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.
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