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:
- In a competitive free banking system, every bank would maintain adequate reserves, to create credibility.
- Also, in case of panics, they would lend to distressed banks, in order to protect the financial system.
- This system of multiple reserves (where each bank keeps its own reserves) would be superior to a centralized system, where only one bank keeps reserves., due to the benefits of competition over monopoly.
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.