Five Reasons for Central Banks: Are They Any Good?

Five Reasons for Central Banks: Are They Any Good?

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Karl-Friedrich Israel

In a time when Federal Reserve reforms are discussed more openly than ever before, it seems appropriate to also think about the more fundamental question of whether central banks are needed in the first place. In 1936, Vera C. Smith (later Lutz) published her doctoral dissertation The Rationale of Central Banking written under Friedrich A. von Hayek at the London School of Economics. Smith reviewed the economic controversies around central banking from the nineteenth to the early twentieth century in France, Belgium, Germany, England, Scotland, and the United States.
Smith made very clear that central banks are not the result of natural developments in the banking sector, but come into existence through government favors.



So what are the justifications for central banks? Smith identified five main arguments for central banks from an economic point of view. Although Smith has written with a gold standard as the underlying monetary system in mind, it is interesting to look at these arguments with the benefit of hindsight more than 80 years later. Has any one of the arguments actually made a strong or even conclusive case for central banking?

One: Uniform Distribution of Risk

The first argument runs as follows. In a system of free banking, which might be stable as a whole, one can expect individual banks to fail from time to time, just like there are bankruptcies in other sectors of the economy. Now, if any bank issues notes over and above their own gold reserves, it runs the risk of bankruptcy. The notes however will not stay exclusively in the hands of the immediate clients of the bank who benefit from the fiduciary note issue, but will be exchanged to other parties. Whoever holds the notes at the point of bankruptcy carries the loss. It seems reasonable to assume that the risk will not be evenly spread over the economy. In particular those individuals who, for whatever reason, are least capable of bearing the additional cost of discriminating between notes from solvent and insolvent banks will be hit the hardest. Therefore, the argument goes, the government should introduce some uniformity in the note issue as well as the distribution of risk over market participants. This can be done by imposition of a legal monopoly, that is, by creating a central bank.
The respective rebuttal of the free bankers was to point out that, while a monopolist on the note issue would indeed spread the risk over all parties more evenly, it would also tend to increase the risk overall. This is definitely a point worth considering.

Two: Over-issue of Notes and Excessive Credit Expansion

The historically most important argument for central banks has been the one about the dangers of over-issuing notes and excessive credit expansion. This might strike a contemporary reader as somewhat paradoxical, but the argument goes like this:

In a free banking system there would be strong incentives for any individual bank to constantly lower their discount rates and thereby expand credit in order to gain market share. At a certain point of the process gold reserves would start to drain, and banks would have to refrain from further credit expansion in order to protect their own reserves. This would lead to an economic crisis.

It was argued that under free banking the fluctuations in the money and credit supply would thus be much more violent, which implies larger instability of the economy as a whole. A central bank would serve the purpose of preventing excessive note issue and credit expansion as well as the resulting interplay of inflationary and deflationary episodes.
The argument ultimately relies on a negative answer to the question of whether the mutual check of interbank clearing would be sufficient to prevent a critical number of commercial banks from trying to reap the short-run benefits of engaging in excessive expansion. Yet, as Smith pointed out, historical examples of competitive systems of note issue from Scotland, Canada, and Suffolk (Massachusetts) suggest that it in fact can be a sufficient deterring influence on fiduciary expansions by individual banks.

Three: The Lender of Last Resort

Another well-known argument is the one of the lender of last resort. The idea is that central banks could mitigate economic crises that might occur in any system, because of their legal privileges and the stronger confidence of the public in their notes. When commercial banks are forced to contract their lending in order to protect their reserves as clients increasingly want to redeem bank notes into specie, central banks could step in and prevent a deflationary spiral, because central bank notes would be accepted without question. In the worst case, redemption could be suspended. Central banks could thus prevent liquidity shortages and possibly severer economic downturns.
The respective counter-argument has been made among others by Ludwig von Mises, who pointed out that the very existence of an active lender of last resort will be incorporated as a datum into the decisions of commercial bankers and incentivize them to take higher risks and indeed lower reserve ratios even further. Hence, it increases the fragility of the entire system.
Moreover, any of the three problems so far considered has a very simple root, namely fractional reserve banking. A full reserve system as has been proposed by many economists, including Fisher, Friedman, some Austrians, as well as the modern advocates of Vollgeld in Switzerland and Germany, would solve virtually all them. Yet, there are two arguments remaining which are of special importance for our modern times.

Four: Central Banks as a Means to International Cooperation

The fourth argument holds that central monetary authorities in any currency area would be needed in order to make cooperation with regard to monetary policy decisions possible. The Bank for International Settlements (BIS) founded in 1930 is not least an outgrowth of the attempt at cooperation and harmonization. However, it is the very existence of central banks that renders monetary policy possible in the first place. The question is of course what kind of monetary policy should be implemented, which leads us to the final argument.

Five: Rational Monetary Policy

The last argument gained attention in the post-World War I era and is indeed the most relevant for us today. Traditionally it has been the aim of monetary reformers to introduce automatic mechanisms of adjustment into the financial system. According to the fifth argument, however, it would be beneficial to pursue an active and rational monetary policy of controlling the volume of cash reserves and credit guided by “scientific criteria.” A central bank would be indispensable for its implementation. The main policy tools would be discount rate setting and open market operations.
The abandonment of the classical gold standard and the introduction of a fiat standard has indeed given more power into the hands of central bankers and fostered the notion that central banks should consciously manipulate the money stock. Any argument or scientific criterion that requires monetary expansion of a certain magnitude is implicitly at least also an argument for fiat money and, a fortiori, for central banks.
The first criterion that has been held up as scientific was price stability. The money stock should be expanded at the rate of real economic growth to keep the general price level constant. However, as Vera Smith pointed out this criterion “has been suspect in theory and just as unfortunate in practice.”
Modern macroeconomics that has developed after the publication of Smith’s work has rationalized monetary expansion even further by arguing for a stable rate of price inflation instead of price stability. Yet, again no study has been presented so far that can be regarded as proof of the overall economic benefits of inflation. In particular no study has shown that the problems of moral hazard, increased systemic risk, perverse redistribution of wealth from bottom to top, and unsustainable inflationary booms are in any way offset by potential benefits of expansionary central bank monetary policy.
That there are benefits of central banking for certain groups is pretty obvious. Leland Yeager in his preface to the Liberty Fund edition of Smith’s book pointed out that it is reasonable to suppose that central banks are valued today, among other things, for providing prestigious and comfortable job opportunities for economists. Nothing is so bad that it couldn’t get worse.

The Bottom Line

It is indeed desirable to have a rational monetary policy, if there has to be one at all. Who could object to rationality? However, no economist has presented a conclusive case for conscious political implementation of monetary adjustments and stimuli. Central banks remain a creature of power politics rather than economic reason.