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Please see About section for more details about the blog.
RG10: Previous post in this sequence is RG9 Who Should Create Money? In this post, we pause to explain the process of money creation by private banks, and the role of Central Banks in enabling and facilitating this money creation. This is necessary in order to understand the history of Central Banking, which we are studying in Goodhart’s book. The standard explanation of this process found in textbooks is false and misleading, and creates many widely believed myths. The following 1m video provides the standard FALSE explanation of how banks create money. It is useful to understand the MYTHS of money creation, encapsulated in this video, in order to explain why they are wrong.
First Myth – Misunderstanding how fractional reserve works: The bank is required to keep 10% of the money you deposit somewhere safe, and is allowed to lend 90% of it out to other customers.
This is a massive misunderstanding of modern money, perhaps based on the idea of money as gold. Cash is now a very small part of money in circulation, most of which exists only as electronic entries in computer ledgers. To understand what happens when John deposits $1000 in form of cash – which is different from the deposit of a check – in his Bank ABC. it is useful to separate this into two different transactions. There is a Cash Kitty of the bank ABC, to which $1000 is added. At the same time, separately, an electronic entry is made in John’s account for $1000. If John deposits a check, then only an electronic entry is made, and there is no change in the Cash Kitty of the Bank ABC.
Second Myth: Bank is a Financial Intermediary – it takes money from depositors in order to give loans. Suppose that after John walks out of the bank, Mike comes in and asks for a loan of $1 Million. The bank will not go and look at its cash kitty to see if there is sufficient money to grant Mike a loan of $1 Million. Instead, it will assess the credit-worthiness of Mike and ensure that he has sufficent collateral — assets worth more than a $1 Million. It will take a pledge from Mike to repay $1M plus interest one year from now, backed by the collateral, to be seized in case Mike does not pay.
Bank ABC will open an account with keystroke entry of $1 Million. This $ 1M comes into existence when Bank ABC gives Mike a loan. This $1 Million is NOT taken out of depositors money – it is create ex nihilo – out of thin air. Now suppose Mike writes checks on his account so that, at the end of the day, Bank ABC must pay $1 M to other banks, where these checks have been deposited. Where will Bank ABC get the money it owes, which it created out of thin air?
The Role of Central Banks: Bank ABC will now BORROW over-night, funds required to cover what it owes. There are two markets where such borrowing is done. One is the Interbank Market – it can borrow keystroke money from any bank having an excess. Banks having an excess are only too happy to lend it overnight and make a profit. However, if liquidity is tight and no one has excess reserves to lend, the Central Bank is the lender of th last resort. It is legally obligated to loan ABC HOWEVER MUCH money Bank ABC wants, in return for good collateral. Here the collateral Bank ABC will offer to the Central Bank is the PLEDGE of Mike to repay the loan, backed by his assets worth $1M.
Maturity Transformation: Converting a one-year loan to a sequence of 365 overnight loans,. Both interbank borrowing and borrowing from the Central Bank are done at nearly the monetary policy rate, while commercial loans are significantly higher, at least by 2% or more. This means that if Bank ABC has to borrow this $1M overnite every night for the whole year, it will still make a profit when Mike pays back his loan with interest. For more details about this, see Monetization, Maturity Tranformation, and MMT
Overnight Clearinghouse: Generally speaking, Bank ABC will not need to borrow the $1 M every night. In the banking system, all the banks are creating money by making loans. At the end of the day, overnight clearing takes place. All of the checks written on all of the banks are cross-checked and balanced. Bank ABC loaned $1 M and may lose $1 M to other banks. However, it will also receive as deposits from money created by other banks, which are deposited into accounts at Bank ABC. Banks with more inflows than outflows will have excess (keystroke) money, which they will be happy to lend in the overnight inter-bank market to those banks which have excess outflows and less inflows. When banks as a whole fall short of funds, perhaps to due to withdrawals of money from the banking system, the Central Bank is the lender of the last resort, and will lend to cover any such shortfalls.
Monetary Consequences: The explanation given in the video, is also commonly used in textbooks. This suggests that if the reserve requirement is 10%, and there is $1000 of cash (called High Powered Money or HPM) in the system, then a maximum of $10,000 worth of money can be created. This is the myth of the money multiplier. It leads to the belief that Central Banks can CONTROL the amount of money in the system. However, since Central Banks are OBLIGATED by law to lend reserves to any Bank ABC which has suitable collateral, there is no restriction on the power of money creation by private banks. When Central Banks attempted to implement Friedman’s rule to keep monetary growth at a fixed rate of 6%, they found that they could not do so. The quantity of money was not subject to their control. It was after this failure that Banks shifted to using the overnight discount rate as the principal instrument of monetary policy decision.
In this post, we will cover the remaining portion of Goodhart Ch2 Case for Free Banking It is worth noting that this chapter is a theoretical preliminary, and not part of the historical analysis which is the main strength of this book. The Central Question of importance, to which no solution is known currently, is the following: Who should create money, and what should be the rules or guidelines for the creation of money? It should be obvious that the power to create money creates enormous benefits for the creator. The free banking debate takes the view that Central Banks are unnecessary government intervention which create a harmful monopoly over the power of money creation. The opposite point of view is that Central Banks are a conspiracy to benefit commercial banks at the expense of the government and the public. The historical evidence is more supportive of the second view. Competition among private banks is harmful to the banks, because to compete, they keep taking increasingly risky positions. The private interests of banks individually are opposed to the collective interests of the banking system as a whole. Thus, Central Banks evolved naturally out of the essential need to regulate private banking, in order to create some stability in a system which is inherently fragile and unstable under competitive forces. After this overall summery, we discuss the second part of Chapter 2, entitled “The Inherent Inflationary Tendencies of the Central Bank”. This completes our discussion of Chapter 2, and we will go on to Chapter 3 next week.
Theoretical Position: Central Banks will take advantage of this power to create large amounts of money, leading to inflation, and destroying the value of currency, causing massive damage to the economy.
Empirical Support: Several Historical episodes where convertibility of Central Bank issued notes to gold was suspended. This suspension indicates that Central Banks issued too many notes, and did not have sufficient gold to be able to provide backing for them.
Question: What is the alternative? Should private banks be allowed to create money? Another way to put the question is: What should be “legal tender”, money that is backed by the law?
Answer: Bagehot argues that if a bank is allowed to issue money freely, it will do so without restraint. However, the Bank of England had this power, and did not do so. WHY? Bagehot thinks that this is because the Board of Directors consisted of un-imaginative merchants, who were unaware of the possibilities open to them. However, Santoni argues that private sector directors were creditors, who had direct interests in maintaining the value of the currency. It was the government’s desire for funds which created inflationary pressures, which would be resisted by private sector directors of the Central Bank.
What does “Legal Tender” Signify? Goodhart makes the point that historically, currencies were designated legal tender in times that they were weak – there was insufficient gold backing, so the government had to step in with a legal protection for acceptance of the currency as payment. Historically, this status has occasionally been given to private currencies issued by banks. The point being made is that governmental legislation and decree is only a small part of what makes money valuable, and other factors, not considered in the debate, matter a lot for money creation.
The Free Marketeers ideological position: Hayek’s claim that “practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people”. Is this really true? Historical evidence does not provide any clear examples, where governments used power of money creation against the public interest. Ellen Brown has argued that free marketeers make this argument in order to take control of money creation away from the government, in order to use it for private benefits of the financial sector. For a more detailed discussion of this point of view, see “The Battle for the Control of Money”.
So what is the solution to this ALLEGED tendency of Central Banks to over-issue currency and thereby cause inflation? Free Marketeers argue that “competition” is the answer. One form of competition is with foreign currencies. If one Central Bank is irresponsible, the currency will be devalued and people will switch to more sound foreign currencies. Hayek did not consider this as a sufficient check on the power of money creation by Central Banks. Therefore he proposed a more radical alternative. Authorize private sector banks to issue money, and let them compete freely in the market for creation of money. However, there are many problems with this theoretical idea – the idea that the private sector would create sound money to maintain credibility is contradicted by the historical evidence. Private sector maintains appearances of credibility while doing extremely unsound and dangerous financial practices because they have inside information, and they are too big to fail. Realizing that there is no hope of creating private currencies, free marketeers have proposed to index money to a basked of commodities, in order to prevent inflationary tendencies. This is meant to replace the Gold Standard, which was a means to keep the currency anchored to a real resource, and thereby to prevent excessive issuance of currency. However, none of the commodity backed proposals have found much acceptability, and so this does not seem to be a viable approach.
Whereas the line of attack under discussion above says that Central Banks have inflationary tendencies and issue too much currency, there is another line of attack from the opposite direction. According to this line, Central Banks are too conservation and issue too little money, causing harm to the domestic economy. This is especially popular after the Keynesian critique of balanced budgets.
Resolution: The empirical evidence on this issue is quite clear. The central claim of the free bankers is that forces of competition would cause private banks to behave responsibly and not create excessive credit. Historical experience of more than 300 monetary and banking crises following the Reagan-Thatcher era of financial de-regulation proves conclusively that this is not the case. Given the power to create money without strict regulation, the shadow banking industry continues to create trillions of dollars of credit leading to extreme financial fragility.
The basis of this discussion is the question of how Central Banks should create money? Should they use their own discretion, or should they follow rules? Again, the empirical evidence on this question is very clear. The experience of rule-based monetary policy has been very bad. Central Banks were unable to control the money supply in accordance with the rules, and following rules limits the ability of Central Banks to take steps to help the domestic economy.
The reason for dis-satisfaction with Central Bank management of money supply arises from the fact that there are many different parties, with different interests. Managing money in any way will help some parties and hurt others, so there is bound to be dis-satisfaction. A brief summary of the conflicts of interest which surround monetary policy is given below, to provide some background for the remaining chapters of the book.
Some Background Information: The process of money creation affects everyone in the economy, but different parties have different interests. In general creditors would like to see stable currency and prevent inflation, while debtors would like to see easy money and inflation, so that the loans they have to pay would be cheaper to pay back. In general, creditors have power, and therefore keep the currency creation in check, to prevent inflation. Apart from this broad perspective, there are institutions and sectors with conflicting interests. The Government, which always needs money to finance projects and would like to see easy money creation. The Treasury must provide revenue to the government via taxation, and borrow money from Central Bank and/or private or foreign sources, to finance government operations. Although it is part of the government, it is interested in keeping spending in check, and raising taxes, both of which are in conflict with objectives of popular governments. The Central Bank, charged with the responsibility of money creation, has responsibility to preserve the value of the currency, and to regulate private banks. It is important to note that the interests of the Treasury and the Central Bank are not aligned. The Treasury, or Finance Ministry, would like to freely borrow from the Central Bank to finance the budget. The Central Bank would like to restrict lending in order to keep money supply in check, to control inflation. Then there are the private commercial banks and the financial sector of the economy. These are the creditors who have interest in keeping inflation low. A tight monetary policy suits them, as it makes it easier to sell credit. On the other hand, private real sector businesses would like to see easy credit, to cheaply borrow and invest. Then, there is the general public, which would like stability of money and prosperity, in the form of jobs created by easy money. In addition to all these conflicting interests, there are powerful effects on international trade. An easy monetary policy would lead to devaluation, making imports expensive and exports cheaper. Conversely, keeping the exchange rate stable might lead to a tight monetary policy harmful to the domestic economy.
8th Reader’s Guide continues our study of Chapter 2 of Goodhart’s “Evolution of Central Banks”. Previous post: RG7: Central Banks: Monopoly or Public Service?
Goodhart cites in detail several arguments made by Bagehot (pronounce Badge-it) in favor of a free banking system without a Central Bank. After listing them, he notes that Bagehot is “engagingly naïve”, as a gentle critique. It is astonishing that a hard-nosed practical financial analyst like Bagehot would indulge in such visionary daydreams about a “free market” system. This testifies to the power of ideology to blind one to the faults of idolized system. Here are some of the “naïve” arguments advanced by Bagehot in favor of free banking:
Goodhart shows that this starry-eyed idealization of free banking is contradicted by Bagehot’s own practical experience in context of the workings of the Central Banking system. Before discussing Goodhart’s critique of Bagehot, we pause for an explanatory note about “adequate reserves”, needed for those not familiar with banking operations
BRIEF EXPLANATION OF ADEQUATE RESERVES: (see Monetization, Maturity Tranformation, and MMT for a more detailed explanation.) In fractional reserve banking systems, the banks keeps only a small fraction of the cash that it has promised to pay on demand to creditors. If all creditors demand what the bank has promised, this creates a financial crisis. The more reserves a bank has, the less likely a crisis. However, the profits of a bank depend heavily on its making large amounts of loans without any backing for them in the form of reserves. So banks have a profit incentive to keep as little in the form of reserve as possible. Thus the motivation of maintaining credibility by keeping high reserves goes against the profit motive which calls for low reserves.
Goodhart writes that while Bagehot thinks that banks will maintain adequate reserves for credibility, elsewhere he explains that maintaining large amounts of solid gold is costly, so banks have every incentive to place their reserves at the Central Bank. This again suggests that Central Banking is a natural requirement of a commercial banking system, rather than a forced imposition by government, which cuts into their freedom and profits. Both theory and experience suggest that (1) is false – banks would not maintain adequate reserves in a free banking system because of the cost and care required to do so.
Similarly, Goodhart argues that (2) is also false. Crises are inevitable in fractional banking, because the public knows that when there is a run on the banks, the latecomers will not get any money, and therefore rush to be the first. In such times, the best remedy is to restore the confidence of the public that adequate reserves are present to support all demands for cash. One of the great advantages of Central Banking is that it is always present as a lender of the last resort — in a crisis, all private banks can rely on receiving adequate reserves from the Central Bank. In absence of Central Banks, Bagehot suggest that banks would lend to each other freely in times of crises, thereby obviating the need for a large Central Bank. However, banking experience cited by Bagehot himself suggests that this is false: “(Lombard Street, p. 290): “At such moments [panics] all bankers are extremely anxious, and they try to strengthen themselves by every means in their power; they try to have as much money as it is possible at command; they augment their reserve as much as they can, and they place that reserve at the Bank of England.” Self-preservation instincts would prevent banks from lending freely to each other, as a replacement for the Central Bank function of lender of the last resort. Furthermore, Bagehot seems to be aware of this.
Similarly, supposition (3) in favor of free banking is false. Goodhart cites another leading economist of the time, Henry Thornton, who discusses what would happen if there were two big banks instead of one. He writes that both would be tempted to rely on the presence of other for crises, and go for the profit opportunities created by lower reserves. Thornton also lists several advantages of having one Central bank, which include reputation, regulation of smaller banks, and others. Thus, it seems that Central Banking is not a governmental impostion upon the commercial banking system, but rather an essential requirement for the functioning of such a system.
This conclusion, which emerges from historical experience, is unpleasant to ideological free marketeers, because it shows that the free market system requires regulation, supervision, and government assistance to function. This is in opposition to the ideology which says the unregulated free markets work best, and all types of government interference in the system only cause harm to the efficiency of the system.
bit.ly/DSIA02F – Part F of Lecture 2 on Descriptive Statistics: An Islamic Approach discusses Corruption Rankings made by Transparency International.
In this lecture, we will examine global corruption rankings in light of The Four Questions which are central to the Islamic Approach:
We start by thinking about “Why we assign NUMBERS to corruption?” After all, it is qualitative condition of the heart, not subject to measurement. There is a long and complicated story which led to the attempts to measure the unmeasurable, which we summarize very briefly, to explain this:
Can Corruption be Measured? Obviously, the internal Qualitative, corruption of hearts, cannot be measured in numbers. BUT External Manifestation, like Bribes, can be measured. It is worthwhile to define BRIBE as the Use of Money for Persuasion towards personally profitable agenda at social cost.
Even if we confine attention to bribes, corruption is multidimensional and cannot be reduced to a single number. To see this, compare two countries. A has 100 corrupt transaction of $ 1M each. B has 1M corrupt transactions of $100. WHICH country is MORE corrupt, A or B? There is NO OBJECTIVE answer to this question. To answer, we need to specify the purpose of making the comparison.
There are situations when it become necessary to try to measure the unmeasurable. In such situations, the following Rules for Measurement are worth remembering.
The simplest case occurs when the Target is ONE-DIMENSIONAL and Quantitative. IN this case ONLY, objective measurement is possible. Much more often we have the case of a qualitative and multidimensional phenomena. In this case, we should explain clearly the subjective choices required to convert qualitative & multidimensional measures into a single number. If we consider a range of options, and also the purpose for which different USERS may find it useful, we will find different numbers for different users. This would be helpful to dispel the image of objectivity created by statistics.
Now, we come to the topic of the lecture. How is the CPI (The Corruption Perception Index) computed by Transparency International? To the best of our knowledge, they poll a group of wealthy businessmen of unknown identity , and ask them to rank countries from 1 to 10 in terms of their perceptions of corruption in a given country. High numbers are high honesty and integrity, while low numbers correspond to high corruption.
As discussed earlier in “What do College Rankings Measure?”, the crucial question is: “How much KNOWLEDGE do they have of global corruption, and of RELATIVE corruption?” Uninformed rankings just report the prejudices of the people who are doing the ranking. There are many reasons to suspect that these rankings are done by foreigners with little knowledge of local culture. Furthermore, it is likely that these businessmen make brief visits to get big jobs done in the fastest way made possible by wealth – they look for corrupt counterparts to avoid the regular process. In any case, it is likely that the perceptions just reflect the prejudices of those doing the ranking, rather than any characteristic of the country.
What do the CPI numbers mean? Statistical analysis in Zaman and Rahim (2009) shows that the CPI has a 98% correlation with log (GNP per capita). In other words, Integrity and Honesty is just another name for wealth. This likely reflects prejudice of the wealthy. In real life, we see that More wealth = more greed & corruption. The Quran also mentions how excess wealth leads to corruption. Remember that Corruption is a two party transaction.The poor accept money to do favors for the rich – the poor get the blame and coverage, while the wealthy escape attracting attention.
If we use the definition of bribe given above, LOBBYING in the USA, is easily seen to be bribery: the use of money to pursue narrow group interests while inflicting huge costs on society. The Global Financial Crisis is one example of how rich financiers got trillions of dollars in bailouts, at the expense of poor mortgagers made homeless by the millions. Another egregious example is the Medicare Prescription Drug Bill passed in 2003 using dirty tactics by Senator Tauzin on behalf of Big Pharma. The bill ensures that the Pharma industry can charge whatever price they like for sales to medicare. The government cannot negotiate, and they cannot import cheaper alternatives from Canada. The bill has been called an $80 billion per annum give-away to the Pharmaceutical Industry. (Despite a campaign promise to do so, Obama was unable to get this bill repealed due to the powerful Big Pharma Lobby.) Afterwards, Senator Tauzin left Congress to take up a $2 million consultancy, and also received more that $11 milion in cash rewards from grateful Big Pharma. But while all of this is documented, none of this is counted as corruption!
Our Islamic approach requires us to dig deeper into the historical context and background of the numbers we analyze. Why CPI was developed? The answer is somewhat complex. In the Post WW2 era, there was a competition between Capitalist & Communist models of development. The World Bank offered the Structural Adjustment Program, as a roadmap for development. There is not a single instance of success – no country became developed by following World Bank advice, but many countries, like East Asia, did industrialize by REJECTING World Bank advice (see Choosing our own pathways to progress). This failure of capitalist model widely documented and acknowledged by all parties. In order to maintain credibility, it was necessary for the World Bank to find some scapegoat to blame for the failure of the capitalist model for development. This was done by putting the blame on the poor countries for their own failure – a standard illustration of blaming the victim. It was not bad models created by the World Bank which led to failure, but bad governance and corruption in the poor countries which caused the failure. For more details see the article on Michael Foucault Power/Knowledge which explains how the powerful shape knowledge for their benefit.
The fourth question is: “What is the IMPACT of CPI?:. We could imagine that, theoretically, a country with a high CPI will make efforts to improve in terms of governance and corruption. Practically, it has the opposite effect. Solid research establishes that my behavior is affected by my PERCEPTION of social norms (and not by the REALITY). So If PERCEPTION of high corruption is created, people will act in more corrupt ways. If PERCEPTION of justice and low corruption is created, people act honestly. This means that the strategy of moving towards greater integrity and honesty is the opposite of the one currently being followed all over the developing world. Institutions like NAB and Anti-Corruption drives highlight corruption and cause it to spread. Instead, an effective strategy would highlight honesty and integrity. If a country has 99 incidents of corruption and one of integrity, publicity for the solitary good incident would create an impression of honesty and help to spread it. Thus, attempts to measure corruption via CPI are likely to be counter-productive rather than helpful in combating corruption.
Conclusions: The Colonization of Globe was justified by Racist arguments. White man was infinitely superior to all other races, and had right to rule the world. The colonization process was so extremely brutal and ruthless, that records have been suppressed from history and memory. Today, this process of colonization continues by financial means. Poor countries make billions of dollars of interest payments to the rich. Justification for this exploitation of the poor by the rich and powerful is still needed. This justification is created by the CPI as well as many types of economic theories of development.
POSTSCRIPT: This concludes Lecture 2 – Previous 5 posts discussed how widely used College Rankings are arbitrary. By choosing factors and weights appropriately, we could make the rankings come out in any desired way. Links to this sequence of posts are: Comparing Numbers , Arbitrariness of Rankings , What do College Rankings Measure? , Goodhart’s Law, and Values Embodied in Factors & Weights
Cross-Post from Islamic Worldview Blog. Shows how rankings always involve mixtures of facts and values when they are multidimensional. This is illustrated in the context of ranking of cars by Car and Driver magazine.
[bit.ly/dsia02b] This is part B of 2nd lecture in “Descriptive Statistics: An Islamic Approach” (DSIA02b) considers the issue of comparing two numbers to decide which is higher. Even though this task is trivial from the statistical point of view, it is very complex when we follow through to try to understand the real world context in which the numbers are being compared. This is illustrated through an example involving ranking of cars.
One of the best sources of learning is reading articles and books. Good articles and books encapsulate deep wisdom, which authors have gathered from their life experiences. Ultimately, the only source of knowledge is life experience itself. Since we have only one life to live, we can only gather a small amount for ourselves. Reading gives us access to the fruits of the life experiences of millions of scholars, throughout the centuries of written works. It is essential…
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This is the 7th Reader’s Guide in a sequence studying Goodhart’s book on the Evolution of Central Banks. For the previous post, see RG6: The Misleading Case for Free Markets. The key question under discussion here is: Do Central Banks provide a service to private commercial banks by supervising and regulating them, or do they use their large size and monopoly power created by legal framework, to extract profits at the expense of the government, the private banks, and the public?
The Bigger Question: The Reagan-Thatcher revolution in the late 1970’s consisted of a move towards free markets, and away from government regulation and control. Of central importance in this move was the deregulation of financial institutions. We would like to understand WHY this change took place, and WHAT were the effects of this change on the working of the USA/UK economies.
Summary of Basic Facts: Financial de-regulation, guided by an ideological belief that free financial markets would work better than regulated ones, was at the heart of the Reagan-Thatcher revolution. The evils of free financial sector had clearly been recognized in the Great Depression, The Emergency Banking Act of 1933 and other regulatory measures wrapped a large number of chains around the financial monster, which is a powerful source of energy, but capable of wild rampages on occasions. Among the most important of these measures is the Glass-Steagall Act, which prevented banks from speculating (with the depositors money). The ideological arguments in favor of financial de-regulation made to support financial de-regulation are just old wine in new bottles – variants of the arguments made by Bagehot, which are the subject of the opening pages of Chapter 2 of Goodhart’s Evolution of Central Banking. The dramatic contrast between the theory and the ground reality can be seen in the Savings and Loan Crisis which immediately follow the deregulation of the S&L financial industry in the 1980’s; for more details, see my book review: Meltzer’s “Why Capitalism?”: An Ideological Polemic. Similarly, in 1999 the Glass-Steagall Act was repealed, while the Commodity Futures Modernization Act of 2000 created the legal framework for a completely unregulated shadow banking industry to emerge. It took only 7 years for this unregulated financial industry to cause the collapse of global finance in GFC 2007. For more details, see Completing the Circle: From Great Depression of 1929 to Global Financial Crisis of 2007.
Opening Passages of Chapter 2: With this as background, we study the first few pages of Chapter 2 of Goodhart, written before GFC 2007. The following passage from the book reflects the effects of the enthusiastic move towards free markets launched by the Reagan-Thatcher revolution:
Currently, there is a groundswell of academic and political enthusiasm for the achievement of greater efficiency through the establishment of more competitive markets, and this again leads to a generalized preference for deregulation in financial, as well as other, markets, unless specific and compelling reasons for the continuation of any interference with laissez-faire can be adduced. This argument was given much weight by Bagehot in Lombard Street, and played a considerable role in the French discussion on free banking in the 1860s
Bagehot’s [pronounce as Badge-it] book is primarily concerned about how to make the Bank of England perform its role as a Central Bank in a better way. However, he makes several arguments why a system of free banking would be better – it is these arguments that we will be discussing. Two questions arise from Bagehot’s preference for free banking.
Q1 for Bagehot: why did Central Banking come into existence, when free banking is a superior system?. Q2 for Bagehot: Why does Bagehot not advocate a shift to free banking, replacing the Central Banking system? The answer to this question is short and easy, and so I will dispose of it first, to turn to the more interesting and difficult Q1. Goodhart writes the answer to this question as follows:
But, if Bagehot supposed the natural system so superior, why did he aim to improve the existing system, rather than change it entirely? Bagehot’s answer to that is that that would not be practical politics (Lombard Street, pp. 66-67): “ … I shall be at once asked-Do you propose a revolution? Do you propose to abandon the one-reserve system (Central Banking), and create anew a many-reserve system (free banking)? My plain answer is that I do not propose it. I know it would be childish. Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible.”
Bagehot’s Answer to Q1: Bagehot argues that Central Banking emerged due to a series of historical accidents. Because it financed the state, it was able to negotiate special legal privileges for itself, which allowed it to grow much larger, and create a banking system favorable to itself, with disadvantage to others. Here is a quote from Goodhart, explaining the views of Bagehot on this matter:
Why, then, had the Bank of England become established as the Central Bank? According to Bagehot, this was not because it served any really useful commercial purpose, but because it had been imposed on the system by legislation, legislation that was in turn a reward for its role, but also thereafter, in providing government finance at times of need on especially favorable terms. With so many advantages over all competitors, it is quite natural that the Bank of England should have far outstripped them all. Inevitably it became the bank in London; all the other bankers grouped themselves round it, and lodged their reserve with it. Thus our one-reserve system of banking was not deliberately founded upon definite reasons; it was the gradual consequence of many singular events, and of an accumulation of legal privileges on a single bank which has now been altered, and which no one would now defend.
The reference to legislation in the paragraph above is the Bank of England Act passed in 1694. For the historical circumstances around the creation of Bank of England by this act, see Origins of Central Banks. It is worth noting a few important points in reference to this debate about the issue of whether or not the existence of Central Banks is necessary for the financial system. There are four parties involves – the Government, the Central Bank, Private Commercial Banks, and the Public. According to the free market ideologues, the Central Bank took advantage of its special relationship, created by providing large loans to the government, to acquire monopoly privileges for itself. As a monopoly, it hurts the interests of the private banks, and the public. It also uses its monopoly power to exploit the government, which must get loans from Central Banks. Thus, Central Banks are pure evil, deriving benefits for themselves at expense of all other parties. In fact, it is easy to show that Central Bank and Government are mutually beneficial for each other – The Central Bank can provide easy finance to the government, which the government cannot get easily from any other source. In turn, the government provides legal protections which allows the Central Bank to operate, and does give it monopoly power. This point of view is presented in a detailed discussion of the Bank of England Act, its renewals, and the causes of its longevity, by Boz & Grossman: Paying for the Privilege: Bank of England Charters. Another point of debate is: does the monopoly powers of the Central Bank, granted to it by the law, harm the interests of the private banks, or is it a mutually beneficial relationship. Here the free market thinkers say that supervision and regulation by Central Banks is harmful to the private banks, and financial de-regulation would improve the efficiency of the system. In contrast, Goodhart is arguing that Central Banks and private commercial banks have a mutually beneficial relationship, and the existence of Central Banks is needed by, and essential for, the existence of the private commercial banks. He aims to prove this by using historical examples to show the necessity of the micro management function of Central Banks.
Ioana Negru, Lucian Blaga University of Sibiu
Lia Alexandra Baltador, Lucian Blaga University of Sibiu
The Collins and Thesaurus Dictionary (1987: 1088) defines uncertainty as ‘ambiguity’, ‘confusion’, ‘dilemma’, ‘doubt’, ‘hesitancy’, ‘lack of confidence’, ‘perplexity’, ‘puzzlement’, ‘scepticism’, ‘state of suspense’, ‘unpredictability’, ‘vagueness’. In economics, the term ‘uncertainty’ is defined in the context of decision theory and it is often conflated with risk. The Austrian economists believe that the future is impossible to predict and believe in (radical) uncertainty; Keynes, Shackle, Lachmann and Hayek are important heterodox economists who have all showcased the role of knowledge and uncertainty to be crucial within economic analysis. But students in general find it difficult to grasp the concept of uncertainty and the question becomes how can we teach uncertainty to students? How can we prepare our students to cope in a world that involves crises, change, transformation and ultimately, uncertainty?
Professor Hofstede’s research consists of a model that addresses comparisons between cultures based on six dimensions: power distance, individualism versus collectivism, feminity versus masculinity, uncertainty avoidance, long term orientation versus shirt term normative orientation and indulgence versus restraint (see https://hi.hofstede-insights.com/national-culture). As mentioned in the first part of our blog on Teaching in the Time of COVID-19, given Romania’s profile, and according to Hofstede, the uncertainty avoidance index is very high (90 out of 100 max). According to the same website cited above: “The Uncertainty Avoidance dimension expresses the degree to which the members of a society feel uncomfortable with uncertainty and ambiguity. The fundamental issue here is how a society deals with the fact that the future can never be known: should we try to control the future or just let it happen?”
In other words, there is a search for certainty and a certain rigidity in the attitudes and principles of individuals populating those societies that have a high uncertainty avoidance index and an opposite attitude of relaxation within societies with a weak uncertainty avoidance index. This makes us question the quest for certainty that we notice within the economics profession that is heavily preoccupied with making predictions, despite the actual health and economic crisis showcasing the presence of uncertainty and the short application span of various economic measures. This highlights a lack of epistemic humility within the economics profession that is indeed worrying.
Based on Roth (2016: pg 10) and Hofstede (see above), there are certain differences between societies with strong and weak uncertainty avoidance regarding the relationship and expectations student/teacher.
Source: Marija Roth, 2016: pg 10
In other words, in societies with strong uncertainty avoidance the teacher represents an authority of knowledge and very often teaching takes place ex cathedra, whilst epistemic humility and modesty is allowed/respected in cultures with weak uncertainty avoidance.
Uncertainty can also be related to processes of change, both at the level of the individual and the level of society, involving high degrees of stress. In terms of the educational environment in Romania, the characteristics of a high-avoidance uncertainty index can be found in the pressure on teachers to be ‘fountains of information’, but this information is not necessarily transformed into teaching practices that result in students questioning the information and overcoming the ‘duality’ level of black and white answers or dual thinking. What is rewarded is theoretical knowledge and fixed answers. Very often students prefer very conservative types of written exams based on theoretical questions or multiple-choice questions and feel very uncomfortable with essay-based exams or case-studies analysis based exams.
There is an impressive discussion in educational studies about the skills we should convey to students in the 21st century, in a continuously changing environment. How can we teach our students to cope with continuous change in the labour market, to learn to deal with uncertainty and adapt to new situations? These are difficult questions and they involve multiple answers. Marija Roth (ibid.) talks about teaching student intercultural competences, which will, of course, empower students at the end of their studies and prepare them for the life within a multicultural society. She also discusses the role of creativity. For us, it is very important to reward innovation in students, and to enable an open/pluralist/critical-thinking mind that will sustain students to cope with the new challenges they will face once they complete their studies. In truth, we do not know what the world will look like next year, let alone in 10-20 years, what the job market will be like and what challenges our students will face. But the capacity to adapt to unknown situations and outcomes will definitely work miracles!
Roth, M. (2016), “The Skills needed to cope with changes”, 9th NEPC SUMMERS SCHOOL 2016: Managing Change and Uncertainty: Education for the Future Shkembi Kavajes I Durres 3rd – 9th July 2016;
Mcleod, T.W. (1987), The Collins and Thesaurus Dictionary, London and Glasgow: Collins.
Website: https://hi.hofstede-insights.com/national-culture, accessed 4th of May 2020.