Transcript of remarks made at a conference of
University of Chicago's Law School held on
April 21. - 23. In Chicago)

1. The Central Bank as Fiscal Agent for the Government is part and parcel of a much wider complex. It is on a element of how society organises the delivery of those services that in today's world only public entities can supply, like: defense, public security and currency. The way a society organizes itself in these respects affects every citizen and therefore also the whole of the electorate. As a consequence the relation between the public entities involved in delivering these services are very sensitive and in principle political in nature. This also holds true of the relations between a central bank and government of which the fiscal agent function is one aspect.

Solutions differ from country to country and over time. Even in broadly comparable countries different approaches can be observed.

These differences are normally not the result of agreements among the parties concerned. Much rather what a central bank is entitled or required to do is normally fairly precisely spelt out in an act of Parliament setting up the central bank and detailing its responsibilities. These legal provisions in turn frequently reflect historic developments and social aspirations subject to changes in the course of time. Obviously the bank is not at liberty to deviate from these provisions except for changes to the act via the appropriate parliamentary proceedings.

Differences In national approaches can partly be explained by history, partly they reflect different concepts of cheques and balances. No function of a central bank moreover should be seen in isolation. The way the fiscal agent function is regulated and executed, easily bears on its other functions and objectives. Thus the fiscal agent activities can have a supportive character for stability oriented monetary policy but equally it can - and that would obviously be more dangerous interfere with the efficiency of monetary policy.

2. The following remarks will briefly deal with history in this field. A description of the usual elements of the fiscal agent function will follow drawing on Germany as an example and equally taking into account the most recent European solution embodied in the Maastricht Treaty. Thus providing a basis for concluding remarks on the interdependence of the fiscal agent function with other vital aspects of central banking.

3. Historical Background

We need not ~o too far back into history to find ourselves in a completely different monetary environment. Only a hundred years ago people lived in a different monetary world. Money did not by far play the role it does today, species was in circulation, therefore money creation was not as dependent on decisions as today, systems of communication and transportation differed significantly. Under these conditions a central bank had a more technical function and delivered services which in many respects did not set it apart from commercial banks except for Its monopoly to have species coined from bullion or to opt for a reversal of that process.

In the multiple step development since then most central banks had to cede the right of coinage to the respective government and instead were bestowed with the bank note monopoly. Species as well as the concept of coverage as a legally binding provision have disappeared. The world has completed the change to flat money. In the process central banking has taken on a completely different meaning.

Under the coverage concept neither government nor a central bank nor even the two in collaboration were at liberty to create money at will, In fact the liquidity of a central bank was threatened when too much money was created. That brake fell by the wayside upon the abolition of coverage. In an environment of fiat money and In the absence of capital controls pressure on the exchange rate of the domestic currency became the only external sanction facing a country which allowed too much money to be created.

Controversy over certain aspects of the fiscal agent function became more common after the transition to the present system of money creation. The Implied economic boundaries to the acceptable accommodation of public financing needs were not discovered and heeded immediately.

Germany in particular had to pay a high price for the central bankÕs generous supply of funds to Government out of its function as fiscal agent. The abysmal experience thus gained in Germany - having seen two run away inflations in this century alone - has sharpened German senses to the risks involved in the fiscal agent function. We did not learn the lesson quickly but we learnt it thoroughly as can be seen from German postwar legislation to which 1 shall turn in a minute.

4. Elements of the Fiscal Agent Function

In larger countries with pluralistic democratic structures there are normally three layers of public activities: Federal, state and local. Central banks even if they dispose of decentralized structures are normally called upon to perform the function of fiscal agent either only for the federal level or at most for the federal and the state level. The local level is usually not included. There is a number of reasons for that. First the organizational structure of a central bank may not be detailed enough to qualify it for a broader role but more importantly the volume of the budgets on a federal and state level are usually relevant from the point of view of monetary policy while the local volume is not equally as Important which Is not to say that the local budgets in the aggregate are immaterial for a central bank.

The activities that a central bank performs for other public entities can either merely reflect preference for account relations with the respective central bank or they can be due to legally binding provisions in the central bank act. The latter regime used to prevail in Germany in the period following World War 11. We are in the process of changing these provisions as a consequence of the Maastricht Treaty which as you know forms the basis for the creation of an Economic and Monetary Union in Europe.

The Agent function in my Interpretation includes most or all of the following transactions:

a) Making and receiving payments for public entities involving accounts at the central bank. These transactions can be executed for central Governments only or also for other levels of public activities, The latter will probably only be possible when the central bank is not a unitary institution but also operates branches to easily reach regional public institutions. In a single month last year the Bundesbank was involved in 250 million transfer transactions of which almost 10 % related to the accounts of public institutions. These transactions encompassed a total of 17.000 billion D-Marks of which about 2,5 % passed through the accounts of public entities.

b) Bringing coins into circulation for Government. In Germany like in many other countries the central bank is only directly responsible for bank notes, while the right to mint coins is a Government affair which, however, uses the services of the Bundesbank to bring those coins Into circulation.

c) Servicing public title on behalf and for the account of the public issuer in particular through the payment of interest to the holders of those title.

d) Issuing and redeeming debt instruments for public debtors and maybe at the same time - advising public entities on the characteristics and conditions of debt instruments to promote their placement in the markets. There are various techniques of issuing those public title. These comprise placements via consortia, through tender offers and sales "on tap". In Germany all of these main types of placement are used in parallel.

e) The central bank can be under an obligation or may have the authority to finance public expenditure in relation to international operations or institutions like the International Monetary Fund or the World Bank.

f) The central bank may grant advances to public entities enabling them to bridge temporary need for funds. These activities can either be dons at the discretion of the central bank or the Act can make it mandatory on the central bank to supply funds. The central bank can either operate within a legal limit for these transactions or advances can in principle or in practice be unlimited in nature.

g) Finally a central bank which normally is also acting as a reserve bank can be called upon to fulfill the obligations related to membership in exchange rate systems. If the rules in such a system require exchange market interventions central banks are normally called upon to undertake these interventions.

By way of a mental footnote I would like to add that in a very broad sense banking supervision could be seen as part of the fiscal agent function. That holds true for both forms of involvement, be it in cooperation with other public entities, be It under full responsibility of the central bank. I will abstain from discussing this point here in greater detail In spite of the fact that at the Bundesbank we have a very precise opinion on the subject. Namely that the final responsibility for banking supervision should not rest with the central bank. On the other hand we see no problem with practical involvement as long as the final responsibility rests with another public authority 80 as to avoid the danger of a conflict of interests between monetary policy and banking supervision. This danger could become particularly acute If the central bank were more or less obliged to act as lender of last resort. The related danger of moral hazard has for valid reason recently been broadly discussed in the US and in Great Britain.

As you may have guessed there is a hidden agenda in my list. I have started with the more technical and unproblematic types of activity while the problematic if not outright dangerous transactions are mentioned in the latter part of my list.

5. Potential Effects on Monetary Policy

I will first turn to the benefits which a central bank can draw from the function under discussion.

The fiscal agent function enables the central bank to draw valuable information on volume and direction of public payments which enables It to react immediately if and when monetary policy objectives require central bank reaction to the flow of public funds. Equally, in regularly dealing In public title, a central bank can gather valuable information on the tone of the market, the direction of developments in it, can identify and perhaps even fine tune the Interest rate development in the money market etc. Equally the central bank gains first hand knowledge about the type of open market operation which would be best suited to compensate effects of the agent function that from a monetary policy point of view require action. It can, moreover, use its more or less permanent presence in the market to influence It without monetary policy purposes becoming Immediately visible. In this way a central bank can supply the market with extra liquidity or withdraw liquidity from it discretely without seriously interfering with the expectations of market participants.

As a positive result of the fiscal agent function a central bank can also introduce, strengthen or weaken (as the case may require) the cost conscienceness of market participants. Since central banks normally are not predominantly profit oriented, they can influence the competitive tone of the market. This might be particularly relevant if a central bank is under the impression that competition among commercial banks is imperfect. Which is not so say that a central bank should not normally impose fees covering all costs for its services 80 as not to confront private market participants with unfair competition.

The fiscal agent function of a central bank can thus in fact - at least to some degree - be turned into an Instrument of monetary policy.

Unfortunately, however, the coin has a reverse side. There are some elements of the fiscal agent function which can be very destructive for monetary policy. When describing the positive aspects the point was deliberately made that a central bank will normally try to determine the liquidity situation in its market In the way that best promises to obtain the central bank's final goal: price stability. Whenever its effort to steer the liquidity supply in conformity with stability on the one side and certain aspects of the fiscal agent function on the other side are out of harmony, the central bank's discomfort with the fiscal agent function starts.

As a result, the fiscal agent function becomes all the more problematic for a central bank, the stronger the probability and the higher the volume of extra liquidity that result from the agent function. If a central bank is in fact obliged to supply public entities with extra means of payment or if it has to intervene in the foreign exchange market in support of exchange rates in a massive way a dilemma situation will normally result for that central bank. Germany has ample experience in this field since it has gone through two total Inflations in half a century as a consequence of the abuse of the central bank for fiscal purposes. The political, economic, and social results of the Inflationary processes following 1914 and 1933 were simply horrible. A second series of adverse experiences was encountered as 8 consequence of exchange rate regimes. So in the early 708 we temporarily lost control over national monetary conditions as a result of intervention obligations deriving from the Bretton Woods System. And in 1992/93 we had crisis conditions in the EMS, again threatening the efficiency of monetary policy.

Of course the central bank will always try to neutralize the unwanted liquidity, but that means that it may have to enter the market at the wrong time or use sub optimal instruments. An extra element of uncertainty can enter into its analysis of current needs of policy. Besides that, it may be confronted with another risk which it may find quite difficult to overcome. If It wants to mop up the liquidity it had to create as a consequence of the fiscal agent function It will normally try to do so in offering certain of its assets to commercial banks. However, normally only part of the assets of a central bank have all characteristics which qualify them for that purpose. It can therefore never be completely excluded that a central bank reaches the technical limits of its ability, to re absorb the liquidity overhang. In these circumstances it may be essential for a central bank to be bestowed with the right of issuing paper for its own account. The Bundesbank 18 given this right since the last change in its Act. In spite of the limitation to this right in volume terms we have fortunately not been exposed to insurmountable difficulties so far but the risks are real.

Another uncomfortable aspect of liquidity creation as a consequence of the fiscal agent function is related to the following phenomenon. Central banks conduct their monetary policy through the money market. The interest rates in this market provide valuable orientations to a central bank. The creation of extra liquidity as a result of the agent function tends to dilute the reliability of market interest rates as indicators for monetary policy.

It has to be taken into consideration also, that through money market operations a central bank can determine the liquidity situation of the national banking system. If as a consequence of the fiscal agent function effects result not only for banks but also for non-banks the central bank will not normally be able to directly influence the more widely defined liquidity aggregates. This is a particularly worrisome aspect of liquidity creation by a central bank as a consequence of the agent function.

My conclusion from my previous analysis is simple: The fiscal agent function can hold serious risk for the efficiency of monetary policy.

6. The Protection of the Efficiency of Monetary Policy

Now the question could or better must be asked how best to avoid that those risks can arise and If they materialize how best to cope with them, 80 that the central bank continues to be as efficient as possible .

Since the rights and obligations of a central bank are usually directly established in its Statutes, that 18 to say, in an Act established through regular parliamentary procedure, it is essential that Parliament should provide for a Statute which to the extent possible avoids monetary policy problems.

It is therefore important that political decisions be taken in full awareness of the choices to be made. In particular these decisions will have to take into account that a central bank which is legally compelled to accommodate the liquidity needs of Government is dependent and cannot be held responsible for inadequate results of monetary policy. In the alternative case it must be able to reject the demand for funds which it regards to be in conflict with the stability orientation of its policies. Only if really independent, can a central bank concentrate on the efficiency of Its monetary policy and has a chance to supply society with the valuable asset that stable money represents .

One could of course reject this view as a typical German preoccupation. But that would be too simple. In the Maastricht Treaty many of the checks and balances that have already been referred to are to be found, That is to say in the most recent central bank statute there is, describing the monetary future of most of the industrialized European countries the agent function has been strictly and very tightly interpreted. Under this future European monetary constitution the System of Central Banks will not finance any public expenditures and its say in determining an exchange rate regime for the Union will be stronger than that of any national central bank to date. On top of all that the future European System of Central Banks will be completely independent of other public entities. Its statutes expressly prohibit any public entity to give whatever instructions to the European Central Bank which in turn Itself is prohibited from asking for advice. Additionally the rules for the personal independence for those in charge of decisions are well balanced and equally convincing.

For countries in the process of transition an independent central bank may be especially Important and it may be easier to take guidance from the international sphere rather than from an individual country. Therefore it would certainly be worthwhile to closely study the Statutes of the future European System of central banks. Since many of its crucial provisions closely resemble the Bundesbank Act the Bundesbank is well equipped to advise those which would like to tie in with the European future and Germany's post war performance.

Of course the Bundesbank is equally experienced concerning the more technical aspects of the activities of a fiscal agent. In this field also the Bundesbank has considerable experience as "manager" of one of the most important currencies, in which reserves are held and title denominated. The Bundesbank acts to an important extent as fiscal agent and therefore is well aware of the blessings and drawbacks of this activity and is equally aware of the numerous technical implications and related problems.