Basel Agreements

The Basel Agreements are a set of documents issued by the Basel Committee on Banking Supervision (BCBS) defining methods to calculate capital levels banks should be required to maintain given the risks they accept on the assets they record within their balance sheets. The first agreement was signed in 1988, amended in 1995, rewritten in 2004, and is currently in its third version, known as Basel III.

These agreements were a response to two concerns that emerged in the 1970s. On the one hand, there was increasing discomfort among regulators, government authorities and conservative academic economists with what was seen as a growing problem of moral hazard created by the existence of safety nets for the banking sector. It was believed that safety nets created an environment where banks were stimulated to seek riskier assets because eventual losses would be borne by the authorities rather than by banks themselves. The second concern related to the increasing internationalization of banking activity, which made it difficult for national regulators to monitor properly the risks to which banks under their jurisdiction were exposed.

Classical dichotomy

The classical dichotomy (Patinkin, 1965) refers to the idea that real variables, like output and employment, are independent of monetary variables. In this view, the primary function of money is to act as a lubricant for the efficient production and exchange of commodities. This conception of money rests on "real analysis", which describes an ideal-type economy as a system of barter between rational utility-maximizing individuals (Schumpeter, 1994, p. 277).

In this sense, money is "the unpremeditated resultant, of particular, individual efforts of the members of society, who have little by little worked their way to a determination of the different degrees of saleableness in commodities" (Menger, 1892, p. 242). Hence, money is considered simply as a social technology for the adjudication and determina- tion of "terms of trade", which are inherently specific to individual dyadic economic exchanges (Dodd, 1994, p. 6). It is thus a social "vehicle" that has no efficacy other than to overcome transaction costs concerning the inconveniences of barter, which result from the absence of a double coincidence of wants (Jevons, 1875, p. 3).

Bretton Woods regime

Bretton Woods is a location, period of history, beginning of an era in the twentieth century, birth of an international organization, but, most of all, an international mon- etary system to regulate trade, peg currencies to one standard, and maintain a regime of fixed exchange-rate parity.

In July 1944 at Bretton Woods, New Hampshire, 44 nations under official British and American leadership set up economic measures for post-war reconstruction. The US dollar - pegged to gold - was approved as the new monetary standard. Two new insti-tutions were also established with specific tasks: the Stabilization Fund (International Monetary Fund, IMF), a "special organization" (Horsefield, 1969, p. 39), to be a watchdog facilitating and promoting trade through monetary stabilization, and the International Bank for Reconstruction and Development (World Bank), with the role of providing member nations with "necessary capital not otherwise available except possibly on too costly terms" (ibid.).

Bank money

Bank money is a liability issued by banks and is sometimes also referred to as credit-money. According to Keynes (1930 [1971], p. 5) bank money "is simply an acknowledgment of private debt, expressed in the money of account, which is used by passing from one hand to another, alternatively with money proper, to settle a transaction".

Chartalists such as Wray (1998) distinguish between state money and bank money. In this view, state money is exogenously created by the state in the form of central bank and treasury liabilities. Bank money is a multiple of state money, recorded on the liabilities side of commercial banks' balance sheets. Chartalists assume that the treasury and the central bank can be considered as one entity from an economic point of view (Wray, 2003, p. 87). Gnos and Rochon (2002, p. 48) disagree, pointing out that "if the Fed is the treasury's bank, then the Fed becomes a central bank vis-à-vis the treasury as well as vis-à-vis private banks, the latter role consisting in converting monies into one another and thus allowing banks to meet their reciprocal liabilities". Additionally, chartalists believe "the [US] government can buy anything that is for sale for dollars merely by issuing dollars" (Wray, 1998, p. ix). But neither central banks nor treasury departments can finally purchase anything by incurring a debt. Instead, every final pur- chase of the treasury or the central bank must be financed with income sooner or later. It is therefore more realistic to suggest that all modern money is (central or commercial) bank money.

Endogenous money

Endogenous money constitutes the cornerstone of post-Keynesian monetary theory, which underlines that the supply of money is determined by the demand for means of payment. An effective presentation of this theory has been proposed by Moore (1988), who differentiates between horizontalists and verticalists. The mainstream theory reflects the verticalist view and states that the money supply function is exogenous, independ- ent from money demand and controlled by the central bank. By contrast, according to endogenous money theory, which reflects the horizontalist view, the supply of money is demand determined, and the central bank can only control the rate of interest, not the quantity of money.

Development banks

Arriving at a concrete definition of development banks is surprisingly tricky, as they have existed in many parts of the world in different forms for centuries. Yet development banks can be broadly defined by their ownership, how they source their funding, and how funding is distributed. Development banks in almost all cases are owned by the State. Unlike private banks, which are created in order to generate profit, development banks are created as macroeconomic policy institutions. This dynamic is not limited to develop- ing countries, or even to central governments. The socialization of finance through devel- opment banks has occurred in many forms under governments of different size, location, historical period, and political leaning.

While the criterion of ownership is a necessary element in defining development banks, it can also create confusion. Many State-owned financial entities that were not created to be development banks have in diverse times and places assumed roles typically assigned to development banks: central banks and State-owned commercial banks have in many instances channelled government funds to specific economic activities gener- ally considered to be part of economic development. Yet the ownership criteria can also make things clear. Institutions that are officially dedicated to economic development, such as the Asian Development Bank, the Inter-African Development Bank, and the Inter-American Development Bank, are not owned by the States in whose territory they operate. These banks were originally created in the post-war period to support foreign currency financing for developing countries, yet their institutional operations have since changed considerably.

Free banking

The term "free banking" is generally used to describe a structure of the credit market based on the principle of laissez-faire and characterized by the absence of entry and exit barriers, freedom of monetary issue and the possibility of unrestricted lending and borrowing.

The best-known examples of free banking are those observed in Scotland (from the end of the monopoly of the Scottish Bank to the Peel Act) and in the United States (between 1837 and 1863).

One of the principal supporters of a free banking regime was Mises, whose theories were adopted (and further developed) by the Austrian School. He declared his approval for free banking while recognizing its limitations. In his view, acceptance of a liberalized banking activity did not imply abolition of every form of control over monetary issue: his awareness that banks could issue money without any limit led him to turn his attention to an integral gold monetary system (see Mises, 1949).

Asymmetric information

Asymmetric information reflects a view among New Keynesian economists that allows for incomplete markets on account of the fact that principal and agent do not possess the same degree of information about a particular event or state. This perceived infor- mational asymmetry weighs heavily on the New Keynesian credit-channel theory of the monetary policy transmission mechanism, based on the loanable funds view of the rate of interest, whereby the real rate of interest acts as a price-rationing device to equilibrate the supply and demand for loanable funds. New Keynesians acknowledge that the real rate of interest may not perform this equilibrating function when the demand for loanable funds rises beyond certain levels. Lenders may withhold credit to otherwise creditworthy borrowers rather than offering loans at higher rates of interest even if these borrowers would be willing to pay those higher rates. Money neutrality is violated as the predicted link between changes in high-powered money and the money stock is upset. Output and employment are then less than their full-employment counterparts.

Clearing system

A clearing system consists of a series of norms and coordinated processes by which financial institutions systematically collect and mutually exchange data or documents on funds or securities transfers to other financial intermediaries at an agreed place called "clearing house". These procedures can also involve the determination of partici- pants' bilateral and/or multilateral net positions and aim at simplifying the discharge of respective obligations on a net or net net basis in a settlement system. Occasionally, the expression "clearing system" implies a mechanism of multilateral netting by novation and the settlement of the corresponding payments or, imprecisely, the process itself of settling transactions. Since their functioning involves "a moderate stock of solid Money [. . .] [while] a large proportion of both solid and paper Money might be spared" (Seyd, 1871, p. 5) and they naturally aim at "eliminating or reducing cash transfers" (Einzig, 1935, p. 66), clearing systems gained particular success in the nineteenth century.

Corridor and floor systems

A corridor-type (with its floor-type variant) system is an approach to the setting of inter- est rates that an increasing number of central banks have adopted since the mid 1990s. The system has now become the operational framework that most central banks utilize for implementing their strategies on interest rates.

The interest rate policy of central banks consists of a strategy and an operational framework. Strategically, central banks set their desired level for one or more interest rates, based on what they consider adequate in terms of their public policy objectives. Operationally, they use a set of instruments and procedures to effectively steer the chosen interest rates toward the target policy rate. Since the 1990s, the prevailing operational framework for monetary policy implementation is a corridor system. In the 2000s, the central banks of Japan and New Zealand, as well as a number of other central banks in the aftermath of the global financial crisis, have further modified their framework and embraced a floor system.

Credibility and reputation

The issues of credibility and reputation of monetary authorities were introduced by the "New classical economists", in order to develop additional arguments in favour of monetary policy rules and against the use of discretionary policies. Their main goal was to show that an "inflation bias" emerges in cases where monetary policy is discretionary. Monetary authorities are said to be credible if private agents believe in their commit- ment to price stability. Kydland and Prescott (1977) showed that it is in the best interests of central banks to announce a low-inflation policy and then, if private agents believe in the policy announced, to switch to a higher-inflation policy in order to temporarily reduce the rate of unemployment. As a matter of consequence, central banks will have a credibility issue, because rational agents will not believe them.

This credibility issue raised by Kydland and Prescott (1977) can only arise under very restrictive theoretical circumstances: central banks have to make their decision first before private agents can react, the game needs to be a one-shot one, and agents as well as the central bank must have full information and must not cooperate.

Credit bubble

A credit bubble is a sustained and accelerating growth of bank loans relative to the growth of Gross Domestic Product (GDP), which finances a boom in both economic activity and in asset prices. The proposition that this growth of credit adds to demand - especially for financial assets - above and beyond that generated from existing incomes contradicts the "loanable funds" vision of lending in which loans are "pure redistribu- tions" which "should have no significant macroeconomic effects" (Bernanke, 2000, p. 24), as lending simply redistributes spending power from lender to borrower without enhancing aggregate demand. However, in the endogenous-money view, lending enables demand to increase in the aggregate, thus financing a growth in economic activity and rising prices on asset markets. Prior to the global economic and financial crisis that erupted in 2008, the dominant view in economics was that the proposition that "credit bubbles" had any macroeconomic significance was a figment of the imaginations of non- economists. The Modigliani-Miller theorem (Modigliani and Miller, 1958) - the relevant subset of the efficient markets hypothesis - argued for the irrelevance of credit to both the valuation of firms (except for the effect of the tax-deductibility of interest payments) and economic performance. The proposition that there could be a "financial accelera- tor" (Bernanke et al., 1996) gave conventional theory an argument as to how credit could impact on economic activity, but this mechanism relied on agency costs owing to asym- metric information and acted through the price of credit rather than its volume.

Deleveraging

Deleveraging is the process by which either economic units (taken individually) or the economy as a whole get rid of their debts. The most obvious way of carrying this out is by repaying existing debt, which should result in the aggregate stock of debt decreasing. However, while debt may fall in nominal terms, the attempt to deleverage - that is, to repay debts accumulated in the past - can increase the burden of debt in real terms.

According to Fisher (1933), repaying the debt implies a decrease in the means of payment in circulation and therefore a fall in the price level. This logic is based on the quantity theory of money. As a result, this fall would increase the debt in real terms; during a crisis, therefore, the attempt to repay debt would result in a larger debt. This means that if all units simultaneously try to deleverage, a debt deflation could occur, resulting in a self-defeating exercise.

Flow of funds

The flow of funds (or financial account) is a system of accounting that records all finan- cial transactions of an economy. Bookkeeping both the financial stocks and flows, it tracks the sources and uses of funds for each institutional sector and for the economy as a whole. The flow of funds is one of the key instruments in national accounting together with the national income and product account, the national balance sheet, and the input- output matrix. It is one of the primary components of the System of National Accounts (SNA) of the United Nations. First published in 1953, the flow of funds was incorpo- rated within the SNA in 1968.

Core inflation

There are several measures of inflation. The official measure - that is, the rate of change in the Consumer Price Index (CPI) in most countries - is also referred to as "headline inflation" owing to its ability to make news headlines. Headline inflation, however, is often subject to large and temporary fluctuations arising from supply shocks, for example production declines due to unfavourable weather conditions or external factors affecting the prices of one or more consumer goods imported into a country. Another measure of inflation aims at removing these volatile components from headline inflation. The concept of core inflation is based on the idea of identifying the underlying persistent trend of inflation.

There are multiple approaches to derive core inflation from headline inflation. Among them, the most widely used approach is excluding selected groups of items from the basket used to compute headline inflation and recalculating the weighted change of prices of the remaining items in the basket. Food and energy items and interest charges are the most popular exclusions. The exclusion method is used by central banks more frequently than other methods, as that method is computationally simple, easy to understand and derivable without any time lag.

Draghi, Mario

Mario Draghi (1947-) is an Italian economist who has held and holds important politi- cal offices. At the time of writing, he is the President of the European Central Bank (ECB).

Draghi's vision of economic policy is partially, but significantly, influenced by Keynes's theory, although he explicitly affirmed that monetary policy "can become an effective, stabilising factor and contribute to collective prosperity in an independent and active way" only if monetary policy decisions are built "into a systematic and predictable strategy, based on price stability, which drives expectations and guides the economy but doesn't shock it" (Draghi, 2012a).

After receiving a Jesuit secondary education, Draghi graduated in 1970 from the University "La Sapienza" in Rome, under the supervision of the Keynesian economist Federico Caffé - the revolutionary reformist who suddenly disappeared in 1987 - and with a dissertation entitledEconomic Integration and Variation of the Exchange Rates, in which he criticized the project of the single European currency (see Draghi, 2012a, minutes 25:00-25:22). He received a PhD from the Massachusetts Institute of Technology in 1976 under the supervision of Franco Modigliani and Stanley Fisher. During the 1980s, Draghi taught economics at the University of Florence and worked for the Inter-American Development Bank and the World Bank in Washington, DC. In 1990, he was hired as economic advisor at the Bank of Italy.

Currency crisis

A currency crisis is a form of financial crisis marked by the abrupt devaluation of a nation's currency ending a period of fixed or pegged exchange rates. A sudden shift in international asset portfolios, with its rapid reversal of capital flows, is the proximate cause of a severe collapse in the external value of a nation's monetary unit. And most would agree that all such events are characterized by "investors fleeing a currency en masse out of fear that it might be devalued, in turn fueling the very devaluation they anticipated" (Krugman, 2007, p. 1). While investor action driven by a fear of a crisis drives the actual crisis, the dramatic change in the external value of a nation's currency defining the actual crisis implicates a nation's macroeconomic accounts, particularly its fiscal deficit, sovereign debt, and balance of payments.

Bank of Italy

The Bank of Italy is the central bank of the Italian Republic, instituted in 1893. The origins and the evolution of the Italian monetary system are, in several respects, pecu- liar. After national unification in 1861, Italy adopted a single currency, the Italian lira. Nevertheless, banknote circulation was fragmented owing to the persistence of strong regional interests (Polsi, 1993): a provision of 1874 recognized six banks of issue, all of which were already performing this function in the pre-unification states.

The resumption of convertibility in 1883 and the building boom triggered by the new national capital, Rome, kindled a large credit expansion, which inflated a real-estate bubble. Most major banks were engaged in generous credit to the building sector, favored by the regulatory vacuum in which they operated (see Fratianni and Spinelli, 1997). The burst of the bubble resulted in a banking crisis, which erupted into a true political and judicial scandal in 1892, when the unsustainable position of Italian banks of issue, and evidence of serious irregularities committed by one of them, the Roman Bank, became public. The scandal highlighted the need to put a limit on banknote issues and to foster the transition towards a single bank of issue (De Cecco, 1990). The Bank of Italy was then instituted by the Banking Law of 10 August 1893 through the merger of three existing banks of issue: the National Bank of the Italian Kingdom, the Tuscan National Bank, and the Tuscan Credit Bank.

Bank of Canada

The Bank of Canada has received many accolades in recent years because of its handling of the financial crisis, especially owing to the popularity of its governor at the time, Mark Carney, who was also appointed chairman of the G20's Financial Stability Board in 2011 and then, in 2013, he became Governor of the Bank of England. As far as central banking internationally is concerned, the Bank of Canada exerts much more prominence among central banks than it would otherwise do when measured simply by the size and importance of the macroeconomy that the Bank oversees through its activities. The Bank of Canada has acquired high credibility also because it has managed a solid and sophisticated banking system, which did not face the same difficulties that plagued the US banking sector during the financial crisis that erupted in 2008.

Much like the US Federal Reserve (Fed), this central bank was founded following major financial crises on the North American continent during the early decades of the twentieth century, namely after the crisis of 1907 for the US Fed and the Great Crash of 1929 for the Bank of Canada (see Lavoie and Seccareccia, 2013). In stark contrast to the Fed, which established a "decentralized" central banking system in 1913 with 12 separate reserve districts, the institutional structure of the Bank of Canada was modelled on the more centralized organization of the Bank of England, with this structure being adapted to the Canadian context following its founding in 1934, for instance in terms of its regional and linguistic representation on its board of directors and governing council. Hence, while first a private institution, the Bank of Canada was quickly nationalized by the federal government within a few years of its creation in 1938 (see Plumptre, 1940; Bank of Canada, 2014).

Banque de France

The Banque de France (BdF) was established in 1800, under the aegis of bankers and Napoleon Bonaparte, who was then First Consul of France. At that time, a few promi- nent bankers were advocating the creation of a private bank of issue, independent of political powers, in order to face up to a state of deflation and lack of cash in the French economy. Bonaparte, who was striving to consolidate public finances and restore mon- etary stability in the aftermath of the French Revolution, agreed to provide public funds to the BdF: he regarded the BdF as a tool for fulfilling his objectives. In 1803, he passed a law in order to provide it with an official charter, which notably endowed it with the exclusive right to issue banknotes in Paris for a period of 15 years. Shortly thereafter, the BdF experienced a bank run owing to the issuance of large amounts of banknotes to finance public spending that eroded public confidence in banknotes. In response, in 1806, Napoleon decided to monitor a reform designed to allow him to exert better control over the BdF's activities. This reform, which was complemented in 1808 with an impe- rial decree providing for the "basic statutes" of the BdF and for the creation of discount offices in main French cities, promoted a relatively balanced power relationship between the State and private shareholders, which was to run until 1936. During that period, the BdF's right to issue banknotes was extended and the network of its discount offices expanded. To deal with the financial crisis that arose from the 1848 Revolution and later from the Franco-Prussian war (1870) and the First World War (1914), the BdF's notes became fiat money for some time. They became fiat money for good in 1936. Legal tender was first experimented with in the 1848-50 and 1870-75 periods, before being definitively enforced in 1875.