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Politics, financial crisis, central bank
constitution and monetary policy
Freiburger Diskussionspapiere zur Ordnungsökonomik, No. 10/5
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Albert-Ludwigs-Universität Freiburg im Breisgau
Suggested citation: Bernholz, Peter (2010) : Politics, financial crisis, central bank constitution and monetary policy, Freiburger Diskussionspapiere zur Ordnungsökonomik, No. 10/5, http:// hdl.handle.net/10419/51548
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zbw Leibniz-Informationszentrum Wirtschaft Leibniz Information Centre for Economics Walter Eucken Institut ORDO Constitutio in Libertate Politics, Financial Crisis, Central Bank Constitution and Monetary Policy Peter Bernholz 10/5 Freiburger Diskussionspapiere zur Ordnungsökonomik Freiburg Discussion Papers on Constitutional Economics ISSN 1437-1510 Institut für Allgemeine Wirtschaftsforschung Abteilung für Wirtschaftspolitik Albert-Ludwigs Universität Freiburg i. Br
Prof.em.Dr.Dr.h.c. Peter Bernholz Center for Economics and Business (WWZ) Universität Basel Postfach 142 CH-4003 Basel Switzerland Tel.: xx41-79-3216701 Politics, Financial Crisis, Central Bank Constitution and Monetary Policy
1. Introduction The damages and suffering caused by inflation during the course of history are enormous.
Still, the worst excesses of inflation occurred not before the 20th century. This development was a consequence of the further technical development of money from coins to paper money and book money together with changes in the monetary regime or constitution ruling supply and control of money. Sustained inflation has always been a monetary phenomenon in the sense that the increase of the money supply is a necessary condition for its occurrence. Moreover, if an increase of the money supply is permanently outstripping the growth of real gross domestic product it is also a sufficient condition for inflation. But that is not the whole story. For it has still to be asked which are the factors and institutional settings that allow the excessive growth of the money supply. And here historical evidence provides a clear answer (Figure 1.1).
2.75 2.5 2.25 1.75 1.5 92 /
Sources: Mitchell (1976), pp. 735-747. Statistisches Bundesamt (1981), pp. 704-706. US Bureau of the Census (1976): Historical Statistics of the United States: Colonial Times to 1970. Bicentennial Edition. Statistisches Bundesamt (2000), pp. 230f.
During the rule of the gold and silver standards until the outbreak of the World War I or after the restoration of it until the Great Depression of the 1930s no upward trend of the price level, but only long-term swings can be observed. But after the demise of the convertibility of banknotes into gold at a fixed parity and thus the introduction on a discretionary paper money standard the price level rises dramatically even in the respective developed countries.
And this is not all, as can be seen by looking at Figure 1.2. Here we observe a similar increase of price levels until the breakdown of the Bretton Woods system in 1971-1973. After that prices rise much more quickly in Italy, Britain and France than in Switzerland, Germany and the USA.
The reasons for these developments are obvious. The latter three countries enjoyed independent central banks, whereas the former did not. And the Bretton Woods System was dominated by the Figure 1.2: Development of Cost of Living in Seven Developed Countries, 1950-2002 %, 1950 = 100
Sources: See Figure 2.1.
US Federal Reserve System (Fed), an independent central bank, whereas the other countries had to follow its lead apart from some de- or revaluations because of fixed exchange rates to the dollar.
This leads to the following conclusions: Inflation has been the higher the greater the influence of politicians on monetary policy. During the gold standard politicians had no influence on monetary matters. With a discretionary monetary system their influence increased, but much less when central banks were legally and in fact independent. But since their directors are only human beings and not bound any longer by automatic rules, they can be influenced by political and psychological pressures and also by the ideas prevailing in their environment. Thus inflation was higher even with independent central banks than under the gold standard. It follows that inflation is absent or the lower the more the hands of politicians are bound by the monetary constitution. Given these relationships it is not surprising that the Freiburg ordo liberal school as well as constitutional economics have been in favor of measures trying to limit political influences on monetary policies.
The ordo liberals in Germany certainly favored an independent central bank in the 1950s. Priority of price stability was considered by Walter Eucken (1952, p. 169) as a constitutive element of a market economy. According to him an international monetary order has to fulfill the following
(a) it has to function automatically, so that the governors of central banks cannot determine monetary policy by discretion according to changing viewpoints.
(b) The mechanism has to work as much as possible towards stability of exchange rates (c) A strong stabilizer has to be built into the mechanism, which works much more strongly than under the gold standard to prevent deflation and inflation.
His disciple Friedrich Lutz (1935, p. 247) had already stated that A particular monetary constitution corresponds to each economic system and the gold standard is the monetary system of the free market economy.
Later he proposed to accept the Chicago plan which proposed a 100% reserve requirement in central bank money for all demand deposits (Angell 1935). Eucken followed him in accepting this idea from the other side of the Atlantic, but proposed to introduce additionally the Graham (1937) plan envisaging a commodity reserve currency with convertibility of money into a commodity bundle of fixed proportions at a fixed parity. This shows how much ordo liberal thinking was influenced by earlier American constitutional thinking. Later Lutz proposed the acceptance of flexible exchange rates, given the relatively stable monetary policies of the Deutsche Bundesbank.
It is also well-known that Hayek (1978) came out in favor of free banking since he lost faith in the stability of money controlled by central bankers.
2. Monetary and Fiscal Policies during the Financial Crisis.
Many historical examples demonstrate that metallic monetary standards as a constitution binding the hands of rulers and politicians have been often the victims of severe financial crises. Such financial crises have especially arisen with the outbreak of wars when ordinary revenues of governments could not be adapted to the needs of war finance. It is not by chance that all European governments except Albania abolished the gold standard at the beginning of World War I. Similar events occurred during the Great French Revolution and the Napoleonic Wars. Even Britain suspended the gold standard at that time though it returned to it at the old parity after this period.
Specie payments were suspended by an Order in Council in February 1797, that is not by an Act of Parliament. Similar events happened even in earlier times when paper notes played no or only a minor role. Frederic II of Prussia debased Prussia's silver currency during the Seven Years War.
And already more than 2000 years earlier Athens debased its silver currency during the Peloponnesian War and Rome did the same much more strongly during the chaotic periods of the fourth century A.D. with its many civil and international wars. But financial crises are not limited to wars. Thus it is not a surprise that the Great Depression brought about the final end of the gold
standard. As President Frankin D. Roosevelt pronounced on April 5, 1933:
All persons are hereby required to deliver on or before May 1, 1933, to a Federal Reserve Bank or branch or agency thereof or to any member bank of the Federal Reserve System all gold coin, gold bullion, and gold certificates.
Let me turn to the first point. In a mistaken fear of deflation the Fed lowered its interest rate to one percent and increased the monetary base by about 39% from 2000 to 2006 after the bursting of the New Economy Bubble. In doing so it encouraged an incredible credit expansion by the financial sector and thus allowed the subsequent asset bubble. Later it helped to pierce the bubble by raising its interest rate step by step above 5% and by strongly reducing the growth of the monetary base.
Though the Fed thus initiated the crisis, we should not deny that it would never have taken such dramatic dimensions hurting the real economy without other well-known defects in the financial
1. Banks neglected to maintain a sufficiently diversified portfolio.
2. The compensation systems for leading managers were far too much based on short-term performances.
3. The control system within banks failed.
4. Rating agencies financed by their customers grossly misjudged the values of firms and assets.
5. The measures by the US government to ease the buying of houses by relatively poor people proved to be mistaken.
6. American liability rules in case owners could not pay the interest on their mortgages encouraged too high levels of indebtedness.
7. The liability rules for gross mistakes by leading managers of business firms were too restricted.
8. The percentages of own capital required for banks by internationally agreed rules (Basle 2) and the valuation at market prices adhered to during the crisis exacerbated it.
9. The permission by Basle 2 for banks to employ their own models to evaluate risks was a mistake.
10. The control of financial institutions by government agencies failed.
11. The lack of knowledge of economic history by leading managers encouraged them to take overly risky decisions.