products, soaring commodity prices and accommodative monetary policies implemented after 1999 to counter the recession and deflation threats have generated ample global liquidity. Recently, we see a contraction in the global liquidity conditions.

¾ Central Bank independence is at stake!

� Bank of England, FED, and last but not the least ECB.

� Either periphery or the independence of the ECB will be sacrificed. ECB may

soon have to purchase worthless government securities.

&21&/86,21

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