8 - The rise of central banks

Summary

Central banks conduct monetary policy for their governments and have oversight of the private bank system. Central banks evolved from private banking. The development of private banking hinged on how interest came to be a normal return on capital. It has a complex history, because religion has imbued interest with questionable morality. The main problem was that a lack of good regulation allowed “usurious” rates of interest to be charged that were considered too high.

For the first two centuries BC, Ancient Indian, Vedic, Sutra and Jatakas texts referred to usury as interest in a negative way. Religions and governments restricted or banned interest. Julius Caesar imposed interest rate ceilings, and in 349 AD all interest was banned in Rome. Pope Clement V banned interest in 1311 for Christianity. Judaism disallowed some forms of interest but was lax in regulating interest payments. Islamic law continues to ban interest to this day (Visser & McIntosh 1998).

Stable money during the Renaissance allowed private banking to flourish. This required innovative ways to avoid the prohibition on usury. Although the payment of interest was at first concealed, its use broadened steadily in ways that led to modern banking. In the fourteenth century the Genoese city state government borrowed money, creating public debt. The funding for such loans was provided by the private investors who helped build Genoa as a centre for transportation and trade. But, with the charging of interest prohibited by the Catholic Church, they resorted to indirect means for obtaining interest for loans.

A way to receive interest developed through the sale of “bills of exchange” between international branches of the same bank. The exchange of bills (debt owed by an entity) allowed them to be redeemed in a different currency in a different country for a set amount after a certain time, such as three months. Then the redemption was transferred back to the original branch, with the exchange amounts specified in the other country's currency such that a larger transfer was returned to the original branch than had left it. This incremental income acted as the interest payment for the length of the transaction.