Central banks pursue selective policies

The Bank of England and the US Federal Reserve are often seen as lacking in 'sectoral' policy during their early years. While these central banks were not as closely connected with 'industry' as central banks in the continent were, their association was not completely lacking. But the main problem with this argument is that these banks were very much involved in promoting sections of the financial sector in their economies.
US FEDERAL RESERVE: The common explanation of the founding of the US Federal Reserve in 1913 was that it was designed to enhance the country's 'lender-of-last- resort' function to prevent the cyclical drains of reserves from regional banks and resulting financial panic that had characterised earlier decades. While this is certainly a part of the story, another key factor was the desire on the part of New York bankers to enhance their ability to compete with London banks in the global financial market. As Carter Glass, who was instrumental in the creation of the system, told a Washington audience during the First World War: "The proponents of the Federal Reserve Act had no idea of impairing the rightful prestige of New York as the financial metropolis of this hemisphere. They rather expected to confirm its distinction, and even hoped to assist powerfully in wresting the sceptre from London, and eventually making New York the financial centre of the world" (quoted in Kolko 1963: 254).
As Broz described in great detail, relative to the prior National Monetary System the key changes in the Federal Reserve Act concerned creating markets in bankers and trade acceptances that would allow New York banks to compete with British counterparts in the highly lucrative financing of international trade (Broz 1997: ch. 1). A key factor was creating a central bank that would allow the bank to discount these acceptances. As Paul Warburg, a New York banker and one of the master-minds behind the Federal Reserve Act put it: "American discounting practices prior to the founding of the Fed was 'as backward as Europe at the time of the Medicis, and Asia, in all likelihood, at the time of Hammurabi' (quoted in Broz 1997: 40.)"
In determining the choice of eligible paper for open market operations, the authors of the Federal Reserve Act chose instruments that would help develop these markets in order to improve the competitiveness of US banks with their London counterparts. These included bills of exchange, or trade acceptances drawn within the United States, which was not used extensively to finance domestic transactions (Broz 1997: 48). Key components of the Federal Reserve Act were also designed to enhance the ability of the US financial system to manage the gold standard. Since the resumption of the gold standard in 1879, the US had perhaps the freest market for gold in the world, and did not have a central bank to protect the supply in case of crisis (Broz 1997: 49). In addition, the US did not have a central bank that could employ gold devices to help create policy space to pursue other goals.
Promoting New York banks in their quest to become more competitive with British banks in global business was also associated with promoting the US dollar as an international currency. Despite the fact that the US had accumulated massive amounts of foreign assets and had been turning into the world's largest creditor, the US dollar was still not widely used in international finance. The Federal Reserve Act was also intended to rectify that situation. This too was seen by New York bankers as enhancing their profits (Broz 1997: ch. 2). To some extent, this promotion of the international aspects of the Federal Reserve Act in order to help New York bankers compete with London was simply a matter of 'rent seeking'. The bankers were well organised and they had the economic and political muscle to push through the Act in Congress, despite opposition from other sectors. Still this act of targeted policy to subsidise and promote a particular financial sector in its quest to become more internationally competitive came at a time of major increase in the US economic and political role in the world economy, and further developed that role. One could discuss many other examples of ways in which the Fed has supported the financial sector of the US - from LDC (least developed countries) debt crisis bailouts, to promoting IMF structural adjustment policies, to underwriting the stock market during the 'tech bubble' - but space does not allow it. Still, it seems clear that, from its inception, the Fed has engaged in significant amounts of sectoral promotion. To claim otherwise is to ignore history.
BANK OF ENGLAND: The case of the Bank of England and its connection to the City of London is well known. London had been the financial centre of the world, or had a monopoly of capital exports at least up to 1850. Rivalry with the French heated up around mid-century, but the Franco-Prussian War destroyed French chances. By 1875, London was supreme in both domestic and international money markets. (Kindleberger 1993: 261). By the late nineteenth century, during the heyday of the classical gold standard, British banks and bond houses were dominant in international capital markets and in the financing of trade. For example, during the boom in foreign securities from 1904 to 1913, British bond and banking houses sent abroad close to half of British savings and 5 per cent of national income (Kindleberger 1996: 136).
A major reason for British financial primacy was the structure and stability of the international gold standard, which, at times, operated more like a sterling standard (Kindleberger 1996: 136). A French study quoted by Kindleberger comparing the relative competitiveness of finance in London versus Paris highlights the role of the gold standard in conferring advantages on London: 'Paris was especially handicapped by the practice of bimetallism, which gave the Bank of France the choice of whether it would pay off its notes in gold or silver - whereas in London one could get all the gold one wanted without hesitation on the part of the authorities or any doubt' (quoted in Kindleberger 1993:262). Summing up, Kindleberger notes that London was a world financial centre, while Paris was a European one. For our purposes, the relevant lesson is this: while other factors were important, such as the efficiency and sophistication of the British financial institutions, the existence and stability of the gold standard, with sterling at its centre (along with gold) was enormously important in the success and global competitiveness of the British financial system. Hence, the efforts and support that the Bank of England made to develop and maintain the gold standard were, in effect, a major subsidy and support of the city of London financial institutions themselves. For England then, central bank policy to maintain the convertibility of sterling into gold was not only a macroeconomic policy; it was, very importantly, also a sectoral policy, designed to support the international competitiveness of British financial institutions. Thus, even during the classical liberal period of the late nineteenth and early twentieth century, all the central banks considered here, including the Bank of England and the US Federal Reserve, engaged in sectoral policies. After the Great Depression and the Second World War, this use of selective policies became even more integral - and more widespread - to central bank policies.
[The third part of the article will be published on Saturday, November 14, 2015]
Jamaluddin Ahmed PhD FCA, a former President of the Institute of Chartered Accountants of Bangladesh (2010) and General Secretary
of the Bangladesh Economic Association, is Chawirman, Emerging Credit Rating Limited.
[email protected]