What do Central Banks Do? (1989)

When the first Central Banks were founded, for example the Swedish Riksbank, the Bank of England, the Banque de France, they were neither expected, nor intended, to perform the functions of a modern Central Bank. Instead, they were established by the government of the day in a position as the main commercial bank in the country, with special privileges provided to them by their original Charter. In particular, they were generally given the privilege of the monopoly of the note issue in certain areas, for example in the London area or in the Paris area. Moreover, you should recall that in these early years the majority of bank liabilities were in the form of notes, rather than of deposits inscribed onto the bank’s books, so this monopoly of note issue effectively provided them with a virtual monopoly of the provision of banking facilities in the capital city. Naturally, the government wanted something in return, and, as you will imagine, this was additional finance. In return for the original Charter, the Bank of England and the Banque de France both subscribed large amounts of their initial capital to the purchase of government bonds, thus relieving the financing problem of the government in that year; in addition, every time the Charter came up for renewal, this led to some additional subscription for extra government bonds. Besides such occasional lump-sum payments, the role of the main central Chartered bank, as the commercial bank with closest direct links to the Government, meant that in times when the government was having particular difficulties in financing a deficit, notably at times of war or civil strife, this central bank would be expected to make additional loans to the Government; and, if such ‘politically forced’ lending should lead to a drain of gold reserves from the central Chartered bank, then the Government, desperate for funds, would normally declare the note liabilities of their central Chartered bank to be legal tender, and to accede to a suspension of the convertibility of the central commercial bank’s note into gold, a convertibility commitment that would otherwise be crucial to the reputation and standing of the bank.