ECB looks very 19th century

4 June 2018

The European Central Bank (ECB) may long have decided to switch its main instrument from interest rate setting to direct lending. Its persistent low and unchanged interest rates and maintenance of net asset purchases brings the ECB close to the origins of central banking. While the ECB was seen as a successor to the Bundesbank, it may now look increasingly closer to its ancestor the German Imperial Bank (Reichsbank).

Central banking was established mostly during the 19th century and early 20th century. Then it was all about bank notes and credit, not inflation. In 1848, the Bank of France became probably the first modern central bank as an official institution with a monopoly in bank note issuance. In 1866, the Bank of England acted as lender of last resort in the Overend, Gurney & Co bank crisis establishing an essential central banking function. In 1875, the Reichsbank was founded to established for the first time a central bank for Germany to regulate bank note issuance and ensure bank note convertibility into gold.

The main monetary policy instrument of early central banks was the bill of exchange. The bill of exchange was a short-term negotiable credit instrument written mostly by corporates payable on endorsement to the bearer. Central banks set their policy rates, the discount rate, and offered credit with full allotment at that rate through bills of exchange discounting. Some central banks altered their policy rates frequently others seldomly.

The Reichsbank was seen as a leading central bank in managing the provisions of the so-called real bill doctrine by which a central bank would always supply sufficient credit to support the economy. It was effective in directly influencing the German business cycle. While its mandate was tied to the gold standard requiring that monetary policy decisions were subordinated strictly to meeting bank note convertibility, it achieved sufficient room of manoeuvre to have an impact on domestic economic conditions.

The ECB’s asset purchases are like bills of exchange discounting only more extreme. The purchases represent credit extensions by exchanging an existing financial claim for central bank reserves. While the Reichsbank only discounted bills with a maturity of less than 3 months, the ECB stretches to 30 years. The Reichsbank at times targeted specific sectors of the economy. So does the ECB with its corporate sector, asset-back securities and covered bond purchase programmes.

The Reichsbank dealt directly also with the non-bank public. The ECB maintains that asset purchases are only conducted with eligible counterparties that are credit institutions established in the European Economic Area. Here, the ECB has still some more room for manoeuvre.

Central banking legislation has made direct lending somewhat more controversial. The 1875 bank act mandates that the Reichsbank maintains convertibility of its notes into gold while facilitating credit and payments. The 1957 Bundesbank act similarly prescribes that the Bundesbank is to ensure currency stability while regulating currency in circulation and credit supply to the economy. The 1992 Maastricht Treaty (Treaty on European Union) simply states that the primary objective of the ECB is to maintain price stability. The need to communicate clearly of why net asset purchases serve price stability is key.

Credit extension was at the origin of central banking operations. The ECB may long have realised that it does constitute a viable alternative to interest rate setting. The market may thus need to get used to the fact that the very old is simply the new. The ECB’s monetary policy may be considered non-standard but it is certainly not from a historic perspective. In fact, today’s central banking looks very 19th century.