Here are a few questions to ponder while reading the introductory chapter of Goodhart (for background see Reading Course: Central Banking). In addition to the 5 questions, an explanation of some theoretical material which is covered very briefly in the Goodhart book is given after the questions. Don’t worry if you cannot follow the theoretical material. Most of the book is a historical argument against the free market theories. The history is of great value in understanding the nature of Central Banking, and not just as an argument against certain false free-market ideology based theories. These questions and explanations cover only the first 3 pages. Next post will start from top of page 4: “To return to the main theme, however, …”
- What is Charles Goodhart’s motivation for writing this book?
- What is “Free Banking”? This is not explained in text but taken for granted. You might read Wikipedia article on Free Banking to get the basic gist.
- Walter Bagehot, author of Lombard Street, supports Free Banking theoretically, but not practically. What does this mean? That is, why does he have inconsistent position, with conflict between theory and practice?
- The issue has been foreclosed – That is, there is unanimous agreement on government control of money supply via Central Banks – but proponents of free banking disagree, and think we should consider alternatives. Think about emerging bitcoins, FB Libra, community based local currencies, and other types on non-government issued currencies, and relate these to free banking. FORMULATE the QUESTION that modern critics of Central Banking would want to ask regarding these emerging privately issued currencies.
- Friedman and Hayek are both free market ideologues. They believe that governments should not interfere with the workings of the free market. However, the two have a difference of opinion regarding Central Banks. What is this difference? Explain how both positions strongly restrict role of government policy but in rather different ways.
EXPLANATORY NOTES: Some of the material which follows covers rapidly a lot of literature – it is not worth asking questions about this because answers would only be possible for someone who knows the literature. Rather, I provide some explanations of what is a very condensed presentation of a rather extensive literature.
Supporters of of free banking for creation of money have done research from two angles – One is the theoretical side, based on rational expectations – for example King, Robert G. “On the economics of private money.” journal of Monetary Economics 12.1 (1983): 127-158., The second is an empirical side, based on analyzing historical experiences of eras where there was free banking. The gist of this research is that the theoretical analysis supports the possibility of free market creation of money leading to efficient outcomes. Also the analysis of historical experience suggests that it was not too bad (contrary to previous research, which said that it was a complete disaster, which is why Central Banks were necessary). The author Goodhart wants to argue AGAINST these positions, and show that Central Banks are needed.
Free market ideologues make comparisons between Free Banking versus Central Banks. Central Banks can be analyzed under Gold Standard, or under a fixed monetary policy rule, such as Friedman’s rule. In both cases, the options of the Central Bank are limited to following rules (like the Taylor Rule). Both of these scenarios are compatible with free market ideology, because the government is forced to follow free market discipline. However, a Central Bank following a DISCRETIONARY monetary policy is NOT compatible with free market ideology. Discretionary monetary policy MEANS that the government intervenes to fix problems with free markets, and is an admission of failure of the free market.
Another, rather different, line of criticism of Central Banking comes from work starting with Public Choice theorist Buchanan. In general, this line takes the view that governments cannot act in ideal ways to help the public because of incentive problems. The Central Bank is an AGENT carrying out orders but the motivation of the agent is not the same as that of the PRINCIPAL. The governor of the state bank is motivated by salary and reputation (which allow him to get future jobs), and this is not the same as doing the best possible action in the interest of the general public. This Principal-Agent literature has had a practical impact on conduct of monetary policy, as we shall see. Governments have tried to devise contracts which provide incentives to the Central Bank to keep inflation low and employment high. Suggestions have been given, and even implemented occasionally, where the salary and job of the governor of the state bank has been made to depend on monetary stability. From the free market ideology point of view, the point of this literature is to show that government interventions will lead to WORSE results compared to the free market. This is a NEW line of argument, and a NEW defense of free markets. It is admitted that free market can fail and can produce bad results. BUT, government attempts to fix the problem will make the problem even worse.
This whole line of thinking is a produce of free market ideology, and seriously flawed because of its ideological roots. Nonetheless, if we want to understand how Central Banks work today, we have to study some aspects of this theory, because it has been very influential in shaping policy making all over the world. It is NOT very important to understand this theory for the purposes of this book. In fact, one of the goals of this book is to show that history does not support the ideas of the free market ideologues. But to understand the book as a counter-argument to free market ideology, we have to understand what the ideology is.
This summary covers up to the bottom of page 3, the paragraph which ends at the top of page 4. We will continue our discussion of the remaining chapter in later posts. For next post, see: RG2: Goodhart on Central Banks
OPTIONAL ADDITIONAL READINGS TO BUILD BACKGROUND KNOWLEDGE AND UNDERSTANDING of material covered on these three pages of Goodhart.
Wikipedia Articles on:
Regulatory Capture: Government attempts to regulate public enterprises. But the regulatory agency is captured by the enterprises that it wishes to regulate. Instead of acting in public interest, it acts on behalf of the private interests of the profit making firms at expense of the public.
Public Choice: A theory about how governments/bureaucracies behave when they try to interfere in the free market for the sake of the public interest.
James Buchanan: One of the leading public choice theorists who exercises a lot of influence on shaping public policy
WEA Pedagogy Blog 
Asad, please forgive me, but where is the link to the actual book itself?
Link to download book is available from the signup registration form for the course – you can open the form, use the link, and exit without doing anything else. If you have any problems downloading book, please let me know.
From point 3 and 4, it seems as if state’s desire to exercise control over money with central banks goes deeper than its willingness to relinquish some control in other markets.
I have a couple of comments before commencing to read Chapter 1 and a comment after reading chapter 1, also a brief note to Prof. Asad on Learning History:
Comments before reading:
In the evolution of central banks, one has to ask a main question before examining the case for or the case against central banks, WHAT IS THE PURPOSE OF A CENTRAL BANK INSTITUTION FOR MY COUNTRY?
The banks performance as conducted in the US (leading for example to the Global Financial Crisis in 200*) warrants the need for a central bank CB (the Fed in US). The CB even if it failed to predict the burst of the bubble as Alan Greenspan stated at least wiped it off quite well.
On the other hand, SAMA, the Saudi Arabia Monetary authority is just an organizing monetary entity with no substantial independent authority in monetary affairs.
So, factors like is the banking system comprised of a substantial number of Banks, that need an entity to organize them; and more importantly an entity to supervise them, especially if these banks undertake actions that have to be supervised (example undertaking subprime mortgage lending).
(There are several other factors like ….Do you need an entity to curb the government’s inflationary bias? Or are you in a developmental level that needs the central bank to be an agent to the government )
The QUESTION I ALWAYS FELT interested to investigate (especially it influences operate under an Islamic Banking System), is the claim that central banks loose the majority of their ability to conduct monetary policy under zero interest rate.
This conventional theory has been refuted in 2008, when the FED, taking from the Japanese experience in swiping a bubble, announced near zero interest rates. The Fed, under Bernanke the CB governor subsequent to Greenspan, had an undeniable role in mitigating the crisis with monetary policies under near zero interest rates-loosing one of it conventional tools discount rate; and of course, along with radical fiscal expansionary policies from the government side.
Comment after reading the chapter:
Goodhart distinguishes the need for a central bank based on the economic school of thought, those with a laissez faire paradigm will not advocate for a central bank institution. On the other hand, advocates of a central bank will determine its operation based on their paradigm again but this time based on rules versus discretion as best reflected by Friedman views versus Hayek views on the operation of a central bank.
Goodhart nicely describes the art of monetary management by distinguishing it into macro-functions and micro-functions. The first is concerned with directing the monetary conditions in the economy while the latter is concerned with the health and well-being of individual banks.
Goodhart states the conventional tools of central banking mainly OMOs and reserve requirements; however, he disregards discount rates.
The publication date of the book is 1998 which is almost a decade before the 2008 Global Financial Crisis, Goodhart views concerning Central Banking could have drastically changed after this crisis.
Comment on Prof. Asad
Prof. Asad poses this question: “Q1: Why are we studying history? How will study of history help us to understand economic theory? For non-economists these questions seem obvious, but for economists these seem puzzliing because modern textbooks on monetary theory make no mention of this history.”
As an economist, I have been trained to understand money …one has to understand the history of money, to understand value, one has to understand the history of value, and so on and so forth. To understand the schools of economic thought one has to study them in a historical, political and social and even sometimes psychological context. So, I am not sure why Economists would be puzzled to study history?
Prof Asad had several guides to read, I have not been able to go over them yet so I am sure he has been over almost all these points; I am just sharing here my own thoughts before and after reading chapter 1.