Bagehot on reforming the Reserve Bank Act

In a comment the other day on my post outlining a possible alternative governance model for the Reserve Bank, Andrew Coleman at the University of Otago included some quotes from Walter Bagehot’s 1873 classic work Lombard Street: A Description of the Money Market (available free here).

The quote that particularly took my fancy was some concluding remarks Bagehot made about the need for changes to the structure and governance of the Bank of England.

“There should be no delicacy as to altering the constitution of the Bank of England. The existing constitution was framed in times that have passed away, and was intended to be used for purposes very different from the present. The founders may have considered that it would lend money to the Government, that it would keep the money of the Government, that it would issue notes payable to bearer, but that it would keep the ‘Banking reserve’ of a great nation no one in the seventeenth century imagined. And when the use to which we are putting an old thing is a new use, in common sense we should think whether the old thing is quite fit for the use to which we are setting it. ‘Putting new wine into old bottles’ is safe only when you watch the condition of the bottle, and adapt its structure most carefully.”

He could have been writing about New Zealand’s situation now.

As I’ve pointed out, our Reserve Bank Act, and particularly the governance features of it, were designed in 1989.  Back then, there weren’t many modern international models to build on.  The provisions of the Act were designed to align with a vision of how core government departments would be run that has now been largely abandoned, they were designed for a conception of what the central bank would be doing that envisaged very little effective discretion, and they were designed before the Crown entities framework was developed for the many other non-departmental government agencies in New Zealand.

Those times have, in Bagehot’s words,  “passed away” and we now need a review and extensive revision of governance, transparency and accountability provisions of the Reserve Bank Act.  Discussion of the issue often focuses on monetary policy, but the governance of the Bank’s extensive powers in banking, non-bank, and insurance regulation is at least as important (and more challenging because the goals are less well-defined).  And as I have been highlighting in the last few weeks, we need to ensure much more openness from the Bank across all its functions, and some more effective structures for holding the Bank and its decision-makers to account.  Bagehot uses a biblical image, but we can go a little further: putting new wine [new expectations of what the Bank should do and how] into old wineskins [the 26 year old Act]  leaves the New Zealand system out of step, and is a recipe for some rather poor and unsatisfactory outcomes.

And with that, I’ll stop for now.  I’ll be back around 13 October,

5 thoughts on “Bagehot on reforming the Reserve Bank Act

  1. The first Reserve Bank Act had a life of 30 years (1934-1964), the second of 25 years (1964-1989), and the third, as you note, is into its 26th year.

    The 1989 Act was a child of the Great Inflation, with policy target, decision-making, and governance arrangements tailored accordingly.

    Looking back, it is evident that the role of the central bank in relation to financial stability – founded on the lender of last resort and banking system oversight roles that go with being banker to the banks – were comparatively neglected. Yet those are the roles that put the ‘central’ into central banking.

    So yes, it probably is time to begin thinking about what shape a 21st century Reserve Bank Act might appropriately take. It would be great if, once you are back, you can stimulate more discussion on this subject.

    Meantime, here are some thoughts of Hyun Shin, now Economic Adviser and Head of Research at the BIS, in a post on the Economist site back in 2011.

    Central banks should prioritise their financial stability role

    A CENTRAL bank is just that—a bank. It borrows and lends, and uses its balance sheet to influence risk premiums and liquidity conditions and hence the degree of risk-taking in the economy. But in the decade or two before the global crisis, this role of the central bank was downplayed by central banks themselves, which preferred to see their role as nudging (or more accurately, pronouncing upon) overnight interest rates. There was nothing special about the central bank performing this role. The same job could have been done by a well-staffed economics think tank with the authority to talk about the overnight rate.

    Meanwhile, the messy and unglamorous business of financial stability was hived off to a separate microprudential regulator. Even for those central banks where banking regulation was kept in-house, the financial stability function was relegated to the basement, metaphorically, away from the core monetary policy function. Able and ambitious younger central bankers knew where they wanted to be.
    Downplaying the financial stability function was seen as a way to enhance central bank independence by portraying monetary policy as a narrow, technical function. For this reason, some still argue that the central bank should not take on the financial stability role. This is misguided. Remember that central bank independence is an instrumental goal—it is a means towards an end, not a goal in itself. A central bank that sees itself merely as a think tank rather than a bank risks ending up being seen as just another interest group pursuing its own intellectual pet projects. That would be the quickest way for it to lose democratic legitimacy.

    No one says that being a central banker is easy. But picking and choosing only those bits of the job that are comfortable is not an option. Basic competence combined with the ability to communicate with the public on the objectives of the central bank will go a long way to build credibility and support for the central bank among the public. We should not underestimate the basic intelligence of the public at large, in spite of the occasional press headline or a politician’s speech.


  2. “Fiscal dominance” seems to be the name for the direction my thoughts were muddling along in:
    “Lord Turner, the former head of the Financial Services Authority, says it is perfectly possible to create a new regime in which the Bank’s Monetary Policy Committee decides how much fiscal funding to permit, calibrating the dosage in exactly the same way that it now regulates bond purchases or sets interest rates. ”

    I think the split between monetary and fiscal that we currently have is probably an error of theory, as both are part of the same system.


  3. I know nothing about economics and am still struggling with conspiracy theories like “Who really owns the Federal Reserve?”.

    Have a good holiday, but when you come back could we perhaps have a posting on this sometime?

    (On the one hand, it seems to me that the Fed could hardly do any worse for the American people if it were working for ‘someone else’. On the other hand, if modern economic theory is as dismal as it appears to be,,then perhaps the mistakes made by the Fed, both in the lead-up to the Great Depression and in their method of dealing with the Global Financial Crisis are understandable.)


  4. It would be good to understand how the RB comes up with their neutral interest rate of 4.5%? The problem the RB faces is that NZ household cash deposits and investments in liquid assets only slightly exceed the level of NZ household debt.

    Therefore a a higher interest rate setting or a lower interest rate setting does not overall effect NZ households net cashflow position as household debt equates to NZ household cash deposits in banks. But a lower interest does affect businesses that do borrow and the building industry is one that borrows heavily. Therefore a higher interest rate setting equates to less development activity and a lower interest rate encourages businesses to grow and expand.

    Debt funding is cheaper than equity funding. Equity funding has a huge risk in loss of control. An entrepreneur sets up a business so that he has full control. The more equity injected the less control the original owner has.


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