Nicholas C Garganas: Why is the role of the central bank important?
Address by Mr Nicholas C Garganas, Governor of the Bank of Greece, at the celebrations marking the
75th anniversary of the Bank of Greece, Athens, 3 November 2003.
* * *
Your Excellency the President of the Hellenic Republic
Mr. Prime Minister,
Your Beatitude,
Ladies and Gentlemen,
Allow me to thank you for having accepted our invitation to join us in today's event. Let me also extend
a warm welcome to Jean-Claude Trichet, who became President of the European Central Bank on
November 1. This occasion marks Jean-Claude's first official function outside of Frankfurt in his new
position. Thank you for being with us today, Jean-Claude. We wish you every success in your new
position.
I also would like to extend a very warm welcome and a special thanks to my central bank colleagues
from the European System of Central Banks as well as those from other parts of the world who have
honored us with their presence for this celebration.
This year we celebrate an important anniversary - the 75th year since the establishment of the Bank of
Greece. During this period, the conventional wisdom about a central bank's institutional role and about
what a central bank can and should do has undergone enormous change. There has, however, been
one constant underlying the responsibilities of a central bank - the importance of discharging these
responsibilities to the health of the national economy.
Why is the role of the central bank important? Because, an economy's central bank is entrusted with
safeguarding the value of the economy's currency and with ensuring the soundness of its financial
system. Safeguarding the value of the currency is not always an easy task. The correct answer to this
challenge forms the basis of an efficiently running economy and of social cohesion. As John Maynard
Keynes observed, "there is no subtler, no surer means of overturning the existing basis of society than
to debauch the currency".
It would be comforting to find in the history of central banking a record of steady progress and orderly
development from earliest antecedents to present knowledge. The facts, however, are different. The
past 75 years have included remarkable achievements and some setbacks both globally and in the
Greek economy. The role of the central bank in an economy's fortunes - and misfortunes -is aptly
demonstrated by the history of the Bank of Greece. During this sometimes turbulent period, the Bank
of Greece demonstrated an ability to adapt to changing circumstances, often playing a leading role in
providing solutions to the main economic problems of the day. Let me use the occasion of the Bank's
75th anniversary to elaborate briefly.
Following a period of monetary instability, in March 1927, the Greek government sought the
assistance of the League of Nations to improve the health of the economy, to secure monetary stability
and to help the Greek banking system function better. Negotiations with the League followed and a
stabilisation plan was hammered out. Among the terms of the so-called Geneva Protocol, signed in
September 1927, was the establishment of a central bank, exclusively responsible for issuing
banknotes. Until that time, the National Bank of Greece, a private institution, had the privilege of
issuing banknotes, which it waived in favour of the newly established central bank. The Bank of
Greece commenced its operations in May 1928. The two main tasks assigned to the Bank, as
specified in its Statute, were to ensure a stable currency and to regulate currency circulation. To this
end, the Statute provided for the Bank to have reserve assets; it also set a strict limit on the financing
of budgetary deficits by the central bank.
The Bank of Greece could not have begun operating at a more difficult time. This was a time when the
international monetary system was operating primarily under the gold-exchange standard. Effectively,
the gold standard aimed at securing the stability of a currency by tying money supply to the gold
reserves of the central bank, thus leaving little room for conducting an independent monetary policy.
The gold standard has been described as nailing the domestic economy to a "cross of gold".
Today, many historians blame the gold standard for helping precipitate the Great Depression that
began in 1929. Regardless, the global stock market crash of 1929 and the ensuing global financial
crisis of September 1931 saw many countries driven off the gold standard.
The new international environment was hardly a favorable one for a fledging central bank. Concerned
about the instability that might follow in the absence of the gold standard -and with the recent period of
monetary instability entrenched in their memories - the Greek authorities attempted to maintain the link
to gold. The drachma, however, came under heavy selling pressures, and, in April 1932, Greece had
to leave the gold standard.
Leaving the gold standard made monetary policy a matter of the discretionary judgement of the
authorities at the Bank of Greece. The new monetary regime opened up the possibility of the Bank
playing a more active role in domestic economic affairs. The Bank was no longer bound by the
discipline imposed by the gold standard. However, in common with most other central banks at the
time, it pursued monetary and credit policies geared toward safeguarding price stability and ensuring a
sustainable balance of payments; after all, this was in accordance with its Statute. In addition, the
Bank sought to remedy the inefficiencies of under-developed money and capital markets by instituting
measures to attract savings to the banking system and to improve credit allocation.
In April 1941, the Axis Powers occupied Greece. For several years, London became the seat of both
the exiled Greek government and the Bank of Greece, with the Bank's gold secretly transferred to
South Africa. Within occupied Greece, the economic situation became increasingly grim and hundreds
of thousands of Greeks died of hunger. The Axis powers forced the country to pay not only for the
upkeep of the occupying troops, but also for their military operations in Southeastern Europe. The
puppet regime established by the occupiers forced the Bank of Greece to resort to the printing press.
As a result, the country was beset with hyperinflation; between April 1941 and October 1944, the cost
of living rose 2.3 billion times. In these difficult circumstances, the country's economic system
collapsed. To give another example of the magnitude of inflation during the occupation, let me mention
that in November 1944, immediately after liberation, a so-called "new" drachma was introduced; it was
set equal to 50 billion "old" drachmas!
In March 1946, a stabilisation plan, which was part of the London Agreements, set up the Currency
Committee, which was to become responsible for monetary, credit and exchange rate policies for
several decades. This Committee consisted of five members, including the Minister of Coordination,
the Minister of Finance, and the Governor of the Bank of Greece. The Committee was given control
over the issuance of money, and the authority to allocate credit among sectors and activities as well as
to determine lending terms.
After suffering through World War II and the civil war, the economy was in ruins. The hyperinflation
produced long-lasting effects on attitudes, and savers were unwilling to deposit their funds in the
banking system. To help attract funds back to the banking system, the central bank sought to
reestablish price stability. At the same time, the Bank of Greece was also called upon to support
economic reconstruction and to help lay the foundations for growth. However, circumstances were
difficult, since certain factors, including substantial expenditures on defense, social policy, and support
of the agricultural sector, caused strong growth of the money supply. The Bank's task was made even
more difficult in view of the country's underdeveloped financial markets. Yet, the Bank was successful
in conducting a tight monetary policy. This, together with the decline in fiscal deficits, resulted in
inflation falling dramatically, from over 40 per cent in 1948 to 5 per cent in 1952. This created suitable
conditions for a reform in exchange rate policy.
In April 1953 the drachma was devalued by 50 per cent against the US dollar and then joined the
Bretton Woods system of pegged exchange rates. In the following year, another "new" drachma was
introduced and set equal to 1,000 "old" drachmas. Coupled with the nominal anchor provided by the
Bretton-Woods system and tightened fiscal policy, the "new drachma" played a key role in reducing
inflation expectations.
During the next fifteen years real GDP growth averaged 7 per cent, one of the highest in the world. At
the same time, average inflation in Greece was less than 2.5 per cent, confirming that strong long-term
growth is not feasible without price stability. The Bank of Greece not only helped restore and maintain
monetary stability, but its interest-rate policy was decisive in channeling private saving to the banking
system.
The nominal anchor of the Bretton Woods system proved unsustainable in the long term. Pressures to
finance the Vietnam war led to an expansionary monetary policy in the United States and inflationary
pressures spilled over to the rest of the world. This, along with the inherent weaknesses of the
arrangement, proved the undoing of the Bretton Woods system, which broke down in March 1973.
Once again, the lesson that there is a need to separate monetary policy from political influences had to
be re-learned. The drachma's link to the US dollar was maintained up to the spring of 1975.
The decades of the 1970s and the 1980s were difficult ones for policy makers worldwide. Among other
things, they had to deal with two oil price shocks in 1973-74 and in 1978-79, an international debt
crisis in the early 1980s in Latin America and a global stock market crash in 1987. Particularly during
the 1970s, Keynesian ideas, which, to some extent, downplayed the connection between monetary
policy and inflation, were at their peak. In Greece, during the second half of the 1970s and the 1980s,
the central bank conducted monetary policy under difficult circumstances, as the policy mix was often
inappropriate. Compounding the difficulty of the Bank's task was the fact that the financial system
operated under a complex framework of rules and provisions, which proved not only ineffective, but
also distorted credit allocation and limited the scope for conducting an effective monetary policy. The
abolition of the Currency Committee in 1982 and the transfer to the Bank of Greece of its functions in
the fields of monetary, credit and exchange-rate policies as well as banking supervision marked the
beginning of a new era in the Bank's history.
With broader responsibilities, beginning in the mid-1980s and until the mid-1990s, the Bank of Greece
undertook the leading role in the deregulation of the financial system. Financial liberalisation was a
gradual process, however, so that the lifting of controls could take place in tandem with the
restructuring of the economy and thus avoid the potentially destabilising effects of abrupt and sharp
reversals of international capital flows. This strategy proved wise; in the 1990s many Asian
economies, which had not given sufficient consideration to sequencing, were exposed to severe
financial crises.
After financial liberalisation in Greece had been completed in the mid-1990s and up to entry into EMU
and the adoption of the single monetary policy in January 2001, the Bank of Greece had at its disposal
more effective and flexible market-oriented means of monetary control and was able to react quickly
and effectively to changes in economic conditions.
The supervisory functions of the Bank have also changed considerably, shifting from the task of
ensuring commercial banks' compliance with credit and exchange controls and regulations, to the
monitoring and the evaluation of bank asset quality, and the solvency and capital adequacy of these
financial institutions.
During the late 1980s and the 1990s, a substantial shift occurred in thinking about the role of the
central bank in the economy. Experience of past episodes of hyperinflation in various countries, as
well as of moderate inflation, exemplified in the breakdown of the Bretton Woods system, led to the
finding that monetary policy is not necessarily independent of the government of the day. Sometimes
central banks have to finance government spending and this results in higher inflation and, ultimately,
lower growth. Thus, the views that the goal of monetary policy should be to provide price stability and
that the central bank should be made an independent institution in the pursuit of this goal gained
ground.
These ideas underpinned the monetary policy of the Bank of Greece in the 1990s as it sought to
support the effort to satisfy the Maastricht Treaty criteria and to join the euro area on 1st January
2001. The Bank's ability to attain its goals was considerably improved by the abolition of the monetary
financing of the fiscal deficit, mandated under the Maastricht Treaty, in 1994, and the law, enacted in
1997, granting independence to the Bank of Greece with a mandate to achieve price stability.
In an effort to bring down inflation, in the mid-1990s the Bank adopted a "hard-drachma policy", under
which the exchange rate was used as a nominal anchor. Real interest rates were kept at high levels to
help ensure the success of this policy. The hard-drachma policy operated, at times, under difficult
conditions, yet it proved highly credible and immensely successful. Ironically, the source of the
difficulty was related partly to the success of the policy. The policy's credibility led to enormous inflows
of foreign capital, complicating the conduct of monetary policy. The Bank was able to neutralise these
inflows, absorbing excess liquidity and thus buying time for other policies to adjust. Within three years
of the policy, inflation was more than halved, falling to under 5 per cent, while economic growth
accelerated sharply. The fiscal consolidation that took place beginning in the mid-1990s, and
moderation in wage increases, contributed importantly to an increasingly-sustainable policy mix,
enhancing the credibility of monetary policy.
With the outbreak of the Asian financial crisis in late 1997, and its spread to other parts of the world,
there were pressures on the drachma. The Bank of Greece initially raised interest rates to stem these
pressures. Then, in March 1998, the drachma entered the Exchange Rate Mechanism of the
European Monetary System, so that it could satisfy a Maastricht criterion, and was devalued to help
maintain international competitiveness. Unlike the currency devaluations in many other countries
around this time, the drachma's devaluation was not followed by the aftershock of a banking and
financial crisis. A well-supervised Greek banking sector, with adequate prudential regulations in place,
limited the exposure of commercial banks to foreign currency risk and, therefore, safeguarded the
financial system.
In the years following the drachma's entry into the ERM, the Bank of Greece maintained a tight
monetary policy so that the inflation criterion of the Maastricht Treaty could be satisfied. Fiscal policy
continued to be tightened and wage restraint was maintained. With an ever-more-balanced policy mix,
real economic growth accelerated. The rest, is history. On 1 January 2001, Greece became the 12th
member of the euro area, where price stability is entrusted to the independent European Central Bank
and the Eurosystem.
The Bank of Greece is now part of a larger family, the Eurosystem, and continues to exercise
extremely important functions. It is an integral part of the Eurosystem, which comprises the European
Central Bank and the national central banks of the euro area. The Governor of the Bank participates in
the ECB's Governing Council, which, among other things, sets monetary policy for the euro area. The
Bank is responsible for implementing monetary policy in Greece and ensuring the smooth operation of
the payments system, which it runs and which is part of the EU's Target System. The Bank also is in
charge of supervising the banking system and maintaining financial stability With the opening of
financial borders in the euro area, these functions will take on added importance in the coming years.
In carrying out its responsibilities successfully the Bank has benefited enormously, in the present and
in the past, from an extremely well-trained and highly dedicated staff. In my view, this has been the
key to its success.
Such has been the journey of the Bank of Greece during the past 75 years. As you can see, in
common with the experiences of other central banks, the journey has not been without bumps and
turns along the way. Yet, the history of the Bank demonstrates that the Bank has always fulfilled its
obligations and, in so doing, it has earned the trust of the Greek citizens.
In the early part of the last century, the famous Swedish economist, Knut Wicksell, said that "Monetary
history reveals the fact that folly has frequently been paramount; for it describes many fateful
mistakes. On the other hand, it would be too much to say that mankind has learned nothing from these
mistakes". I might add that in recent years we have learned a great deal from the mistakes of the past.
As confirmed by the history of the Bank of Greece, the role of central banks, both institutionally and in
actual practice, has been upgraded in such a way that it contributes to the improvement of living
standards.
Ladies and Gentlemen, thank you for your attention.