Central Bank Autonomy in Mexico / Volume I: The Central Banking System in the World
Author: Eduardo Turrent
Date: 2015-11-13T06:00:00+00:00
Publisher: Banco de México

Central Bank Autonomy in Mexico

A Historical Overview

Volume I

The Central Banking System in the World

Agustín Carstens

Governor

Roberto del Cueto Legaspi
Manuel Ramos Francia
Manuel Sánchez González
José Julián Sidaoui Dib
Deputy Governors

BANCO DE MÉXICO

EDUARDO TURRENT
Project supervision

AÍDA GARCÍA DIMAS
Historical research and project coordination

ANTONIETA CRUZ
Editorial coordination

ANTONIETA CRUZ
GERMÁN GÓMEZ
Iconographic research

NOSTRA EDICIONES
Editing, design, and prepress

SANDRA FERRER ALARCÓN
Graphic and editorial design

LUCERO VÁZQUEZ TÉLLEZ
ROSALINDA RESÉNDIZ PADRÓN
Graphic design

GREGORY DECHANT
Translation

MARÍA ESPERANZA ZOREDA LEE
Translation oversight

LIDIA CASTRO RAMÍREZ
Text transcription

LUIS EKIRO
GERARDO PEÑA TORRES
Banco de México images 2012

We would like to thank the following institutions for their support:
Sistema de la Reserva Federal
Banco Central de Chile
Centro de Estudios Monetarios
Latinoamericanos, CEMLA

Banco de México:
Oficina de Acervo Numismático
Subgerencia de Coordinación de Archivos
Subgerencia de Numismática y Comercialización

The reproduction of the images of banknotes used to illustrate the present work has been authorized by the Secretaría de Hacienda y Crédito Público (official authorization UBA/DGABM/1339/2005, dated November 2005).

First edition, 2012

All rights reserved

BANCO DE MÉXICO
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IEBN: 484-132-000005-28

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Preface

Agustín Carstens
Governor Banco de México

Banco de México’s autonomy, which was granted almost 20 years ago, has brought countless benefits for the country. In Mexico we now have a better standard of living because, among other reasons, the central bank is independent and has the proper monetary tools to assure the purchasing power stability of the currency it issues.

Why must central banks be independent? What does “autonomy” mean? Does the fact that the central bank being a state institution that nevertheless is independent in terms of monetary policy management has rendered benefits for all Mexicans? How is central bank autonomy related to the achievement of its essential objective of ensuring price stability, as stated in our Constitution?

I will try to respond to these and other questions that, quite rightly, are raised by many Mexicans that are not necessarily specialists in economics or monetary policy. By doing so, I will be welcoming the reader to the book “Central Bank Autonomy in Mexico: A Historical Perspective” by Eduardo Turrent, and to its splendid prologue written by Miguel Mancera Aguayo, first governor of the newly independent Banco de México in 1994.

Historical experience has taught us that the banks of issue of legal tender are an invention, almost as useful and clever as money itself. Experience, however, also warns us that central banks can be an extremely harmful tool for the economy of a country if they do not operate under an adequate institutional –that is, a legal– framework that prevents countries from misusing the power they have to create money through them.

As it was mentioned in 1993 in the Statement of Purpose of the Constitutional Reform to Grant Autonomy to Banco de México, throughout the history of our central bank there was always the permanent concern of “controlling in some way the central bank’s credit flow, basically for two reasons. First, the existence of a link between the central bank’s credit flow and the development of prices in the Mexican economy has been known for quite a long time. Second, the loose credit control measures by the central bank have led to the innumerable hardships caused by inflation, still very present in our memories.”[*]

When a central bank is not independent, the major recipient of its credit flows is often the government, which might incur high fiscal deficits. The Statement of Purpose described this illness and its terrible symptoms: high fiscal deficits associated with high levels of inflation; and the most frequent cause of such symptoms: the practically unrestricted amount of financing the central bank could grant the government, who very often demanded it; and, in the end, the solution to the problem: granting autonomy to the bank of issue. “Therefore, if there should be a policy of permanently fighting inflation, it is clearly more convenient to separate the function of creating money from other State tasks, which continuously involve the demand for higher spending.”[**]

And in the last 20 years of Banco de México’s autonomy that is precisely what has happened: for the first time in history, the country and all Mexicans now rely on a permanent policy to fight inflation and we have largely benefited from it.

As a result of Banco de México’s autonomy, its Governing Board analyzes, discusses, and decides with no restrictions the appropriate monetary policy stance at all times and has all the tools to implement it, without interferences of any sort.

Autonomy is not a privilege that favors Banco de México’s officials over other public sector officers. Autonomy is a guarantee for all currency users that Banco de México will not grant credit to the government to finance its spending, and hence that the central bank’s essential mandate is to assure, by all means, that the currency preserves its purchasing power.

Banco de México’s autonomy has been a key ingredient in the low interest rates that we currently have, in the financing in pesos at fixed rates and at terms as long as 30 years, so that the banking system remains solid and resilient.

Over the last 20 years, Banco de México’s autonomy has also overcome successfully two major financial crises. The first one, in 1994-1995, originated by a balance of payments disequilibrium. From that crisis, Mexico, turning need into virtue, decided to embrace a free floating exchange rate system, which gives monetary policy more degrees of freedom to operate. A floating exchange rate system, which has proved successful in Mexico, can therefore be conceived as a reinforcement for the central bank’s own autonomy.

The second one was the great global crisis that burst in the second half of 2008, and whose repercussions are still affecting several advanced economies by keeping them under high fiscal deficits and facing recession. Banco de México’s autonomy has also operated effectively in this environment.

There are some that mistakenly interpret central bank autonomy as if being excluded from the government and its economic policies, or even as if being obliged to confront those policies, as if such attitude were to make Banco de México a permanent counterbalance. This is not the case.

Banco de México’s Governing Law in fact states that the central bank is to be a financial advisor for the federal government. And during these first 20 years of autonomy, the central bank has acted in a coordinated and compatible way with the government’s fiscal and financial authorities in all matters related to macroeconomic policies.

It is true that sometimes autonomy has involved episodes of disagreement between the federal government and the central bank, but these differences, which will most likely take place in the future, refer to very specific situations and have always been resolved through institutional channels.

Mexico has gained many benefits from Banco de México’s autonomy and for that reason it is worth valuing it, understanding it each time better, and standing up for it. It is a guarantee for all. It allows the value of wage-earners and pensioners’ fixed income to be preserved over time, it contributes to wealth creation, and it favors credit granting, providing us with more stable and longer term prospects to frame our future.

The autonomous Banco de México belongs to all Mexicans. That is why our institutional identity spots read: “Take a closer look. It’s your money.”

Foreword

Miguel Mancera Aguayo

Nowadays we are so accustomed to the existence of a central bank in every country, or at least in a group of countries, such as the European Union, that we take the need for such institutions for granted. But we may wonder: Are they or have they always been necessary?

Central banks have not been around forever. Their main raison d’être today is their responsibility for issuing currency. Needless to say, currency —some kind of currency— has long been indispensable to fluid economic transactions, but this does not mean that the currency used in a country has to be issued by a central bank, or even by another entity in the country itself, since it is feasible to use foreign currency exclusively, or almost exclusively, as has occurred, for example, in certain Latin American countries (Panama, El Salvador, and Ecuador). What is clear is that, if a country does not have a currency of its own, it does not need a central bank in the strict sense of the term either.

Although the use of a foreign currency as legal tender saves a country certain efforts and complications, it also deprives it of significant benefits. As a result, most countries prefer to have their own currency. I will not discuss here the advantages and disadvantages of using a foreign currency, since the subject would require more space than this foreword would prudently allow.

It is interesting to consider who issued currency before central banks existed, since most of them were not founded until the nineteenth and twentieth century. Through the eighteenth century, and in most countries in the nineteenth century as well, most currency was issued by governments through the minting of coins. The most valuable issues were gold and silver coins. For a long time, in most places, even the most prosperous ones, governments determined the characteristics of their coinage in so far as its metal content, stamping, weight, and dimensions were concerned. In these metallic monetary systems, however, the authorities did not decide how much money was to be minted, since this was largely determined by the production volume of the mines. In such systems, the government, or an agent, paid for the right to transform into coinage the precious metal delivered to it, by private persons or entities, in the form of ingots or other easily measurable quantities. A natural consequence of this fact was that the excess or scarcity of monetary circulation depended on the success or lack thereof of the mining operations. It is not surprising, therefore, that when large amounts of gold and silver were extracted in the Spanish colonies of New Spain and Peru, the result was a metropolis with one of the highest rates of inflation known to economic history.

In the nineteenth century and, although less often, even before that, commercial enterprises were founded in many countries for the purpose of safeguarding the coins or ingots of precious metals entrusted to them by their clients. Upon receiving the coins or metals, they would issue documents that certified the amount of coin or metal on deposit and promised to return an equal amount on sight to the bearer of the paper. These documents came to be called bills or notes and the companies that issued them, banks. The notes were very practical because they were easy to keep and could be used to pay for economic transactions, if there was sufficient confidence, of course, that the issuing banks would return the corresponding metal when the bearer of the bill or note so requested. These documents gave a remarkable advantage to the banks: they were able to extend credit not only by lending the metal at their disposal in their vaults, but also additional amounts through the delivery of bills or notes to the borrower. By extending credit in this way, the total amount of the notes issued by each bank was greater, obviously, than the value of the metal in its possession. In order for this arrangement to work, all holders of the notes could not come to the bank of issue and request the exchange of their paper for all of the metallic money held by the bank. If this were to happen, the bank would be forced to suspend payments and would eventually go bankrupt.

Given the different degrees of confidence the banks of issue inspired in the public, as well as the variable geographical extension of their operations, it was common that not all of the bills or notes were taken at par value in the market. Whether they were taken with or without a discount, and with how much of one, depended on what the bank of issue was. Of course this situation did not facilitate the development of commercial activity.

These problems are at the origin of proposals to confer the authority to issue banknotes on a single bank. In Mexico, ideas to this effect began to be considered at the beginning of the twentieth century. It was only, however, when the Constitution of 1917 was debated that the creation of a single bank of issue was seriously proposed and accepted. The idea took concrete form with the foundation of Banco de México in 1925.

It is important to remember that, although Mexico has had a single bank of issue since that moment, it did not yet have an institution that monopolized the issue of every kind of legal tender. Mexico was on the gold standard at the time. As a result, the Mint, a department of the federal government, would mint precious metals for private individuals in exchange for payment of the corresponding rights. With Mexico’s abandonment of the gold standard in 1931, and through other measures in subsequent years, the control of issues of metallic money also devolved to the central bank. Today, coins are no different from banknotes, expect for the material out of which they are made.

In all laws that have governed central banks at different times and places, the concern for having a stable currency, in terms of its purchasing power, has always been present. Thus, in times of the gold standard, the authorities established that the monetary unit would be equivalent to so much of the precious metal. In Mexico, during the last years of the gold standard, a peso was equivalent to 745 grams of pure gold. It was also stipulated that the central bank must exchange its banknotes for Mexican gold coins at par and without limitations. Since one of the characteristics of gold was thought to be its superior capacity to preserve its value in terms of purchasing power, the conclusion was drawn that the banknote was a stable currency.

Sometime after the abandonment of the gold standard, what might be called the dollar standard was installed in Mexico. According to this arrangement, Banco de México was obliged to exchange Mexican pesos for US dollars, in unlimited amounts, at an exchange rate the federal government undertook to maintain. Since the dollar was thought to have a relatively stable purchasing power, the pesos acquired the same quality.

This permanent concern with the stability of the purchasing power of the currency, present in the legislation of the most diverse countries in many different ages, demonstrates an acknowledgment, not always explicit, of the correlation between stability and the proper functioning of the economy. There are good reasons to believe in this correlation, since without a stable currency it is virtually impossible to predict the true outcome of contracts that stipulate the payment of pecuniary obligations. Indeed, when the term of payment arrives, the value of the currency may have changed, in terms of purchasing power. In other words, one party will end up paying more or less, in real terms, than what was expected. It is obviously difficult for a market economy to function efficiently in these conditions. Savings and investment decisions become more difficult and riskier, as do a whole range of operations involving payments in installments. It has sometimes been thought that, by means of indexing the amounts of certain obligations, such as those in work or credit contracts, it might be possible to overcome the problems created by an unstable currency. But this resource, useful in certain conjunctures and for certain purposes, can hardly be applied generally, and its indiscriminate use would in any case give rise to other inconveniences no less serious than the ones caused by price instability.

Although the laws regulating central banks have explicitly or implicitly acknowledged the connection between monetary stability and the sound functioning of the economy, not all of them have succeeded in providing effective ways to obtain a solid currency. Economists have always acknowledged a certain inverse correlation —though it is considered far from absolute nowadays— between the amount of money in the economy and its purchasing power. That is why for a long time legislation contained regulations aimed at limiting monetary expansion. In Mexico, for example, the central bank laws previous to the present one imposed certain limits on this expansion. But, as the reader shall see in many interesting passages in this book, these limits tended eventually to be modified or ignored, if they were not rendered irrelevant by the devaluation of the currency in terms of foreign exchange or by the redefinition of the bank’s liabilities. It will be recalled, for example, that for years there was the regulation that the amount of banknotes in circulation plus the central bank’s sight deposits could not exceed four times the value of its reserves in gold, silver, and foreign currencies. In practice this provision was rendered irrelevant by the simple expedient of devaluation, since the value of the reserves as expressed in pesos could be increased by this means.

In order to ensure permanent monetary stability, many countries have recognized the advisability of conferring autonomy on the central bank as regards to its handling of the money supply. Without such autonomy, stability may be achieved at certain times, but not permanently. It may happen when both the central bank and the government that happens to be in power believe in the virtues of a sound currency and act in consequence. Such was the case of Mexico during the long period of economic prosperity that extended from the mid-1950s to the end of the 1960s. Such situations, however, tend not to last. Governments are prey to many temptations to spend more than they can properly finance and therefore resort to excessive credit from the central bank, if existing legislation or indeed the simple abuse of power so permits.

Central bank autonomy consists essentially of the institution’s authority to determine by itself the amount of credit it will extend. Sometimes central banks are spoken of as independent, but this should not be understood to mean they are sovereign entities. This is not the case. A central bank, though autonomous in the exercise of its functions, is a state body, subject to laws not enacted by the institution itself, whose performance is reviewed de jure by various departments of the government, not to speak of international institutions, domestic and foreign analysts, and —increasingly— the general public.

In Mexico, the essence of autonomy has been enshrined in the Constitution, whose Article 28 states unambiguously: “No authority may order the bank to grant financing.” It is fortunate that this stipulation, given the importance of conferring the greatest possible soundness and stability on the central bank, is incorporated in the Constitution itself.

It is through the credit of the central bank that deposits of commercial banks held by it are created. They can be converted into legal tender at any time, in the case of sight deposits, or when they come due, in the case of term deposits. This is why, from an economic standpoint, sight deposits are considered equal to banknotes and are part of what is called the monetary base. The credit of the central bank comes in various forms: as loans to the commercial banks and as government securities acquired on the market, or as so-called external credit, in the form of foreign currencies, made up largely of deposits or securities from foreign banks or governments. The law authorizes —though it does not obligate— Banco de México to extend direct credit to the federal government, but only in very special cases and in modest amounts, at very short terms.

It is through the amounts, interest rates, and terms of its credit operations that Banco de México can influence, as an institution, the intensity of demand for goods and services, or aggregate demand, as it is called, and in this way fulfill its principal legal mandate —enshrined in Article 28 of the Constitution— of ensuring the stability of the purchasing power of the national currency.

In order for it to successfully achieve its goals, the central bank needs more than exclusive control over its own credit and the mandate to ensure monetary stability. It must also perform its functions effectively. This is why the legal provisions that govern the institution are designed to ensure, as far as is humanly possible, its good management. These provisions —based on Article 28 of the Constitution and complemented by the organic law of the central bank— stipulate that the institution be administered by a Board of Governors made up of a Governor and four Deputy Governors, all with a single vote, but with the Governor having the deciding vote in the improbable case of a tie. In addition to possessing certain legal qualifications, members of the Board of Governors are appointed by the President and confirmed by the Senate. Their terms are staggered, so that the more senior members can give the more junior ones the benefit of their experience and in order to avoid major changes in management, which evolves more gradually as the members of the board are rotated one by one.

As we can see, the governance of the central bank is collegial in the true sense, something essential to an autonomous institution. The conduct of such an institution cannot and should not be entrusted to a single person, however qualified, since a single individual is necessarily more prone to error than an entire body of highly qualified officials. Because the Governor is the spokesperson of the institution, the mistaken impression is sometimes conveyed that he makes monetary policy decisions unilaterally.

As we have seen, the Board of Governors system is designed to ensure the best possible management of Banco de México. There are risks however the most obvious being that the persons appointed to the Board are not ideal choices. For this reason, the President and the Senate must take the greatest care and responsibility in their duty of designating and ratifying in their positions the Governor and Deputy Governors. This has always been the case until now, without personal or partisan interests having prevailed in their choices.

The solidity of the precepts on which the autonomy of Banco de México rests, as well as the clarity of its mandate in the conduct of monetary policy, gives reason to expect that the efforts undertaken to reduce inflation will continue, reinforcing that essential basis of economic growth, the stability of the purchasing power of the currency.

In this informative volume by Eduardo Turrent, the prestigious author of several books on Mexican financial history, the reader will find some of the most important episodes in Mexico’s monetary history narrated with great skill, and will be able to follow in detail the long and fascinating path leading to the autonomy of Banco de México.

The Central Banking System in the World

The Constituent Congress and the Banks of Issue

In September 1913 Venustiano Carranza, the First Chief of the Constitutionalist Army, delivered an important speech in the Salón de Cabildos in Hermosillo, Sonora, in which he outlined the new system expected to replace the one that had consolidated itself during the Porfiriato. Of special interest were Carranza’s ideas about currency and the banking system:

We will change the entire banking system now in place… and abolish the right of private banks to issue notes or paper money. The issue of banknotes must be the exclusive privilege of the nation. Once the Revolution triumphs, it will establish the Single Bank of Issue, the State Bank…[1]

Carranza’s speech had a political purpose in opposition to the Porfirian regime, but he was not speaking in ignorance of the mechanics of banking or of the long-term trend toward central banking systems. Even before his important speech in Hermosillo, efforts had begun to be undertaken in the United States which would culminate in the establishment of that country’s central banking system. It should not be surprising that the first tentative project to establish a single bank of issue in Mexico was proposed in 1916, before the enactment of the Constitution. According to that project, the creation of the single bank was to be preceded by a unification of the fiduciary currency, which consisted at that time of banknotes in the hands of the public and Constitutionalist paper money. The single bank of issue that was to be established would immediately have to “confine itself to operations that are permitted, in accordance with the experience of European banks and the most modern principles of banking economy, to banks of issue and discount.”[2]

As pre-Constitutional President of Mexico, Venustiano Carranza convened the Constituent Congress that drew up the new Constitution of 1917. Article 28 of the Constitution stipulated that the issue of banknotes was to be reserved exclusively to the State.

Inevitably, the thorny question of a single bank of issue became a subject of debate during the Constituent Congress in Querétaro at the end of 1916. The Article 28 proposed by the Carranza government did not include the issue of banknotes among the activities to be reserved for the State. In its original version, this important article stated that in Mexico there would be no “monopolies or exclusive rights [estancos] nor exemption from taxes or prohibitions by way of protection of industry.” The draft article went on to indicate the exceptions: the minting of money, postal and telegraph service, and radiotelegraphy were to be the exclusive concern of the federal government. When the proposal was being ruled on, Rafael Nieto, an eminent delegate to the Congress, submitted an important addition to the original article. According to Nieto’s proposal, the issue of banknotes was to be added to the activities reserved exclusively to the State, to be carried out by a single bank of issue which would be controlled by the government. By his intervention, though perhaps without intending to, Nieto made good on the famous promise formulated by the First Chief Carranza in 1913.

No one at the Constituent Congress dared to speak in favor of multiple banks of issue, since this system was identified with the Porfirian regime. The idea that the faculty of issuing banknotes would be reserved to a single bank of issue therefore imposed itself gradually and tacitly. By contrast, the question of the degree of involvement that the government would have in the institution gave rise to a flood of rhetorical give and take, of pros and cons, and imprecise invocations of international experience in the area of banks of issue. Under Secretary Nieto had foreseen that for the moment, all that was required was approval for the principle of a single bank of issue controlled by the government. The specific way in which the institution was to be organized and the formulation of a regulatory law to govern the model chosen would therefore have to wait until later, that is, until the next legislative session. Nieto’s call went unheeded and the debate about the government’s involvement in the institution got underway. The discussion was opened by congressman Espinosa, who brought up the etymology and semantics of the term controlar, a Gallicism whose official meaning in Spanish was “to inspect, examine, or supervise.” Something different, in other words, than the initial idea of having a single bank of issue under the direction of the State.

The thesis finally accepted by the Constituent Congress was that the single bank of issue would be a State institution in the strict sense that the government would hold a majority share in it and could therefore appoint the majority of the members of the Board of Directors. Thus, the groundwork was laid to move on to the delicate question of whether the government would be in a position to abuse its control over the single bank of issue. None of the constituyentes, the delegates to the Congress, went so far as to speak of independence —or, on the other hand, of the institution’s subordination to political interests— but the notion of this danger was clearly formulated in the contributions of at least four orators.

With intuitive insight, the delegate González pointed out that if the word controlar meant that the government had authority over the bank of issue because it “held the majority of the shares, or had the employees, or for any other reason,” the risk of contamination would be high. This would be the case if “the ties between the official power and the institution come to be so strong and positive that they necessarily involve a conflict both to one and to the other at a given moment.” In contrast, and with much less foresight, congressman Zavala did not think it important that, if the single bank of issue was established, in return for the monopoly and “in compensation for the advantages” that implied, it were to “extend to the Government loans free of interest or with derisory interest and at times also a share of the profits.” This quotation precisely reveals the kind of action that might result in a serious deterioration of inflation. In opposition to this, and with the best possible judgment, another delegate, congressman Espinosa, put his finger on the heart of the matter:

The State Single Bank of Issue, according to some theorists, runs the risk of being political rather than financial; banks constituted in this way would always tend to accept letters of exchange from supporters of the Government and would always reject letters from enemies of the Government.[3]

The only known antidote, then or later, to keep the single bank of issue from being subject to political powers or the vested interests of society, whatever they might be, was therefore clearly stated at the Constituent Congress. Nevertheless, no agreement was reached on this fundamental matter, nor was it formally declared to be open for future discussion. Be that as it may, the subject was repeatedly to arise, implicitly or explicitly, within the framework of the numerous draft projects that were prepared and discussed over the following eight years. The idea that the single bank of issue should be under government control would lend itself to different interpretations, as had occurred during the Constituent Congress. In Querétaro, Under Secretary Nieto himself had pointed out that, even if the principle of exclusive issue was accepted, it remained a subject of future debate whether “a private bank, an exclusive State Bank, or a public bank controlled by the Government” would have to be established.[4]

The Constituent Congress assembled in the Teatro Iturbide in Querétaro through the end of 1916 and the beginning of 1917. The delegates agreed on the need for a single bank of issue and debated the advantages that an autonomous institution would offer.

In the very intense —and sometimes quaint— debate in the Constituent Congress in Querétaro about the issue of banknotes and the exclusive competence of a single bank of issue in this matter, various references were made to the central banks that already existed in the world. With good sense, Nieto supported the proposal of a monopoly on issuance by citing the examples of countries that had successfully adopted this formula. Prior to Nieto, congressman Heriberto Jara had already launched this line of argument by pointing out that “almost all European nations had accepted this system —that is, the Single Bank, the State Bank— as the one which gives the best results.” In the discussions that followed at the Constituent Congress the case of the Bank of England was cited at least three times.[5]

It is not surprising that the example of the Bank of England was invoked during these debates: it was the pioneering central bank in world history and possibly the most prestigious among all institutions of its kind. Originally established in 1694, the Bank of England had come to acquire its definitive status as a centralized institution in the course of a long evolutionary process of more than three centuries. This process of successive advances took place in at least four activities. Of primary importance was its relationship with the British government, to which may be added its function in centralizing reserves and acting as a banks’ bank and its role as a lender of last resort. Also of great importance were the Bank of England’s monopoly of note issue and its autonomy. Another significant issue involved the status of the banknotes issued by the institution as legal tender in various stages of its existence.

The Bank of England was not the first bank of issue established in Europe —it was preceded by the Riksbank in Sweden, founded in 1668— but it blazed a trail by becoming a central bank in the middle of the nineteenth century.

Another fundamental concern in the case of the Bank of England was its relationship with the government. Since the institution had been established to extend credit to the government, this delicate function had marked its development from the beginning. The power was expanded every time the equity of the bank increased over the course of the eighteenth and nineteenth centuries. A century after its founding, a controversy arose as to whether the English central bank was authorized to extend credit to the government through the acquisition of government bonds. The debate was settled by Prime Minister William Pitt’s decision to ratify the authorization, but at the same time legal limits were set on this kind of financing. The role of the institution as the government’s banker was consolidated in 1715, when it was agreed that subscription for placements of government debt would be liquidated by the Bank of England. Later on, the institution was even given the task of administering the government’s debt.[6]

Reasonably well-informed concerning the majority of central banks in the world, delegate Nieto cited several cases, apparently well known to him, to back up his argument against a plurality of banks of issue. He did so in the second of his interventions, apparently addressing lingering doubts about the superiority of a central monopoly of note issue over a system of multiple banks of issue. It seems that some of the delegates were hesitating because of their distaste for the term “monopoly,” although it referred to a function —the issue of banknotes— in which the public authorities might be expected to intervene. In order to strengthen his argument, Nieto referred —with apparent knowledgeableness— to the case of Japan, where the government had intervened to move the country from a plural system to a single bank of issue.

During the debates at the Constituent Congress about the single bank of issue, the example of the Bank of France was also mentioned alongside that of the Bank of England. It was brought up in relation to two matters: the advisability of giving note-issuing powers to a single bank and the choice between a private sector institution and a State Bank. Congressman and delegate Espinosa demonstrated that, in the matter of central banks, the world had not decided in favor of either of these two options and that the question therefore remained open for Mexico:

[T]here are State-controlled single banks of issue and banks of a private nature. The former are those whose equity corresponds wholly or partly to the State. This is the case in Russia, Switzerland, and Sweden. On the other hand, the private sector banks, although they are single banks of issue, like those in France, England, and Germany, are made up of private equity, that is, of private individuals.[7]

It made sense to refer to the case of the Bank of France, if the idea was to buttress the argument for a monopoly of note issuance. In France, the institution had acquired its monopoly in a very interesting process of successive stages. In 1803, just three years after the creation of the Bank of France by the government of Napoleon Bonaparte, the institution was granted a monopoly on the issue of banknotes in the Paris region. Between 1817 and 1838, however, nine regional banks of issue were established, until the Bank of France began to compete with them through the establishment of provincial branches. The normative framework of the Bank of France stipulated that, upon opening a branch in a city in which there was no local bank of issue, it automatically acquired exclusive note-issuing powers. A large step was taken with the banking reforms of 1848, when the government made Bank of France banknotes the legal tender of the country. In that same year, all of the regional banks accepted their merger with the central institution and became branches of its network.[8]

The Bank of France’s position with respect to its independence from the central government had been less clear, and even more controversial, since the middle of the nineteenth century. Following the banking crisis of 1848, the important measure of fixing a maximum limit to the issue of banknotes was adopted in France. This limit was originally established in 1848, the mechanism was expanded in 1870, and by 1878 a system of three types of controls was in place: the first was a prohibition against issuing notes of low denominations; the second was implicit in the system of conversion by means of metallic money; and the third fixed a total quantitative limit.[9]

Apart from the Bank of France, other central banks in continental Europe were alluded to at the Constituent Congress, including those of Germany (the Reichsbank) and Sweden (the Riksbank), as well as the banks of issue of Russia, the Austro-Hungarian empire, and Switzerland. The bank of Tsarist Russia was to disappear shortly thereafter, when the Bolsheviks took power and the Soviet Union was created. As a consequence of the First World War, the Austro-Hungarian empire was also dismembered and its central bank would cease to be a reference in Mexico’s efforts to establish a single bank of issue. But this was not the case of the central banks of Germany and Sweden, which were paradigms in the matter. The Bank of Sweden in particular was an exemplary case, having been created even before the Bank of England, although it is true that it became a central bank after its British counterpart.

The question of the independence of the Riksbank is particularly interesting. Although the institution always maintained great autonomy from the Crown, from when it was reorganized as the Riksbank in 1668 it was placed under the authority and supervision of Parliament. As a result of this reorganization, the institution’s capital was supplied by the State and the management of the bank was entrusted to a collegial body appointed by Parliament. The Parliament also passed a law to establish the gold standard in Sweden and to grant a monopoly of note issue to the Riksbank. As Michiel de Kock has written in his exceptional book on the central banking system, the Riksbank “succeeded in acquiring a large measure of independence in matters of banking policy and administration as well as attaining a position of unquestioned leadership in the Swedish financial system.”[10]

Charles A. Conant, a distinguished expert in the field of banks of issue, wrote a voluminous treatise in 1910 on the National Bank of Belgium for the National Monetary Commission, which had been established in the aim of creating a central banking system in the United States. This work may have been familiar to Under Secretary Nieto, who was able to cite the case of Belgium with such confidence. What is of importance here is the metallic backing of the banknotes issued by the Bank of Belgium, which was fixed at 33.3, a limit that could be suspended by the Ministry of Finance in the case of an emergency. As for its management, the governor of the bank was appointed by the Crown but the rest of the board members were chosen by the shareholders and total equity of the bank was in private hands. As a national bank, the Bank of Belgium offered the government the usual services of a centralized institution, but up until the time that Conant wrote his treatise, “the State had kept its hands clean from dipping into the resources of the Bank by loans.”[11] Also, since 1873, a tax of 0.5% had been in place on banknotes in circulation when the balance exceeded a pre-established ceiling.[12]

Much more famous than the National Bank of Belgium in the second decade of the twentieth century was the Reichsbank, or Central Bank of Germany. The Reichsbank had been created in 1875 on the foundation of the Bank of Prussia. Inspired by the British model, it was created as a private equity institution. The French case influenced the management of the bank, whose chairman was nominated by the chancellor and appointed for life by the emperor. Private shareholders made up the central committee.

Karl Erich Born, an important scholar of the institution, wrote at the time that the influence of representatives of the private sector on the Reichsbank was always widespread, as was the notion in Germany that there were many advantages to maintaining a mixed central bank instead of an institution managed solely by the state.[13]

Exactly ten foreign banks of issue were alluded to by delegates to the Constituent Congress. This is not surprising, since banks of issue —whether national or central banks— had already given rise by the first decades of the twentieth century to the publication of various specialized treatises on the subject. One of the principal sources was Charles A. Conant’s A History of Modern Banks of Issue, which went through several editions.[14] From this and other sources it was possible to compile a list of twenty-two national banks of issue, including the outstanding cases of England, France, Germany, Japan, and the United States.

Since the second half of the nineteenth century, civilization had become aware of the economic damage that could be caused by uncontrolled issues of paper money. Indeed, inflation and its harmful consequences had been known since the Roman empire, so it is not surprising that all of the central banks dealt with by Conant were subject to more or less strict rules governing the issue of money. These included three basic mechanisms: one or several limits on the balance of banknotes, requirements for backing in the form of coinage or other assets for the banknotes issued, and the obligation to ensure interconvertibility. In previous ages, limits on the amount of credit a central bank could extend to its government were of great importance. Indeed, the provisions governing this matter, like those connected with metallic backing and limits on the issue of banknotes, became part and parcel of the independence or autonomy granted to the central banks. In the period just after the First World War, this was particularly true of the Bank of Spain and the Bank of England, for which limits were fixed on the basis of equity.

In the case of all the central banks in question there were limits on banknote issue, though these could be modified in some cases, such as that of the National Bank of Belgium. The other side of the coin was the requirement for backing up issues of paper money. In many countries —for example Belgium, Holland, Spain, Bulgaria, and Portugal— this guarantee consisted of a 3-to-1 ratio of metallic coinage with respect to the notes in circulation. In a smaller number of cases a second guarantee was required for issues not backed by metal. The Bank of Portugal, for example, demanded that banknotes not backed by metal were to be guaranteed by a first-class liquid portfolio. In the case of the Bank of Japan, the issue of banknotes up to its official limit had to be backed by a high-quality portfolio; above that limit, the backing had to be entirely in metal.

The obligation to ensure that the banknote could be redeemed was always a powerful incentive for banks to commit themselves to a prudent issuing policy. Sooner or later, overly exuberant issues would lead to a loss of trust in the notes. From there, it was just another step to finding a crowd of banknote holders demanding metal coinage in exchange. This had been confirmed by the experience of the Bank of England, which on two occasions —in 1697 and 1797— had been forced to suspend the redemption of its banknotes. The same thing had happened, even more often, to the Riksbank in Sweden, and in every case the cause of the problems had been the credit granted to the government. In short, strict limits on issues, primary and secondary backing of paper money, the obligation to ensure notes could be redeemed, and limits on the credit granted to the government were the pillars of the sui generis judicial figure of that period known as central bank autonomy.

The Federal Reserve System

It is strange that, during the most heated stage of the constitutional debate, the most foresighted of the delegates to the Congress on the questions of note issue and a single bank of issue did not invoke, in order to buttress his case, the example of the central banking system in the United States. Perhaps Nieto did not draw on this argument because his knowledge of developments in the United States was out of date. Carranza’s Under Secretary of Finance was apparently not aware, toward the end of 1916, that the creation of the Federal Reserve System in 1913 had definitively installed the principle of a central bank in the United States. He was blatantly mistaken when he affirmed, as he did to the Constituent Congress, that “among advanced countries only the United States maintain the principle of multiple banks of issue.” If he had not been suffering from this misconception, Nieto would have been able to wield with greater force his undoubtedly correct thesis that “in all more advanced countries the principle is gaining ground that it be a single Bank that issues notes.”[15]

There had been at least two failed projects in the history of the United States that would have allowed the country to advance in the direction of a monopoly of banknote issue. It had fallen to the first Secretary of the Treasury, Alexander Hamilton, to lay the foundation for the first Bank of the United States. Hamilton dreamed that this institution would come to possess the same capacity to influence the development of the banking system in his country as the Bank of England had had.[16] In spite of the antagonism caused by the proposal, Hamilton succeeded in convincing President Washington of the advantages of the project and presented his bill in 1791. The government was to subscribe 20% of the institution’s capital, leaving the majority of votes on the Board of Directors in the hands of private investors. Also, it would be prohibited to establish another similar institution for the term of the bank’s charter. The limit for issuing notes would be that of the bank’s capital stock. As for credit to the government, this would be limited to an amount equal to the government’s contribution to the capital, that is, 20%.

The first Secretary of the Treasury, Alexander Hamilton, conceived the project to create the first Bank of the United States, which did not manage to survive.

The first Bank of the United States was unable to endure. Strong political opposition to the bank manifested itself from the beginning, on the grounds that the government lacked the constitutional authority to create a banking corporation. Further opposition to the renewal of the charter came from the so-called state banks, which saw in the national bank a danger to their interests. No less farseeing than his predecessor Hamilton, Secretary of the Treasury Albert Gallatin appealed in vain for a renewal of the charter, with an increase in the capital stock and in the proportion of credit that could be granted to the government. Gallatin adduced to no avail the advantages that the government would derive from the institution: the safekeeping of public funds, the ease with which these funds could be transmitted, operational support for tax collection, and the possibility of obtaining credit.[17]

In 1812 war broke out between the United States and England and two years later the new Secretary of the Treasury, James Dallas, declared that the only way to restore the public credit would be by establishing a national bank with sufficient capital and ample lending powers. At first President Madison resisted the proposal, but it was finally approved by Congress in 1816. On the model of its predecessor, 20% of the capital was subscribed by the government and the limit on note issue was determined by the amount of the capital stock. There is no mention in the sources consulted of an explicit limit on financing to the government, but it is clear that the institution’s mandate included handling Treasury funds.

The details of its operations, however efficient or inefficient these may have been, had little to do with the disappearance of the second Bank of the United States. The problem was legal, or rather legalistic, and vested interests can be glimpsed behind the political and legislative battles that took place around the bank. In spite of vigorous lobbying by Nicholas Biddle, the prestigious president of the institution, the bank was unable to survive. Although a bill to extend the charter was approved by both houses, it was vetoed by President Andrew Jackson.[18]

Between the closing of the second Bank of the United States in 1816 and the outbreak of the Civil War, banknotes were issued by an increasingly large group of local banks. The government modified this system, adopting one of issue based on federal banks, which issued government banknotes even when they functioned as commercial banks.

As the Civil War loomed, the governments of both the Secessionist South and the Unionist North had three methods of financing their respective war efforts: more taxes, the placement of government debt, and the issue of paper money without metallic backing. From the beginning of the conflict, in 1861, the Lincoln administration opted for the third method. It did not take long for the inflationary effects to be felt. Circulation of the so-called greenbacks (owing to the green paper on which they were printed) and “legal-tender notes” multiplied, going from 21 million dollars in 1860 to 612 million dollars in 1864. The effects of these issues on rising prices were considerable. All prices, including that of gold bullion, of course, rose continually, as people scrambled to turn their monetary surpluses into goods and services. When the Civil War ended in 1865, price levels were twice as high as they had been in 1860.

The creation of the system of national banks was to some extent a consequence of the harmful effects of this inflation. First of all, the new system would make it possible for bank charters to be issued in uniform fashion by the federal government, instead of by local authorities, as had been the case with the state banks that had proliferated in the antebellum years. With regard to the issue of banknotes, the new system offered two advantages. First, it would allow for a single type of note created by a single authority: the office of the Comptroller of the Currency, which was in charge of supervising the banking system. The second advantage was that these issues had to be backed up by government bonds, offering an excellent opportunity for capturing resources.[19]

From the period after the Civil War to the establishment of the Federal Reserve, the monetary system that existed in the United States was far from ideal. The lack of order came mainly from the existence of a wide variety of instruments of circulation. Having arisen for different reasons, these currencies were not issued with a single purpose. Defective as the country’s monetary system was, the banking system was even worse. As vested interests and other structural rigidities that obstructed its reform, the banking crisis of 1907 finally struck.

Silver certificates were backed up by existing silver reserves. The Treasury acquired silver largely to support the regions where the precious metal was mined.

The monetary system can be characterized by the U.S. currency known as “greenbacks.” A direct offspring of the Civil War, these notes had been issued to finance in part the Unionist war effort. This explains why their circulation increased so rapidly, to a total of 449 million dollars by January of 1864. It is interesting historically to note that they continued to serve as legal tender until well into the twentieth century. In 1875 negotiations began on a reform whereby these notes were made convertible again. Part of this reform was a plan to gradually withdraw the greenbacks, though it was never carried out. Thus, in 1878, the decision was taken to fix the total amount of these notes at 347 million dollars, a level which remained unchanged until the middle of the twentieth century.[20]

In the half century leading up to the creation of the Federal Reserve there were three types of certificates in circulation: gold certificates, silver certificates, and the so-called treasury notes of 1890. In 1863, Congress authorized the Department of the Treasury to issue gold certificates against deposits of gold bullion in the Treasury. These certificates continued to be issued even after greenbacks became convertible again and they circulated with full backing in metal. In 1886 Congress authorized the issue of silver certificates in denominations of 1, 2, and 5 dollars, so that greenbacks with a face value of 5 dollars need no longer be issued. It was a question, therefore, of a practical decision by the monetary authorities. These instruments must have satisfied a considerable monetary need, in so far as they increased in circulation from 6 million to 316 million dollars in just a decade following 1880. The Treasury notes of 1890 also affected the movement in favor of the monetary uses of silver. Thus, by the Sherman Law of 1890, the Treasury Department was authorized to acquire silver in return for the above-mentioned notes. Statistics show that the circulation of these instruments increased from 50 million dollars in 1891 to 115 million dollars in 1897.[21]

In the period between the end of the Civil War and the foundation of the Federal Reserve the national banks were of central importance in supplying currency. It was a curious system under which a large number of banks were authorized to issue a single type of currency. These issues were designated “national” because the operating license of the issuing banks had been granted by the federal government, though they belonged to a banking system fragmented into purely local institutions. This is reflected in the number of these banks, which rose from 3,935 in 1900 to 7,514 in 1913. As Friedman and Schwartz point out, the note issues of the national banks can be considered governmental inasmuch as they were backed up in the issuing banks by assets consisting of government bonds. The backing of these issues therefore had nothing to do with the solvency of the intermediaries and the balance of banknotes depended basically on the availability of government bonds.

Table 1 presents an overview of the kinds of currency circulating in the United States during the decades leading up the establishment of the Federal Reserve System. In general terms, currencies during this period included three types: metallic coins, government paper, and banknotes issued by national banks. The metallic currency consisted of gold and silver coins. Among the different types of government paper there were four currencies in circulation: US banknotes (greenbacks), gold certificates, silver certificates, and Treasury notes of 1890. The national banknotes were the notes issued by the national banks.

Table 1
United States
Currency in Circulation
(millions of US dollars)

Years

Gold

Silver

Greenbacks
(US banknotes)

National
banknotes

Treasury notes
1890

Other

1867

284

16

744

584

-

248

1880

316

64

320

339

-

426

1890

640

369

347

182

-

421

1900

916

76

347

301

-

-

1913

1871

175

347

745

569

-

Source: Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963), pp. 17, 131, and 180.

Although the focus of the present work is on non-metallic currencies, the subject of gold and silver coins deserves a brief mention. According to Friedman and Schwartz, by 1867 gold coins accounted for 14.5% of the domestic money stock. This important monetary element varied in value, inasmuch as there was a floating exchange rate in the United States until the country took the very important step of adopting the gold standard, at an official parity of 23.22 grains of pure gold to the dollar. Thus, under the system of free minting then in effect, anyone could redeem gold ingots at the Mint at a rate of $20.67 an ounce.[22]

The Federal Reserve System is a decentralized organization consisting of twelve regional banks, including the Federal Reserve Bank of New York. The headquarters, where the Board of Governors holds its sessions, is located in Washington, D.C.

The era of semi-fiduciary silver coinage in the United States began in 1878, with the passage of the Bland-Allison Act, which required the Department of the Treasury to purchase between two and four million dollars of silver at market prices every month. The metal would be minted into “silver dollars” with a unitary weight of 412.5 grains. This coin was semi-fiduciary insomuch as the value of its silver content was always less than its face value. The Department of the Treasury was not obliged to put these pieces in circulation so long as there was a budget surplus. Nevertheless, the Treasury often used its silver reserves to purchase government bonds over the following years.

The flaws in the banking and monetary system in the United States were manifest, there for all to see. Complacency with the status quo, however, the strength of vested interests, insufficient foresight, and the force of inertia impeded preventive correction of these defective structures. It would take the damaging banking crisis of 1907, with the consequences of economic collapse and suspension of payments, bankruptcies and loss of savings, for the authorities to react and lay the foundations for a central banking system in the country. In his book The ABC of the Federal Reserve System, Professor Edwin Kemmerer (the “Money Doctor”) explained the deficiencies of the banking system in the United States, showing that they were basically the result of an inability to apply effective monetary regulation and of the absence of a lender of last resort in the event of a banking crisis.[23]

As for the obstacles to applying effective monetary regulation, Kemmerer identified five problems: the dispersion and immobility of reserves; the rigid and cyclical character of the mechanism for issuing banknotes and withdrawing them from circulation; the inelasticity of this mechanism in the event of crisis situations and suspensions of payment; the imperfection of the system of payments in the case of foreign checks and other similar instruments; and the inefficient and costly decentralization of the mechanism for administering the federal government’s deposit currency. At the same time, all of these flaws made it impossible to apply a functional mechanism for last-resort lending.

In order to correct these deficiencies, explained Kemmerer, several mechanisms needed to be created: a system to centralize bank reserves and make them easily available to be used where they were needed; a mechanism for issuing banknotes with sufficient flexibility to adapt to cyclical fluctuations in the demand for means of payment; a functional and efficient system of payments and settlement; and a modern, centralized, and flexible procedure for administering the Treasury of the federal government.

The need to solve all these problems in one fell swoop led to the establishment of the Federal Reserve System. Given the importance of the economy of the United States in the world, its geographical proximity to Mexico, and the fact that it had preceded its southern neighbor in the creation of a central bank, made it an indispensable reference in the march toward fulfilling the stipulations of Article 28 of the Constitution of 1917. As we can see, the problems had been very different in the two cases. In Mexico it was necessary to reconcile the public with the idea of paper money and to create a system for issuing notes to replace the mechanisms in place during the Revolution, of which nothing could be salvaged. In the United States, all that was needed was the substitution of the ineffective system in place by one which would remedy its defects. Although Kemmerer did not formulate the problem in this way, he was suggesting that an elastic and flexible mechanism for issuing banknotes would correct almost by necessity the rest of the deficiencies that the 1907 banking crisis had brought to light, on the understanding the bank reserves would be centralized in the new organization, which would be equipped with efficient mechanisms for expediting payments and administering the funds of the federal Treasury.

One consequence of the establishment of the Federal Reserve System was the acceptance in the United States of a legal principle that had been abhorrent for many decades to large segments of the population, who found in turn a defense of their views in Congress: the monopoly of banknote issue. Created along with the new institution was the Federal Reserve note, which through a long and gradual process was to replace definitively the gold certificates and other currencies circulating in the United States. From a monetary —or rather circulatory— viewpoint, this meant implicitly that there was a new medium of payment in the issue of which the public sector would not participate. This new medium would replace others that were issued by the Treasury and that still recalled an age when money was merchandise.

A well-worn example of a “greenback” (so called because it was printed with green ink), the celebrated currency that circulated widely from 1864 to 1914 and even afterwards.

There was another facet of the Federal Reserve System that would come to play a fundamental role in the development of a central banking system in Mexico. It was significant to the work of founding the institution and would continue to be so in the course of its evolution. This important aspect was the independence or autonomy of the Federal Reserve. Since the establishment through the Aldrich-Vreeland Act of the National Monetary Commission, which would carry out the reforms required by the monetary and banking system in the United States, it was clear that an independent institution was to be created. The first sign of this intention to create an independent institution was the makeup and functions of the highest governing body within the Federal Reserve System: the Board of Governors, which convened in Washington, D.C. Until 1935, two members of the board served exofficio —the Secretary of the Treasury and the Comptroller of the Currency— while the rest were appointed by the President with confirmation by the Senate. The members of the Board of Governors are expected to represent the different sectors of the economy and the geographical regions of the country. At least two of them should be persons widely known for their knowledge and experience in the areas of banking, finance, and currency.

In his book on the independence of the Federal Reserve System, Jerome Clifford has argued that in the United States, for structural and historical reasons, the autonomy of the institution is understood to exist with regard not only to the government —the executive and legislative branches— but also to the banking sector.[24] The author justly underlines the notion that it was considered undesirable for the Federal Reserve to be subordinated to the commercial banks. The commercial banks had a role to play, exerting influence over the central bank, but obviously not controlling it.

The Federal Reserve was to be organized in such a way as to guarantee its independence from the government and the banking sector while at the same time ensuring its ability to operate in function with these two entities. Three fundamental measures were adopted. The first was to make the twelve regional reserve banks, each of which was organized in the same way, independent of each other and of the government. Steps were taken to ensure that the control of these regional banks was equally distributed, with no sector in particular exerting undue influence. The second measure concerned the supreme governing body of the institution, its composition and operational powers. I am referring, of course, to the Board of Governors, which has been described above. The third measure had to do with the operations involved in the issue of banknotes.

Another important chapter in the creation of the Federal Reserve System concerned its relations with the legislative branch. The close relationship of the institution with Congress ensured that autonomy would not come to signify isolation. Another issue was that of the rendering of accounts. If the Federal Reserve System was to be independent, then it also had to answer to society with regard to its performance. The obvious channel for this function was the Congress. It is remarkable that, over the course of the years, all of these issues have maintained the importance they had when the system was created in 1913 and 1914.

The well-known seal of the Federal Reserve System, which appears on all legal tender in the United States.

New Central Banks

By 1920, the doctrinal, institutional, and political foundations had been laid for the creation of many new central banks in the world. In his important book on the central banking system, Michiel H. de Kock listed the institutions established in the decade of the 1920s.

Central Banks Established in the Decade of the 1920s[25]

1921

South African Reserve Bank
Bank of Latvia
Bank of Lithuania

1923

Bank of the Republic of Colombia

1924

National Bank of Hungary
Bank of Poland
Bank of Danzig
Commonwealth Bank of Australia and Bank of the Republic of Uruguay converted into central banks

1925

National Bank of Czechoslovakia
Central Bank of Chile
Central Bank of Guatemala
Banco de México

1927

Central Bank of Ecuador
Bank of Estonia converted into a central bank

1928

Central Bank of China

1929

Central Bank of Bolivia

In the establishment of many of the central banks that opened their doors in the third decade of the twentieth century, the influential American economist and professor Edwin Walter Kemmerer played an important role. Professor Kemmerer’s adventures as a consultant all over the world were part of a widespread intellectual and diplomatic process that involved many other consultants from the United States, a movement of monetary, economic, and financial reformers who visited countries on every continent. Often hired by the governments of the countries they visited, they helped to reform, with different degrees of success, the economic systems of the nations that called on their services. None of these consultants achieved the celebrity of Kemmerer, however, who was nicknamed the “Money Doctor” for his collaboration in reforming the monetary systems of at least five countries. Kemmerer’s services focused not only on installing or restoring the gold standard but also on a range of further issues: renegotiating foreign debt, implementing monetary and banking reform, reorganizing the tax and duty systems, and the subject of the present work, the establishment of central banks.[26]

The well-known and —in his time— successful “Money Doctor,” Edwin Walter Kemmerer, an American professor and international consultant who participated actively in the establishment of central banks in Colombia (1923), Chile (1925), Ecuador (1927), Bolivia (1929), and Peru (1931).

In Latin America, the governments of five countries consulted directly with Professor Kemmerer in the creation of their respective central banks. These banks, in chronological order, were the Bank of the Republic of Colombia (1923), the Central Bank of Chile (1925), the Central Bank of Ecuador (1927), the Central Bank of Bolivia (1929), and the Central Reserve Bank of Peru (1931). All except the last two were newly-created institutions. In Bolivia, the central bank was the result of the reorganization of the former Bank of the Bolivian Nation, while in Peru the new central bank emerged from the Reserve Bank that had been founded in 1922.[27] In Mexico, Kemmerer was invited by the government of Venustiano Carranza in 1917 to visit the country and offer advice concerning the reimplementation of the gold standard. There are several possible reasons why the famous Princeton economist was not called on years later to participate in the establishment of the central bank in Mexico.

The Banco de Chile and Banco de México were created by almost parallel processes. Why was it in Chile and not in Mexico that Kemmerer contributed directly to this foundational act? First of all, the historical background was an important factor… Kemmerer’s 1917 mission in Mexico provoked nationalistic repudiation in certain circles and a confused debate in which the “money doctor” had declined to participate —but silence implies acquiescence. Moreover, the monetary missionary had shown little sensitivity to the very difficult social and political circumstances in Mexico at the time and his proposals there were not exactly crowned with success. Finally, the government in Mexico almost eight years later was very different from the one that had hired Kemmerer in the first place in 1917. It was not by chance that it had seized power from the Carrancistas by force of arms.[28]

But before Chile and Mexico, Colombia had managed to establish its central bank. In recent time Colombian scholars of currency and the central banking system have argued about the degree of influence Kemmerer and his band of experts had in the establishment of the Bank of the Republic in 1923. It is true that there had been precedents and documents in Colombia which had contributed various essential elements to the organizational and operational framework later incorporated into the Organic Law of the Bank of the Republic. The argument is buttressed by the fact that these principles were not only to be found in documents but even in bills and statutes. Nor was it by chance that several influential individuals in Colombia agreed with Kemmerer’s proposal for a gold standard and a functional central bank based thereon.[29] Nevertheless, these pioneering initiatives cannot efface the real influence of the Kemmerer mission and the man who headed it. The mission was very important in making politically and legislatively viable the project of a central bank, for which there was already a need in Colombia. Kemmerer’s intervention was not only essential to the realization of this project but also propitious in terms of the moment in history at which it came.

Coinciding, as we have seen, with bills and statutes already drafted in Colombia, Kemmerer designed for the Bank of the Republic a model inspired by, or at least fairly similar to, the Federal Reserve System.[30] The Organic Law of the Bank of the Republic called for an institution in which one half of the capital was paid in by the government and the other half by private banks, local or foreign, and individuals. The Board of Directors would have ten members, four of whom would represent the local banking system, two others the foreign banks, three others the different productive sectors, and the remaining one the individual shareholders. With the authorization of Congress, government bonds could be converted into shares of alternative series (corresponding to the banks or to private individuals) and the institution’s capital could be increased without an increase in the shares held by the government. One scholar has clearly seen the intention in the law to create a mixed institution with considerable independence from government influence.[31] This principle was confirmed by the ceiling imposed on credit granted to the government, which could not be more than 30% of the paid capital plus reserves, with the approval of a qualified majority of the Board of Directors required for operations of this kind.

The Organic Law granted the Bank of the Republic a virtual monopoly over the issue of banknotes, also fixing the highest level of backing in metallic currency of any central bank in the world: 60% of the notes issued plus the deposits in banks in London and New York. Even more surprising was the proportion of metallic reserves, during the first seven years of the institution’s existence, to the balance of banknotes in circulation: a little more than 127% on average. This confirmed the fact that the first administrators were even more stalwart defenders of the gold standard than Kemmerer himself. Moreover, during this entire period the portfolio of loans to the government remained well under the legal limit of 30% of paid capital plus reserves. Thus, the scholar who has most closely studied the career of the celebrated Princeton professor has written:

Numerous interviews with Colombians had reinforced Kemmerer’s conviction that government should have a minimal role in the central bank. Colombians saw insulating the Bank from government interference as the paramount consideration because of past inflationary abuses, [and] because of monetary orthodoxy in the period…[32]

Kemmerer’s participation in the foundation of the Central Bank of Chile also makes for a fascinating story. According to the institution’s own brief account of its history, by the beginning of the 1920s, “Kemmerer was already an acknowledged international expert, who participated actively in debates on monetary systems and was identified as a firm supporter of the reestablishment of the gold standard and of the creation of independent central banks.” Thus, an important preliminary was the interview between the economist and President Arturo Alessandri in 1922, at which the latter expressed his interest in hiring a mission of experts to advise on the founding of a central bank in Chile. Not long thereafter, in February 1925, through the good offices of Mathew, the Chilean ambassador in the United States, an agreement was reached to hire the mission of experts, to be headed of course by Edwin Kemmerer.[33]

It was Arturo Alessandri’s idea to hire Professor Kemmerer to help with the establishment of the Central Bank of Chile. The project finally came to fruition when Alessandri was elected president of Chile in 1925.

The political and economic situation of Chile at the time was propitious for the work of the mission. After a few weeks’ work the draft projects were drawn up and quickly approved by Congress, for both the implementation of the gold standard in Chile and the foundation of the central bank. What Kemmerer and his team proposed in terms of a central bank involved virtually no technical innovations, but “the value of Kemmerer’s mission was the external political validation of an eminent economist.”[34] The Law of the Central Bank of Chile stated that the purpose of the institution was the stabilization of the currency and the regulation of interest and discounts rates, “in order to avoid disturbances in the industrial and financial development of the Nation and to foster its economic progress.”[35] In addition, it was granted a monopoly over issuing banknotes, albeit with the commitment to maintain the gold standard, which fixed an unchanging parity for the Chilean currency. To this end, it was decided that the gold reserves backing up note issue would amount to no less than 50% of the banknotes in circulation and of the deposits of shareholding banks and the general public. According to Kemmerer, this guarantee was intended to inspire confidence, especially when the Bank was just starting up its operations.[36]

The key point of the law was the legal autonomy conferred on the Central Bank of Chile. In his “Statement of Purpose,” Kemmerer gave great importance to the subject of autonomy or independence, which he considered a fundamental requirement of the institutions, having observed a “widespread and deep-seated fear in the public… that the Bank would be subject to the illegitimate influence of the government.” Thus, the autonomy of the Central Bank of Chile rested on four pillars: the makeup of the capital stock, the membership of the Board of Directors, the regulations governing the distribution of earnings, and the limit on the amount of credit that could be granted to the government. The capital stock consisted of series “A” shares —held exclusively by the government and limited to a 13.3% share of the paid capital— and series “B,” “C,” and “D” shares, reserved to domestic banks, foreign banks, and the general public, respectively. As for earnings, after a fixed proportion was provisioned for reserve funds and other ends, dividends were distributed equally among all the shareholders. The Board of Directors, made up of ten members, was mixed in terms of the types of shares represented. Seven of the directors were appointed by series “C” and “D” shareholders and the remaining three were to represent the productive sectors, including a representative of the workers’ sector. Finally, the law set a limit on credit to the government even more rigorous than that of the Bank of the Republic of Colombia: a maximum of 20% of paid capital and reserves.

The other central banks in Latin America were established after Banco de México, which opened its doors at almost the same time as its Chilean counterpart. Nevertheless, Kemmerer and his missions had left their imprint in the countries of the region on economic thought about central banks.

A draft project to create a central bank on the Kemmerer model contained standard clauses with regard to objectives, capital, management, independence from the government, exclusive right to issue banknotes, financial transactions, and other subjects. Kemmerer proposed a central bank whose main purpose was the stabilization of the currency, which presupposed adopting and following the rules of a qualified gold standard. The bank was to be the owner and administrator of the international reserves and was to possess a monopoly on the issue of paper money. Its capital was to be subscribed and paid in by both the government and the general public. The makeup of the Board of Directors was to guarantee ample representation of the different sectors of the community and at the same time ensure that no single one of them had a decisive influence on its decisions. Note issues were to be largely backed up by gold reserves and/or convertible currencies, while a lesser share could be of a fiduciary nature, since the central bank would be authorized to perform short-term rediscount transactions in limited amounts. The bank would perform transactions with shareholding banks and also with the tax authorities.[37]

Professor Kemmerer’s intervention was a decisive factor in the founding of the Central Bank of Chile. This photograph, which shows the American economist in the company of Valentín Magallanes, the Chilean Finance Minister, was taken on Kemmerer’s arrival to the country. All these processes in which the “Money Doctor” participated led to the establishment of autonomous central banks.

Of great importance to the creation of a central bank in Ecuador was the period of high inflation through the early years of the twentieth century. The domestic price index went from 130 in 1915 to 194 in 1921, before leaping to 245 in 1926, precisely when Kemmerer’s mission arrived in the land of volcanoes. The country’s system of multiple banks of issue, based mainly in the port of Guayaquil, became the target of those protesting the price rises, and not without just cause. What the circumstances implicitly demanded was the establishment of a central bank which would provide responsible management of the currency. Another significant circumstance was that Ecuador had already established a sort of primitive central bank through the creation of the Central Issuing and Amortization Fund. This institution was authorized in a limited way to place notes in circulation.[38]

Growing inflation was one of the causes of the political unease in Ecuador and one of the reasons put forward to justify the coup d’état carried out by a junta of young army officers against President Gonzalo Córdova Leguía in July 1925. The coup installed an authoritarian reformist government that sought to modernize the country and in particular the currency and banking sector. The decision to hire the Kemmerer mission was a direct result of this aspiration. Kemmerer’s acceptance of the invitation was interpreted as an implicit endorsement of the junta, involving the economist willy-nilly in the local political situation. Indeed, Kemmerer supported the idea that the return to democracy be postponed until the necessary monetary, banking, and fiscal reforms had been implemented. Since the junta was far from enjoying the support of all Ecuadorians, the tacit approval of the head of the monetary mission provoked strong criticism from nationalist quarters. One of the accusations was that the hiring of the group of consultants and their activities in the country simply constituted flagrant foreign meddling in the internal affairs of the nation.[39]

Owing perhaps to the ample support received from the government, Kemmerer made much more ambitious proposals in Ecuador than in his other adventures as a consultant in South America. In Ecuador the mission proposed reform measures in the areas of currency, the banking system, mortgage and agricultural loans, and credit instruments in general. Within the framework of currency matters, two projects were encouraged: the implementation of the gold standard and the establishment of a central bank. In his history of the Central Bank of Chile, Carrasco points out that the model recommended by Kemmerer for Ecuador was exactly the same as the one he had proposed for Chile.[40] Obviously, one of the tasks of the new single bank of issue would be the maintenance of the gold standard.

The reforms proposed by Kemmerer in Chile also attracted the attention of the government in Bolivia. The Bolivian president, Hernando Siles, sent envoys to Chile to report on what the Money Doctor had achieved there. On the strength of a favorable recommendation, the Bolivian government contacted Kemmerer through its consul in New York. As in the case of previous missions, Kemmerer organized a team of consultants who proposed reforms in a wide range of areas: currency and the banking system, taxes and budgets, customs, railways, public credit, and financing systems. Kemmerer and his group worked under the direct supervision of President Siles and, in the economist’s view, the innovations they proposed offered “technical prestige” to Bolivia. At the time, unlike Ecuador and to some extent Chile, Bolivia was not suffering from inflation or any devaluation of its currency. Also, the country already had a central bank authorized to issue banknotes and perform other related functions.[41]

The headquarters of the Central Bank of Ecuador, also founded with the decisive help of Edwin Kemmerer, the “Money Doctor.”

The Bolivian government organized three commissions to draft the required bills, working in collaboration with the Kemmerer mission. The currency and banking commission produced a draft law for the central bank. Since such an institution already existed in the country, the work of the mission and the local committee consisted of making the necessary modifications in order to achieve the desired “Kemmerer model.” Although some critical voices were raised against the prospect that the Bank of the Bolivian Nation would lose its ability to extend credit, because of the weakness of the local banking system, support for the “scientific” modernization of the central bank was almost unanimous. The existing institution had been sharply criticized for its inability to implement the gold standard in Bolivia and for the drop in metallic reserves to back up issues of banknotes, which had fallen from 42% in 1923 to 33% in 1925. The Bank of the Bolivian Nation had also been criticized for competing with local commercial banks and for yielding too readily to government demands for credit.

As in all the previous Kemmerer missions, the one to Bolivia helped to implement the gold standard and establish an official parity for the national currency.[42] The most outstanding features of the new central bank law concerned the makeup of the Board of Directors, the metallic reserves required for the issue of banknotes, and the limits on credit granted to the government. In the matter of the Board of Directors, Kemmerer’s intention that the government be less represented than the country’s economic sectors is clearly observable. Apart from the two directors appointed by the government, there would be two appointed by the commercial banks, two appointed by private shareholders, and two more appointed by separate associations of miners and merchants. Also, at least 50% of the sum of banknotes in circulation and deposits in the central bank had to be backed up by metallic reserves. Finally, regarding the credit the institution was permitted to extend to the government, Paul Drake has written:

The greatest fear among Bolivians was that voracious politicians would bleed the bank. In response, Kemmerer established the rule that loans to the government could not exceed 25 percent of paid capital and reserves, or 35 percent in emergencies. Although the Bank of the Bolivian Nation had had a legal ceiling of 20 percent, its extensions to the treasury had far exceeded that limit.[43]

Edwin Walter Kemmerer, the omnipresent Money Doctor, also played a crucial role in the economic reforms carried out in Guatemala, one of which consisted of the establishment of the central bank. Kemmerer’s contact with Guatemala was even prior to his involvement in South America with Colombia, Chile, Bolivia, Ecuador, and Peru. The little Central American country had an oligopolistic system of a small number of banks authorized to issue banknotes and make loans to the government, which together constituted a considerable debt. In 1919 the government of President Manuel Estrada Cabrera invited Professor Kemmerer to provide a diagnosis and propose the required reforms. As part of his proposals Kemmerer recommended the creation of a central bank with exclusive note-issuing powers and the other functions typical of an institution of this kind. This program of reforms to which this project belonged failed to be implemented, however, as both President Estrada and his successor Manuel Herrera were overthrown in successive coups.

The program of reforms was finally executed by President José María Orellana. In 1923 Orellana’s government had already created a Regulatory Bank in the aim of stabilizing the exchange rate and laying the foundation for a future central bank. The following year the Guatemalan government invited Kemmerer to participate again and he made essentially, with certain formal modifications, the proposals that had been set out in Colombia, Chile, Bolivia, Ecuador, and Peru. In November of 1924 a law was enacted to make the quetzal the national currency and preliminary measures were adopted for the implementation of the gold standard. In 1925 the legislature began to work on the creation of the central bank, which eventually opened its doors in June 1926. Kemmerer always insisted that the institution be endowed with the autonomy indispensable to carrying out his commission to maintain the gold standard.[44]

Professor Edwin Kemmerer worked as a consultant for Peru in 1931. His work led to key reforms implemented by the Reserve Bank of Peru. In the image, the façade of that institution’s main building

Endnotes

The Central Banking System in the World

[*] Banco de México Annual Report 1993, p. 232.

[**] Op. cit., p. 235.

[1] Venustiano Carranza, Speech delivered at the Salón de Cabildos, 24 September 1913.

[2] Antonio Manero, El Banco de México. Sus orígenes y fundación (New York: F. Mayans, 1926), pp. 143-154.

[3] Quotations from Francisco Trejo (ed.), El banco único de emisión y las demás instituciones de crédito en México, vol. I (Mexico City, 1992), pp. 10, 17, 13 and 14.

[4] Ibid., p. 8.

[5] Ibid., p. 6.

[6] Charles Goodhart, “The Bank of England,” in The New Palgrave Dictionary of Economics, second edition, 2008.

[7] Ibid., p. 15.

[8] Vera C. Smith, The Rationale of Central Banking (Indianapolis: Liberty Fund, 1990), pp. 30-34.

[9] Ernesto Aguirre Carrillo, La génesis de la banca central: antecedentes, creación y evolución de bancos centrales en el mundo occidental (Bogotá: Banco de la República,1991).

[10] Michiel. H. de Kock, Central Banking (London: P. S. King and Sons, 1939), p. 14.

[11] Charles A. Conant, The National Bank of Belgium (Washington, D.C.: National Monetary Commission, 1910), p. 7.

[12] Ibid., pp. 5-10.

[13] Cited in Charles Goodhart, The Evolution of Central Banks (London: London School of Economics, 1985), p. 93.

[14] Charles A. Conant, A History of Modern Banks of Issue (New York and London: G. P. Putnam’s Sons, 1927).

[15] Trejo (ed.), El banco único de emisión, p. 8.

[16] Conant, A History of Modern Banks of Issue, p. 337.

[17] Ibid., pp. 340-342.

[18] Ibid., p. 352.

[19] Richard H. Timberlake, Jr., The Origins of Central Banking in the United States (Cambridge, MA: Harvard University Press, 1978).

[20] Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963), pp. 17, 24, 130, and 179.

[21] Timberlake, The Origins of Central Banking, pp. 141 and 157.

[22] Friedman and Schwartz, A Monetary History of the United States, pp. 17, 25-29 y 130, and 179.

[23] Edwin W. Kemmerer, The ABC of the Federal Reserve System (Princeton: Princeton University Press, 1920), pp. 3-27.

[24] A. Jerome Clifford, The Independence of the Federal Reserve System (Philadelphia: University of Pennsylvania Press, 1965), pp. 41-48.

[25] De Kock, Central Banking, p. 19.

[26] Robert N. Seidel, “American Reformers Abroad: The Kemmerer Missions in South America, 1923-1931,” in Paul W. Drake (ed.), Money Doctors, Foreign Debts, and Economic Reforms in Latin America from the 1890s to the Present (Wilmington, DE: SR Books, 1994), pp. 86-110.

[27] Frank Tamagna, La Banca Central en América Latina (Mexico City: Centro de Estudios Monetarios Latinoamericanos, 1963), pp. 67 and 68.

[28] Eduardo Turrent, “Kemmerer, Mexico, Latin America and the Central Bank,” in Edwin W. Kemmerer, Inflation and Revolution, facsimile edition (Mexico City: Banco de México, 2010), p. 82.

[29] Aguirre Carrillo, La génesis de la banca central, pp. 172-179.

[30] Paul W. Drake, The Money Doctor in the Andes: The Kemmerer Missions, 1923-1933 (Durham, NC: Duke University Press, 1989).

[31] Aguirre Carrillo, La génesis de la banca central, p. 180.

[32] Drake, The Money Doctor in the Andes, pp. 44 and 45.

[33] Seidel, “American Reformers Abroad,” p. 95.

[34] Camilo Carrasco, Banco Central de Chile, 1925-1964. Una historia institucional (Santiago de Chile: Banco Central de Chile, 2009), pp. 16-77.

[35] Ibid., p. 77.

[36] Seidel, “American Reformers Abroad,” p. 95.

[37] Carrasco, Banco Central de Chile, p. 107.

[38] Ibid., p. 111.

[39] Drake, The Money Doctor in the Andes, pp. 133.

[40] Carrasco, Banco Central de Chile, pp. 110 and 111.

[41] Drake, The Money Doctor in the Andes, p. 188.

[42] Carrasco, Banco Central de Chile, p. 13.

[43] Drake, The Money Doctor in the Andes, pp. 193 and 194.

[44] Ibid., p. 225.

Central Bank Autonomy in Mexico

A Historical Overview

The publication consists of 10 volumes:

1. The Central Banking System in the World
With Preface and Foreword

2. Mexican Central Bank Autonomy: Historical Background

3. Concurrent Visions

4. Echoes from Abroad

5. Institutional Autonomy

6. A Difficult Takeoff

7. Unprecedented Stability
With Sources Consulted

Table of Contents

- Preface

- Foreword

- The Central Banking System in the World

- The Constituent Congress and the Banks of Issue

- The Federal Reserve System
- New Central Banks
- Endnotes