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 Similarly, in 1999 the Glass-Steagall Act was repealed, while the Commodity Futures Modernization Act of 2000 created the legal framework for a completely unregulated shadow banking industry to emerge.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.