Six centuries of central bank independence

A historical rehabilitation

The economic and financial crises of the last 12 years have led to large-scale unconventional central bank measures and renewed discussions on central bank independence, culminating in the 2018 publication of Paul Tucker’s Unelected Power. The same year, the Economist noted that, ‘Operational independence for central banks is relatively new. The principle grew out of work in the late 1970s and early 1980s by prominent economists working in the “rational expectations” school of economic thought, among them Finn Kydland and Edward Prescott, who were eventually awarded the Nobel prize.’

The true story of central bank independence is much older and less academic than what the Economist and others assume.

Central banking from the 15th century until the end of the Bretton Woods era in 1973 meant in essence issuing liabilities with overnight maturity that would be redeemable into precious metal. Monetary stability therefore required unconditional trust in central banks’ ability to remain liquid and solvent. Any substantial recourse of a financially stressed government to central bank resources could undermine this, jeopardising the central bank’s ability to deliver on its convertibility promise. The rational anticipation of this problem prevented the establishment of successful central banks until the late 19th century, despite many attempts. Frederic the Great of Prussia, who took a personal interest in the establishment of a Prussian central bank, failed no less than four times to establish one. All attempts in the Kingdoms of Spain and France failed for centuries because none of the imagined schemes could establish ex ante credibility. Credibility required a sufficient combination of central bank independence and the rule of law.

Three tools have been applied to achieve central bank independence since the 15th century.

First, explicit limitations, or prohibitions of central bank credit to the public sector. Limitations to the Taula de Canvi’s lending to the city of Barcelona were introduced as early as 1412, and again in 1438, when it was decided to limit the size of such loans. By 1468, any lending of the Taula to the city was forbidden. Similarly, the Senate of Venice committed to never borrow from the Banco di Rialto when it was established in 1587. The Bank of Amsterdam was in principle, according to its statutes, not supposed to lend to the city of Amsterdam, although in reality it did. The Riksens Ständers Bank’s charter of 1668 precluded the government from accessing the bank’s financial resources. The ban was respected for just a few years. Some loans to the government were provided as early as 1675. Large-scale lending threatening convertibility started in 1703.

The issue was discussed in various bank plans which did not materialise, such as in Peter van Oudegherste’s 1576 national bank project for Spain, which foresaw strong lending prohibitions: ‘To allay the widespread fear that banks could not survive in a monarchy, the king would swear never to lay hands upon their assets; and upon coronation each successive monarch would repeat the oath. Since the banks would extirpate the deadly sin of usury, the pope would be asked to excommunicate anyone who despoiled them. For directors who authorized irregular advances to the king, the penalty would be death.’

The 1791 Bank of the United States bill prevented direct financing of the government, and required a law to be enacted for each loan surpassing $100,000, raising high hurdles and preventing covert state financing. Those who infringed this rule faced hefty financial penalties.

Second, relative independence within the public sector. Public central banks typically enjoyed institutional separation. Their administrators were assigned objectives defined by law. They had clear mandates to pursue the bank’s interests through careful management, with regular reporting to the municipal council regarding the bank’s books. For example, the 1619 charter of the Hamburger Bank specified the bank’s objectives (to develop commerce and trade by providing a means of payment, and lend to stressed debtors to prevent abuse by usurers) and the composition of its board, including a rotation mechanism, presumably to prevent its administration being monopolised by a few citizens who over the years could collude with the government.

The effectiveness of the governance of the Bank of Amsterdam has often been praised, emphasising the bank’s successful 170 years of operation. However, in 1801 Büsch provided a more critical analysis, arguing that a major weakness of the bank, compared with the Hamburger Bank, was that it had few members and little turnover in its governing bodies. This made it easy to provide covert loans to the city and state-sponsored firms like the Dutch East India company.

Riksens Ständers Bank reported to the Swedish parliament, giving it distance and independence from the crown. The success and stability of the charity-based public giro banking system in the Kingdom of Naples was also based on a strong separation from the crown, achieved by putting the system into the hands of charitable institutions.

Third, private ownership. This was pioneered by the Casa di San Giorgio and Bank of England. Machiavelli, in his 1521-1524 Historie Fiorentine, noted that the foundation of the Casa di San Giorgio allowed it to be a ‘state within the state’. He wrote that the Casa represented ‘liberty, civil life and justice’ in Genoa, while the state stood for ‘tyranny’ and a ‘corrupt life’. He implied that the Casa’s independence through its separate private governance would have been used in all citizens’ interests. John Law took up the ‘state in the state’ image of Machiavelli in his own words: ‘The bank is independent from the state, and is a sort of separated republic’.

When it was founded in 1694, the Bank of England was privately owned by its stockholders. Over the next 200 years, many central banks copied the BoE model, including the Bank of Scotland (1695), Banque Générale (1716), Caisse d’escompte (1776), Banco Nacional del San Carlos (1782) and Bank of the United States (1791). However, the 20th century saw an almost complete reversal to public ownership.

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Ulrich Bindseil is Director General of Infrastructure and Payments at the European Central Bank. This article is based on his book, Central Banking before 1800: A Rehabilitation, which he wrote as Director General of Market Operations.

Further reading

John Nugée: Central banking before 1800 – book review

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