Central Banking 101: When Monetary Anchors Collapse

By the 1960s, a surplus of US dollars built up outside the US, caused by persistent balance of payments deficits due to its foreign aid, military spending, especially due to the Vietnam War, and foreign investment. A point was reached when the US did not have enough gold at the rate of $35 per ounce to cover the volume of dollars in worldwide circulation. 

Presidents John F. Kennedy and Lyndon B. Johnson adopted a series of measures to support the dollar, including foreign investment disincentives; restrictions on foreign lending; and coordination with other countries. Nothing worked; there were periodic runs on the dollar. It was just such a sell-off that prompted President Richard M. Nixon to announce on August 15, 1971, the suspension of the dollar’s convertibility into gold. He also ordered that an extra 10% tariff be levied on all dutiable imports to induce major trading partners to adjust the value of their currencies upward and the level of their trade barriers downwards to allow for more imports from the US. So reminiscent of the present day!

It was a global shock wave, especially the assertive manner in which his Treasury Secretary, John Connally, conducted exchange rate negotiations with his foreign counterparts. “Our currency, your problem”, he infamously is reported to have remarked. A few doomed attempts to fix the problem later, six members of the European Community tied their currencies together and jointly floated against the US dollar in March 1973, a decision that effectively signalled the abandonment of the Bretton Woods fixed exchange rate system.

Regime collapse stared at central banks across the world, spiralling them into a no-man’s land.

Monetary Policy Acquires a Domestic Orientation

With the breakdown of the exchange rate-based monetary system and, in fact, even before it, central banks turned inwards. Actually, the post-World War II period right up to the 1980s became known as the interventionist era.

While monetary policy controls the total volume of credit in an economy, central banks in the then-developed and the developing world adopted structured interventions to direct credit towards specific sectors such as agriculture, small industries and exports to secure their developmental and reconstruction aspirations, including social welfare.

Monetary Policy and Credit Allocation
The underlying rationale was that in those days of reconstructing from a war-torn past, most economies were constrained by the lack of adequate institutional development in the form of banks and financial institutions to widely create credit that would lubricate the wheels of growth and development. Moreover, credit markets are notoriously inefficient and unfair. They thrive on unequal availability and access to information, which leads to their excluding some sources of credit demand, especially the disadvantaged. This market asymmetry and inequality could be eliminated, it was believed, if correct amounts of scarce credit were allocated among the best productive uses.

Central banks and even governments assumed the mantle of the markets like an auctioneer who calls out a price, participants announce their supply/demand quantities, and if there is an imbalance, the auctioneer raises or lowers prices and shouts again until equilibrium is met. The auctioneer only allows trades to take place when supply equals demand in all markets simultaneously. The auctioneer simplifies the market mechanism by acting as a frictionless entity that eliminates the need for individuals to search for the best price and access/demand. This concept was introduced by Leon Walras, a French mathematical economist. Accordingly, monetary policy took on the garb of credit policy. Selective credit allocations, credit ceilings, administered interest rates and window guidance entered the arsenal of central banks.

It was a regime in which monetary policy mattered, but it toiled under fiscal dominance even though it sought to be married in some countries, like India, with so-called ‘non-inflationary deficit financing’.

The Later Regimes
By the 1970s and 1980s, credit allocation policies failed and were largely abandoned, although vestiges survive to the present day. By setting interest rates artificially, capital was channelled toward less productive sectors and inefficient firms. By insulating these firms from market competition, credit policies stifled productive investment and slowed long-term growth. Governments often directed credit toward public sectors or preferred industrial projects, which reduced the availability of credit for the private sector and resulted in inefficient resource allocation. Controls and directed lending caused market operators to develop ways to bypass them or even manipulate them through connected lending. This resulted in high levels of non-performing loans and financial distress in banks. Credit controls also clashed with the rapid development of financial markets, making the conduct of monetary policy less effective and unstable. In many countries, the outcome was high inflationary pressures and massive distortions.

By the 1960s and 1970s, credit allocation policies came to be associated with a rapid expansion of the money supply, a “Great Inflation”, and stagnant growth. The term ‘stagflation’ entered the lexicon of central banks. Global oil shocks in 1973 and 1979 significantly aggravated the inflationary situation, transforming it into a major economic crisis.

The Abandonment of Credit Allocation
In the US under the Nixon administration, attempts to curb inflation through wage and price controls proved largely ineffective, creating a crisis of confidence in monetary policy. The influential view of Milton Friedman, the winner of the 1976 Nobel Prize in Economic Science and the intellectual leader of the Chicago School, began to permeate economic thinking, pointing to a neglect of money in the analysis of inflation dynamics. “Inflation is always and everywhere a monetary phenomenon,” was his famous claim. The advocacy grew for monetary policy to engineer a constant rate of growth in the money supply, or Friedman’s celebrated k-per cent rule. In fact, it also spurred a drive for the measurement, revamping and publication of alternatively defined monetary aggregates, with an inclination towards broader definitions.

The Move Towards Targeting Monetary Aggregates
Starting in 1970, the US FOMC decreed that the growth of the money supply should not deviate significantly from projections and ranges of tolerance were specified for various monetary aggregates. In October 1979, the FOMC, under its chairman Paul Volcker, adopted an operating procedure that was focused on controlling the growth of the money supply in order to reduce inflation. The strategy was highly successful in achieving disinflation in the US, at the cost of recessions. A new monetary policy regime took shape.

Actually, Germany’s Bundesbank was the first to adopt this strategy in late 1974, initially targeting "central bank money" before switching to a broader concept of money supply in 1988. The Bundesbank was not strictly monetarist, however, and often allowed targets to be missed if other goals, like exchange rates or output, were more pressing. Along with Germany, Switzerland pursued monetary targeting seriously for over 20 years. The Swiss National Bank switched to targeting the monetary base or its own balance sheet in 1980, though it briefly suspended monetary targeting in 1978 to address a surging exchange rate. In the UK, formal targeting began in 1976 using broad money, or M3. Under Margaret Thatcher, the strategy aimed for a gradual deceleration in money growth. Other countries like Canada, Japan and several emerging and developing countries also adopted the regime, although it is fair to state that none of them followed the strict form given in Friedman’s rule. Instead, ‘discipline with discretion’ became the norm.

At the core of this regime was the need to understand and predict why people want to hold money. They would want to hold it for day-to-day transactions (which could be proxied by GDP) and for precautionary reasons like preparing for a rainy day. To the extent that this entailed giving up holding alternative return-bearing assets like commodities, bonds, equities and foreign currency balances, the holding of money involved an opportunity cost in the form of the rate of inflation, interest rates, yields, equity returns, exchange rates and so on.

In the heyday of fashioning this regime, much effort went into refining econometric methods to improve estimation and also to accommodate more complex dynamics in money demand equations. The US Fed developed the so-called P* (P-star) model, which used the quantity of money and estimates of long-run potential output and velocity (the ratio of nominal income to money) to predict long-run inflation trends.

Once money demand was determined, the money supply could be programmed by the central bank to satisfy it. Currency and deposit liabilities of the central bank, or reserve money, or base money, have a mechanistic relationship with the money supply. Every unit of this high-powered money multiplies itself several times to form the money supply in the economy. By how many times it multiplies itself is driven by the desire of the people for currency relative to deposits. Central banks have the power to dampen the value of the multiplier by asking or inducing banks to maintain higher reserves with them (CRR). Thus, reserve money is the operating target, which the central bank can set to achieve a certain order of change in the money supply. Money demand (or its equivalent in equilibrium, money supply) performs the role of an intermediate variable because it reflects, in a stable and predictable way, the goal variables of monetary policy – growth and inflation.

A new regime with targeting of monetary aggregates at its core took over.

The masterclass continues in Part 5, which examines India’s monetary policy journey from exchange rate anchoring and credit allocation to the taper tantrum and the eventual collapse of the multiple indicator approach.

Masterclass with Michael Patra: Previous Sessions

Part 1:
Central Banking 101: Origins, Ideas and Institutions
Michael Patra begins the masterclass by tracing how central banks evolved from fragile monetary experiments into institutions entrusted with preserving trust, stability and confidence.

Part 2:
Central Banking 101: RBI and the Safeguarding of Confidence
The series then turns to the RBI’s evolution, its expanding institutional role, and the delicate balance between autonomy, growth and price stability.

Part 3:
Central Banking 101: The Rise and Fall of Monetary Policy Regimes
From Bretton Woods to monetary targeting, the masterclass examines how central banks repeatedly reinvented policy frameworks when old anchors collapsed.