Reverting to type — why our central bank never had control of its destiny

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By Cormac Lucey

The Central Bank of Ireland celebrated its 75th birthday recently. This was marked by celebrations alongside a letter reviewing the Central Bank’s history by its former governor Patrick Honohan. An interesting aspect of Honohan’s presentation is that it was only after 20 years of national independence that the CBI was actually established.

This reflects the pattern set in America, where the Federal Reserve was created in 1913 — 137 years after US independence. Yet, back in the 18th century, Alexander Hamilton — the first US treasury secretary, whose historical importance has been re-emphasised recently by the eponymous Broadway musical — had already proposed to establish a national bank to improve the economic stability of the nation.

It was the so-called Panic of 1907 that finally led to the founding of the Federal Reserve. In a three-week financial crisis, New York stock prices fell almost 50% from their peak the previous year. Panic compounded the problems of recessions, and there were numerous bank runs with fearful depositors pulling out their cash.

That crisis was staved off thanks to a private conglomerate, led by JP Morgan, who set themselves up as “lenders of last resort” to banks in trouble. This led to calls for the establishment of a publicly owned and controlled central bank to do that job in future.

There are two important lessons from that episode. First, increases in the power and authority of central banks are generally a response to a financial crisis. Second, it can be profitable to be a lender of last resort. JP Morgan and his associates made huge money by intervening after substantial price falls.

Honohan recounts how it was the approaching Second World War that finally led to the establishment of our central bank. Dublin commercial banks made precautionary inquiries to see if the Bank of England would help out with emergency liquidity if needed in Ireland. This appeal was rejected and Montagu Norman, then governor of the Bank of England, wrote sternly in his diary: “Éire is a Dominion and we in London cannot provide Emergency needs.”

The government then acted on a recommendation made in 1938 by the Banking Commission it had formed to proceed and establish a central bank in Ireland. Without a lender of last resort, the functioning of the Irish banking system could have been disrupted.

With the Bank of England refusing to play this role, the commercial banks’ opposition to the creation of an Irish central bank disappeared and the Central Bank of Ireland was established in 1943. This was four years after war broke out, a familiar slow-paced official institutional response to looming financial crisis.

For the first four decades of its establishment, the job of the Central Bank was relatively simple. The official policy of holding the Irish pound at parity with sterling meant that Ireland had to follow the British lead.

By locking our currency to sterling, we threw away the keys to pursue an independent monetary policy. It didn’t really matter. Ireland and Britain largely fulfilled the qualities needed for an optimum currency zone. Trade between the UK and Ireland was high. Labour markets were fully integrated and there was a strong symmetry in the ebbs and flows of the two economies. An appropriate interest rate for the UK was likely to also be appropriate for Ireland.

The Central Bank became a sort of Department of Finance in exile. The governors of the bank were invariably former top officials from the department. The public utterances of the Central Bank reflected departmental orthodoxy.

Honohan writes of how he found a 1957 letter from bank governor James McElligott to Desmond Williams, a UCD professor of history, in which he complained the college had “one professor of economics and seven professors of Irish of one kind or another . . . and yet we wonder why we are not making more progress in the development of our industry and our agriculture”.

The same complaint could be made today about the mismatch between the broadcast media’s coverage of business versus its coverage of arts and culture.

The equilibrium of Irish central banking was disturbed eventually. The spending desires of western governments proved incompatible with the fixed currency exchange rate system that was set up at Bretton Woods towards the end of the Second World War. The resulting economic instability was visible in currency volatility, unleashed after President Nixon unilaterally ended the convertibility of the US dollar to gold in 1971 and the price instability of rampant inflation that rose steadily over the 1980s.

In a currency premonition predating the UK’s Brexit decision by more than three-and-a-half decades, Ireland opted to join the European Monetary System in 1979 while Britain kept out. That led to the rupture of the Irish pound’s parity relationship with sterling. Ireland then joined the euro while the UK did not.

And there is a lack of symmetry in the ebbs and flows of the economies in other eurozone nations and Ireland, which means an interest rate appropriate for them may be inappropriate for us. Eurozone interest rates that were too low for Irish needs were the main cause of Ireland’s boom up to 2007.

The resulting bust revealed the Central Bank was ill-prepared to act as lender of last resort. It lacked the resolution powers to take the banks into temporary state custodianship while they were repaired. Those powers came only with legislation passed several years later.

The Central Bank of Ireland has now largely morphed into a Dublin branch of the European Central Bank (ECB). It executes monetary policy decisions taken elsewhere. The regulation of larger banks is now the responsibility of the ECB, and our bank gets to regulate the rest. A century ago we didn’t have a central bank with key decisions made in London; today our central bank is in Frankfurt.

Published in The Sunday Times (Ireland edition)
April 15th 2018