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CENTRAL BAHKINQ OBJECTIVES. QPIDBS AMD MEASURES
Remarks of
KARL R. BOFP
Tice President*
Federal Reserve Bank
of Philadelphia
and
Lecturer on Finance,
University of Pennsylvania
before the
iinDTrtif v n u n t JIODVA/Xllullufl
louvmipTfli
Mlfini.villll f i M m a
9ew York City
October 23, 1953
6:30 p. m.
CENTRAL BANKING OBJECTIVES, GUIDES AHD MEASURES
I am surely rash to philosophize about central banking,^as KorriB
Johnson asked me to do, on a program that includes Randolph Burgess and Marcus
Nadler. After all, they wrote the authoritative texts that I stuiied in college.
Nevertheless, I accepted the invitation as a means of self-discipline because I
find it necessary from time to time to back avay from current events to take a
larger viev of the profession of which I am a part and to subject ny thinking to
informed criticism. And of course, time passes. Even I shall have to squeeze a
year of study, practice or teaching of central banking into each minute that I
talk.
It is a pleasure to acknowledge at the outset how much ny life and
thought have been enriched because so many of you are personal friends. You
have helped me return to the road when my thoughts went astray. I must confess,
however, that your valiant' efforts have not yet equipped ny mind with a gyro
scope that keeps me unerringly on the path of truth - especially the one spelled
with a capital T.
I propose to.discuss two topics: first, objectives of policy and re
lated programs, and second, guides to current operations and measures of influ
ence. Both these questions have persisted through the history of central bank
ing and it is important periodically to review our alternatives so that we may
arrive at solutions appropriate to our time through the democratic process of
informed discussion. X do not bring you final answers to either of them.
I.
Objectives of Policy and Related Programs
It should not be surprising that central banks have seldom pursued
policies too far out of line with what the public has really expected of them.
Fundamental habits of thought usually
slowly
central bankers are in
fluenced by the same forces that affect the population of which they are a part*
j&erlou* conflicts have arisen only occasionally when the views of central bankers
nave been Influenced too slowly by heresies that became respectable. During most
of their histories, however, central bankers and the great majority of the
people have held similar basic Ylewsj The public at times has expected too much
but more frequently has been charitable when achievement has fallen short of
expectation*
Neither the desires of the public nor the objectives actually pursued
can be defined precisely, and the rough correspondence between the development
of the two is not primarily a matter of deliberate design.
and large, It
seeas to me that observers have been bolder than the practitioners to innovate.
One need only contrast the observations and analyses of Henry Thornton with the
practices of the Bank of England under the Governorship of his brother Samuel to
see what I have in mind. Before we become too enamored of the observer and too
critical of the practitioner, however, we should remember that boldness should
come more easily to the outside observer than to the responsible practitioner and
that it is not all observers but only those whom subsequent developments have
vindicated who might have la^roved on practice. Contemporary observers have
aljttst always Included not only such experts but both reactionaries and crack
pots as well, ^fortunately, time Is needed to place each into his appropriate
- 2 -
category.^1 ^
r n ----------------------------------
Perhaps each vill be placed into his final category only at the end of
time! Consider, for example, the possible changing classification through time
of Thomas Attwood, a banker of Birmingham, who testified before the Parlia
mentary Committee on the Bank of England Charter in 1832 as follows:
Q. 5^39*
"Then what you propose as the new standard, is not gold, but a
definite quantity of wheat? - If we must have a gold standard,
which I think by no means suitable to our artificial state of
society, I should think it wise and prudent to adopt such a
standard as would preserve such a plenty of money as should
keep the bushel of wheat at 10 s.
Q. 56kO.
Is not that equivalent to making the standard of value, not gold
but wheat? - It certainly has a tendency to bring in new princi
ples in aid of the ancient standard, or rather it creates a new
metallic standard of value.
Q. 564l.
Would not those principles entirely subvert the ancient standard? I think they probably would.
Q. 5758.
Do you consider that so long as there exists a labourer in the
country not fully employed, an increased issue of currency may
be made with advantage, whatever it be? - As a general principle,
I think, unquestionably, that so long as any number of indus
trious honest workmen in the Kingdom are out of employment, sup
posing such deficiency of employment not to be local but general,
I should think it the duty, and certainly the interest, of Govern
ment, to continue the depreciation of the currency until full em
ployment is obtained and general prosperity.
Q. 5759«
What is your test of full employment? - It is difficult to obtain
an absolute test.
Q. 5760.
If you have not an absolute test to which you can refer, may not
the principle you recommend lead to an indefinite depreciation,
since different persons, and different ministers, and different
Governments, will have very different notions with respect to
what full employment means? - I think not, every one considers
that full employment certainly existed in 1825.
Q,. 576l.
Were there no persons unemployed in 1825? - I think no honest
man.
Q# 5762.
Would you have the depreciation go on as the population increased?
I see no necessity for that, whether we have got the present state
of population, or double its number, a just state of the currency
would employ them all.”
- 3 -
It is difficult to ascertain the objectives that have actually be e n
sought by central banks.
They are seldom announced with precision and must
usually be inferred from specific acts.
A few outstanding practitioners have
developed their thought and conduct systematically and w ith appreciation of the
evolutionary character of central banking.
At times, however, central banks
like other institutions - including universities - seem to have had no conscious
objectives but seem to have acted .either on the basis of precedent and routine
or empirically as detailed issues pressed for solution.
Even w h e n objectives
have been announced, the verbal evidence may be difficult to interpret.
Real
identity of thought may be obscured under variety of expression and significant
differences may be covered b y identical phrases.
The precise development of central banking policy in the interest of
the general welfare has not been planned, systematic, or even orderly. Older
central banks were founded to make profit. It was not untii the suspension of
cash payments at the time of Napoleon that Henry Thornton, whose book on paper
credit and speeches and testimony before Parliament and its committees will al
ways remain a monument to his breadth of view;j demonstrated that the Bank of
England had peculiar obligations because of TTs unique position in the banking
system. The Bullion Committee in l8l0 took a similar position, but their views
were not popular at the Bank and apparently had little immediate influence on
its policy. In 1832, however, J. Horsley Palmer, the Governor, recognized that
the Bank of England had responsibilities unlike those of other tanks ^when he
said that it should limit its discounting to times of disdrecfit. * Nevertheless,
the Bank Act of 18M4- was based on the proposition that the Bank should have no
discretion in its Issue Department and that it would best promote the public
interest by seeking its own gain in the Banking Department. There were such
interruptions in the development of central banks as public institutions; but by
1873 even that extreme advocate of free banking, Walter Bagehot, admitted that
"money will not manage itself."(2 )
Everyone ¿who is aware that he is living in the middle of the Twentieth
Centuryp&Srees in general terms that central banks should influence monetary and
credit developments so that they may contribute a m a ximum to the general welfare.
Disagreement arises as to h o w it can b e s t b e done.
A mere listing of the s p e c i
fic objectives that have b e e n advocated wo u l d fill several pages.
In choosing
an objective, a central ban k - or an analyst - is, b y implication at least, in
dicating the conditions under whi c h credit should b e eased or tightened.
The paragraph from whi c h this clause is taken reads as follows:
"I a m b y
no means an alarmist.
I believe that our system, though curious and peculiar,
m a y be w o rked safely; but if w e w i s h so to work it, we must study it. We must
not think we have a n easy task w h e n we have a difficult task, or that we are
living in a natural state w h e n w e are really living in a n artificial one.
Money
w i l l not manage itself, and Lombard street has a great deal of money to manage."
It
Bagehot
b e haved
Hankey,
w as not a willing admission and candor requires me to mention that
was provoked to write Lombard Street not only b y Governor Holland who
as a central banker in the Overend crisis of 1866 b u t also b y Thomson
a former Governor who did not understand - well, w h i c h end was up.
-
k
-
Although it may do violence to particular versions, it is convenient
to limit discussion to some basic objectives and the related conditions that
would call for or permit expansion or contraction. To focus our attention, I
have constructed a skeleton of five such objectives and their related programs
of action. Such formulations appeal to observers because they promote clarity
of thinkingj they often annoy practitioners because they leave out so much that
is relevant in the complicated world we are trying to understand.
Table 1.
Objectives and Related Programs
Conditions calling
for or permitting an
easing of credit
Conditions calling
for or permitting a
tightening of credit
High and/or rising
primary reserves
Low and/or declining
primary reserves
Contractive
Increase in monetary
volume of output
Decrease in monetary
volume of output
Chain-reaction
3* Stable price
level
Declining prices
Rising prices
4. Full employment
Less than full
employment
Jobs In excess of
workers
Expansive
5. A fixed rate of
interest
When savings are
Inadequate
When savings are
excessive
Chain-reaction
Objective
1. Convertibility
^7 sites
2. Productive /
credit
Inherent Bias
Casual inspection will reveal the general relationships between the
objectives listed In column 1 and the conditions Itemized in columns 2 and 3* I
doubt that there would be serious disagreement in principle on the correlations
as tabulated, if allowance is made for the fact that every expositor has his own
terminological preferences.
You will note that some of the phrases in columns 2 and 3 are under
lined. This is done to indicate that the several objectives do not compel ex
pansion arid contraction with equal force. For example, if the exclusive objec
tive is convertibility, the central bank's sole concern is not to issue too much
credit. Convertib 11ity sets a limit beyond which the bank dare not expand. The
limit to contraction, however, is reached only when the bank's assets consist
exclusively of primary reserves - gold. In other words, a central bank is under
greater compulsion to contract than to expand. In this sense, one may say that
convertibility has an Inherent contractionary bias, as Indicated in column 4.
In the
sense, full employment has an inherent expansionary bias, because a
central bank must expand when there is unemployment but is not compelled to con
tract when employment is more than full.
- 5 -
Productive credit and a fixed rate of, interest have self-inflammatory
biases that I have labeled "chain-reaction". ^The most sophisticated formulation
of the productive credit idea is the so-called "real hills doctrine". The doc
trine involves circular reasoning because it would make the volume of money de
pend on the monetary volume of trade which is itself influenced by the volume of
money. An initial increase in prices for any reason would produce a larger volume
of real bills, which in turn would support a larger volume of money $ which in turn
would stimulate further increases in prices. Similarly I
ornfcerest main
tained below the equilibrium rate would on the reasoning developed by Wicksell
lead to cumulative inflation. Conversely, a rate pegged at too high a level would
lead to cumulative deflation.
•
An objective should not be ruled unwise merely because it is subject to
an inherent bias. [Objectives with a bias, however, are not usually definitive
and must be supplemented to prevent unlimited Inflation or deflation^ Many ad
vocates of particular objectives are aware of these biases. It may be that some
sure influenced in their choice of objectives by a desire to take advantage of
them. Thus, advocates of convertibility may desire a monetary mechanism with a
contractionary bias because they fear inflation more than deflation. Advocates
of full employment, on the other hand, may favor an inherently inflationary system
because they fear deflation more than inflation.
It should not be Implied that the biases inherent in the rationale of
the several objectives are an accurate basis for forecasting actual monetary
developments in countries that pursue them. For example, the contractionary bias
of convertibility would not assure that pursuit of this objective would prevent a
run-away inflation should some nuclear physicist Invent a method of producing
gold in virtually unlimited amounts for a dollar a pound.
I do not wish to infer that a central bank operating alone can achieve
all or any of these objectives. I suppose each of us would be satisfied, possibly
even happy, if the central bank always moved in the direction appropriate to our
particular objective so that all of us might be happy if all objectives pointed
in the same direction. There are times when this happens; namely, when all the
conditions listed in column 2 or all those listed in column 3 exist concurrently.
For example, if unemployment is increasing, the price level is falling, the coun
try is adding to existing large reserves of gold and foreign exchange, and the
government is borrowing heavily, all signs would point to an easing of credit.
Suppose, however, that employment Is decreasing, that the price level
is stable, and that the country is posing gold and foreign exchange in volume.
Under these circumstances maintenance of full employment would call for an expan
sionary program, maintenance of a stable price level would call for no change,
and the rules of the gold standard would call for contraction. Consideration of
such sets of circumstances indicates that conscious choice among basic objectives
is desirable because some choice is inevitable - at least in terms of behavior since multiple objectives may be irreconcilable and mere hoping will not dissolve
conflicts between them. It does not follow, however, that a rational choice must
be of the "all or nothing" variety. It may be a combination - and in different
proportions over time - of irreconcilables. The actual choice, of course, may be
empirical, and It should not be Inferred that central banks have always made a
conscious choice or that the fundamental issues are always sharply drawn in real
life.
As I mulled over alternative objectives, I found myself coming out with
a combination of the price level and employment. I am aware that some observers
- 6 -
favor stability of the price level as the exclusive objective, in part on the
ground that if action is directed toward that end serious unemployment will not
arise. They may be right, but events have a way of exposing hidden errors in
even our most cogent reasoning, and I would not close the door to possible action
if employment declined seriously despite a relatively stable price level.
So long as employment did not fall too far, the central bank could move
in the direction indicated by the price level. Should employment fall too far,
even though prices remained stable, the emphasis could be shifted gradually from
the price level to employment. The greater the decline in employment the greater
the emphasis to be placed on it as an objective.
I shall weasel on the critical level of employment and on the rate of
change in emphasis. Though something is revealed, much necessarily remains
hidden behind that cold figure "employment", For tabulation purposes, a member
of the labor force is either employed or he is unemployed. For the problem at
hand, however, the definition and measurement of the labor force, the extent of
overtime - and of part-time, the relationship between job openings and unemploy
ment, the rate of flow of individuals through the group who are unemployed, and
other aspects are also relevant. For example, a boom period may bring into the
labor force people who are not normally employed, and a change to less hectic
activity and less pressing demand for labor may cause their withdrawal from the
labor force without necessarily involving extensive unemployment among the nor
mally employed. There are, of course, similar questions with respect to the con
struction of an appropriate price level. Such problems are too complicated to
throw magnitudes around as though they had precise meaning.
Faced by a choice between a stable price level and full employment,
some observers apparently would emphatically urge the stable price level as the
proper objective of monetary policy, while others would just as emphatically advo
cate full employment. It would seem, however, that there has been a growing
realization during recent years of the potential conflict between the two and a
widening acceptance of a compromise - high employment without serious inflation
or deflation. Here again, however, there is rather wide latitude for differences
of definition.
II.
Guides to Current Operations and Measures of Influence
III discussing programs to achieve specific objectives, I have talked
glibly abbut expansion and contraction, about easing and tightening credit.
Actually the matter is not so simple. Such apparently innocent words curiously
have no precise inherent content. Both scholars and central bankers have devoted
much effort to devising guides to current operations and measures of the influence
being exerted.
Keynes, you may remember, developed in Chapters 2, 25 and 32 of his
Treatise on Money the principle that the best guide to current policy in countries
such as England and the United States is the volume of member bank reserves, and
that the measure of a central bank's influence is its ability to establish such
reserves at predetermined levels. A few years after publication of the Treatise,
Seymour Harris concluded that "central bankers ought to concentrate their atten
tion on the cash balances of member banks; it alone is the variable to be
- 7 -
controlled if they have any serious intention of exercising control over the
money market."(3)
I must confess that I quoted this statement of Harris with approval in
a review of his book. As I read contemporary literature, including the publica
tions of the Douglas and Patman Subcommittees, I gain the Impression that this
view is still widely held.
It now seems to me that it is based on an overly-mechanistic view of
central banking, deposit creation, and the flow of purchases. We are told that
confession is good for the soul; but I have not introduced this topic merely to
confess what now seems to me to have been error on my part. Rather I am inter
ested in your criticisms of the views I now hold after further reflection. I
still recognize, of course, that the volume of reserves is an important monetary
magnitude. I wonder, however, whether it is the only or even the best guide to
current policy or the best measure of immediate results. For one thing, it
seems clear that a given change in the volume of reserves can have different ef
fects on the jeconony via thd money market, depending on such aspects as whether
it is accompanied by changes in security holdings or by changes in the borrow
ings of member banks. Indeed, even these categories may be too inclusive to be
definitive as to effects.
My real doubt, however, arises from broader considerations. Keynes’
reasoning led him to the conclusion that on the Continent before the First World
War central bank control was possible only because bank notes were so important
as a means of payment.(4) He doubted that the Continental central banks would
have had adequate strength had they been operating in a country where deposits
were relatively much more Important, as was the case in England.
I have just spent a couple of years of my spare time analyzing the
operations of the Reichsbank from its foundation to the outbreak of the First
World War in the belief that such study might contribute to.understanding not
only that specific experience but general principles of central banking as well.
;Before I give you the results of that study, I would like to recount a
fragment of English experience which re-enforced my doubt that any single measure
of the quantity of money or of the monetary base is the true lodestar. English
experience came to mind because more than a century ago an influential group also
focused its attention on such a magnitude to the virtual exclusion of other fac
tors. The Currency School, you may remember, believed that Bank of England
policy ought to be simply currency policy. As Samuel Jones Loyd phrased it:
"Now a paper currency is nothing more than the substitution of paper notes in the
place of what would otherwise be metallic coin, and the rule for the regulation
of it s6:ems to be very obvious, viz. that the paper notes ought to be kept .the
same in amount as the metallic coin would have been." To the Currency School the
volume of currency was not only the mechanism by which the Bank accomplished its
objectives but also the measure of results of its policy. Incidentally, it is
w ----------------------------------
S.
E. Harris, Twenty Years of Federal Reserve Policy, Cambridge, 1933, P*13*
The emphasis does not appear in the original.
{k)
Treatise, Vol. II, pp. 233-234.
- 8 -
tempting to conclude that theory like politics sometimes makes strange bedfellow
Keynes would not have accepted the objectives of the Currency School,
lifs4*"
logic forced him to accept their measure of influence for the Continent under
conditions similar to those in Engl and when the Currency School was prominent.
But let us return to the Currency School itself and particularly to
their criticism of the Bank of Engl anti for its activity in the Panic of 1839*
The Bank, no longer limited by the usury laws, increased its rate to an "unex
ampled" six per cent; it borrowed abroad, and reduced the maturity of bills it
was willing to discount. The money market^was under severe pressure. But all
of this did not satisfy Loyd. He argued that the Bank should have ‘
made greater
efforts to reduce the amount of its notes because of its loss of gold. Contrast
this view with Thornton's earlier discussion or with Bagehotfs later famous
rules for dealing with panics! An important weakness of the Currency School was
that its members thought that the Bank should pay no attention to the volume of
its deposits in determining its policy. No one any longer makes that mistake,
but may we not now be paying too exclusive attention to the volume of reserve
balances?
This brings us to the German experience. We may begin by pointing out
that before the First World War the Reichsbank paid virtually ho attention to
reserve balances and ordinarily did not know what their magnitude was. It did
not try to establish their amount at predetermined levels. Furthermore, it was
not in position to do so quite apart from any queatimjofyopi^olllng its assets
because of the magnitude and variations in its ^^Ke3^^ccouB%8T^"F1 nal 1y, German
banks did not maintain either their reserve deposits or their total primary re
serves at any customary relationship toaeposits.
A student enamored of the reserve balances approach to central banking
confronted with such a loose-jointed system might be tempted to conclude that
the Reichsbank had little power to enforce its will. ®ie impediments to an ef
fective policy seem too formidable. But this conclusion would be premature.
The Reichsbank had power to affect the supply of liquidity relative to the de
mand. At no time were its earning assets less than several times the total pri
mary reserves of the banks even as reported in their annual balance sheets. The
banks were fully aware that the liquidity of their portfolios of eligible bills
rested on the willingness of the Reichsbank to discount them and that to secure
cash they would have to pay the rate established by the Reichsbank. The market
as a whole was always indebted to the Reichsbank and had to meet its terms to
acquire additional reserves or cash. The Reichsbank had branches throughout the
Bnpire at which credit was available not only to commercial banks but to com
merce, industry and agriculture as well. A change in the terms on which it
granted credit was quickly felt at many points.
The Reichsbank was in position to pursue an effective policy regard
less of the reserve requirements that the banks set for themselves at the moment
because it could make cash scarcer or more plentiful than the banks wanted it to
be. As a result of a change in terms at the Reichsbank the commercial banks
would find it profitable to achieve the degree of liquidity they wanted by ad
justing their lending
investing operations - that is to say, by tending to
move in the direction desired by the Reichsbank.
Where does this leave us so far as general principles of central bank
ing are concerned? It suggests that an appropriate measure of a central bank’s
influence is its ability to make "the terms of credit" conform to the "current
- 9 -
needs of the economy". "Current needs", of course, are related to objectives,
as I indicated in a general way earlier. The concept "terms of credit" has many
related facets but they consist essentially of cost and availability. In the
abstract, the two are distinct - one being rationing through price and the other
rationing by rules; but in practice they tend to merge. Thus, even if a single
price Is charged, the effect 1b similar to rationing against the highest quality
of paper.
The tone of the credit market is Influenced by many factors. The rela
tive importance of these factors and the procedures employed to establish the
tone will vary from country to country and from time to time depending on basic
social philosophies, Institutional arrangements, and so on. We have a responsi
bility to develop techniques best suited to our dynamic Boclety. The point I
want to emphasize here, however, is that even the most Ingenious central banking
techniques will not be effective unless they can and are permitted to influence /
the rate of interest, the availability of credit, or both.
.
y
So far as the general credit market is concerned^wS^^^^^SeifSial bank
needs is a supply of earning asBets that it can use to absorb liquidity and
¿F
authority to issue notes and create reserves so that it can release liquidity.
By influencing the supply of liquidity relative to the demand, it can In effect ******** >
induce the economy to act in the desired direction by making more attractive the
alternative methods of adjustment - which for banks is to change their willing
ness to lend and invest and for the economy as a whole is to change its rate of
purchases.
. l£ou may object that my formulation is more complex than that of Keynes.
My reply IB, first, that the simplicity of Keynes was achieved at the expense of
relevance to the real world; second, that conceptually my formulation is still
relatively simple even though not all of its aspects are subject to precise quan
titative measurement; and third, that even under the formulation of Keynes the
practitioner must decide in advance the exact level to which he will push reserve
balances * which is not necessarily any easier than determining and measuring the
degree of ease or tightness in the money marketTj
This last problem of relating conduct to principles is not unique to
central banking. General von Clausewitz had this to say about it In his Princi
ples of War; "The conduct of war resembles the workings of an intricate machine
with tremendous friction, so that combinations which are easily planned on paper
can be executed only with great effort." Although observers are interested pri
marily in principles »»id participants In conduct, many individuals are both, and
the degree of success that central banks achieve hinges on the quality of the
influence that both exert. Speaking from experience, I am tempted to paraphrase
another Clausewitz dictum: "The .results on which we count are never as precise
as Is imagined by someone who has not carefully observed a money market and be
came used to it."
And now I must thank you for inviting me here because although I may
have said nothing that 1b new to any of you, I learned more under the compulsion
of putting W thoughts down on paper at this time than I have learned under any
self-imposed compulsion in a long, long time.
Distributed at meeting on
Table 1.
OBJECTIVES AND RELATED PROGRAMS
Conditions calling
for or permitting an
easing of credit
Conditions calling
for or permitting a
tightening of credit
1. Convertibility
High and/or rising
primary reserves
Lov and/or declining
primary reserves
Contractive
2. Productive
credit
Increase In monetary
volume of output
Decrease in monetary
volume of output
Chain-reaction
3. Stable price
level
Declining prices
Rising prices
None
4. Tull employment
Less than full
employment
Jobs In excess of
workers
Expansive
5. A
When savings are
Inadequate
When savings are
excessive
Chain-reaction
Objective
fixed rate of
interest
KRB
Inherent Bias
@FedFRASER