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!

References:

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.

 

Lia Alexandra Baltador, Lucian Blaga University of Sibiu

Ioana Negru, Lucian Blaga University of Sibiu

 

In the Romanian education system, the online teaching tools have been mostly used… with caution. There are some objective and subjective (hard and soft) reasons behind this situation. Let’s start with some facts. Romania has a low education spending, 2.8% of the GDP (compared with 4.6% EU average) and the lowest share in the EU, with only 10.1% of the adult population having above basic digital skills.[i]

There are structural socio-economic problems, such as high income disparities, poverty and social exclusion. According to the latest working papers on the Country Report Romania 2020 for the European Semester[ii] “Social transfers have a limited impact on poverty reduction. Inequalities persist, in particular for people in rural and disadvantaged areas early school leaving are also very high.” Last year, for instance, the early school leaving rate was 16.4%[iii]. Also, the document assessed limited progress in improving the quality and inclusiveness of education. So, even before COVID 19, “one in three Romanians is at risk of poverty or social exclusion, with vulnerable groups, including the Roma, being the most exposed.” Other findings of this paper indicates that the number of highly digitally equipped and connected schools in Romania is significantly below the EU average.

Also, an OECD study indicates that in Romania teachers reported high development needs in Information and Communications Technology (ICT) teaching skills (21.2%), while 49.8 % of Principals reporting shortage or inadequacy of digital technology for instruction [iv].

On a softer note, the Romanian culture stands out, in Hofstede’s Model, on two dimensions. It ranks one of the highest on the Uncertainty Avoidance Index and the highest on the Power Distance Index, both having a value of 90 (out of 100 max).  Would these cultural characteristics play a role in education? We think they do, and in our experience they have been confirmed as doing so. Romanians are uncomfortable about uncertainty. We need to know, even if the situation is critical. The new situation was without precedent and the government appeared (and probably was) very confused and vague in its instructions and subsequently updates. This become obvious in the high volume of fines that law enforcement officers applied to confused and disobedient citizens. A high Power Distance Index indicates cultures in which people accept uneven distribution of power between members of societies, but expect solutions from its leaders, without much individual civil engagement. The lack of clear rules resulted in much speculation, mostly among the least educated, who are also more inclined to be manipulated.

Our faculty encouraged their staff to make use of digital learning tools, so that many colleagues would use online platforms, such as Google classroom. However, in many cases we wouldn’t rely on it much for teaching, per se. The suspension of face to face classes put professors in front of a screen, where non-verbal feedback was not possible, while verbal feedback involved long pauses and, as Murphy would predict, crowned at some points with technical difficulties. … These experiences raised some questions: What was the biggest challenge for us and for our students for the foreseeable future? Why were there so many communication difficulties? What should be changed in our teaching practices?

In our attempt to find out how our students are coping, we raised this question via menti (an app which ensures anonymity for respondents). Some of the answers indicate several stress factors, including the inability to meet one’s family and friends, isolation and loneliness,  the need of parents to go to work in a risky environment, being bored and without motivation or being constantly indoors. Most of this challenges we could feel on our own, so mutual understanding and empathy was easily created. Even some of the more introvert students seem to be more approachable and shared their experience, so, to some extent, the social distancing brought us closer.

While communication relies on sending messages and receiving feedback, the latter is much more difficult to obtain online. In our experience, not getting the immediate verbal and non-verbal response resulted in a feeling much like that of a tv anchor presenting the news. And it is frustrating to some point not to be able to know if the message got through, more so in a climate of confusion, uncertainty and fear. Furthermore, Romanians, as with many Latin cultures, tend to speak not only with the mouth. The inability to make use of and exchange kinesics, facial expressions, eye contact and proxemics hindered effective teaching.

In future, classes should aim to develop critical thinking, team-work and compassion and care for others. If there is (at least) one lesson to be learned from this pandemic it’s: We are all in it together!

 

[i] European Commission (2019), Digital Economy and Society Index (DESI) 2019- Country report Romania, available at: https://ec.europa.eu/digital-single-market/en/scoreboard/romania

[ii] COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP https://ec.europa.eu/info/publications/2020-european-semester-country-reports_en

[iii] European Commission (2019) Education and Training Monitor 2019 Romania https://ec.europa.eu/education/sites/education/files/document-library-docs/et-monitor-report-2019-romania_en.pdf

[iv] OECD (2019, Romania: Teachers and teaching conditions (TALIS 2018), available at: https://gpseducation.oecd.org/CountryProfile?plotter=h5&primaryCountry=ROU&treshold=5&topic=TA

 

 

 

 

 

 

This is the introduction of my recently published paper “Models and Reality: How did models divorced from reality become epistemologically acceptable?” (May 3, 2020). Real World Economics Review, Issue 91, p20-44, March 2020. Available at SSRN: https://ssrn.com/abstract=3591782

1: Intro: From Surrogates to Substitutes

The problem at the heart of modern economics is buried in its logical positivist foundations created in the early twentieth century by Lionel Robbins. Substantive debates and critiques of the content actually strengthen the illusion of validity of these methods, and hence are counterproductive. As Solow said about Sargent and Lucas, you do not debate cavalry tactics at Austerlitz with a madman who thinks he is Napoleon Bonaparte, feeding his lunacy.  Modern macroeconomic models are based assumptions representing flights of fancy so far beyond the pale of reason that Romer calls them “post-real”.   But the problem does not lie in the assumptions – it lies deeper, in the methodology that allows us to nonchalantly make and discuss crazy assumptions. The license for this folly was given by Friedman (1953, reproduced in Maki 2009A): “Truly important and significant hypotheses will be found to have ‘assumptions’ that are wildly inaccurate descriptive representations of reality”. In this article, I sketch an explanation of how economic methodology went astray in the 20th Century, abandoning empirical evidence in favor of mathematical elegance and ideological purity. Many authors have noted this problem – for instance, Krugman writes that the profession (of economists) as a whole went astray because they mistook the beauty of mathematics for truth.

To begin with, it is important to understand that modern economics is entirely based on models. There is a lot of merit to the idea that economic knowledge must be encapsulated in models. This is because economic systems are complex and interactive. We may well have strong intuitions about some local aspects of the system, but when we put all our intuitions about the different parts together, something unexpected may emerge. This is now well known as the phenomenon of complexity, and emergent behavior. This also explains the central importance of mathematics in modern economics. When we want to piece together parts of a complex system into a whole, mathematics is necessarily and inevitably involved, because the required integration cannot be done intuitively and qualitatively. The central hypothesis which drives this paper is that the relationship between economic models and reality shifted over the course of the 20th century. The nature of this shift can be described by borrowing some insightful terminology from Maki (2018). He defines two types of models. One is a surrogate model: such a model is a simplification which attempts to match some complex reality, and can be judged by the degree of resemblance it achieves. The second type is a substitute model: the imagined mini world of the model is a substitute for the target maxi real world, rather than an attempt to approximate the latter. As Maki (2018)) notes: “surrogate models can be wrong (or right), while substitute models cannot even be wrong about the world (since they are not presented and examined as being about the world).” Our main thesis in this paper is that economists started to use models as surrogates, but eventually fell in love with their own creations, and began to treat them as substitutes for the real thing.  The goal of this paper is to sketch how and why this happened.

2:A middle-brow history of methodology

Our goal in this essay in NOT to add to the debunking of economics – this task has been done in many books and essays, and the debunking has been contested by many other books and essays. A balanced state of the art survey is available in Uskali Maki (2002) who opens the book with:
Fact or fiction? Is economics a respectable and useful reality-oriented discipline or just an intellectual game that economists play in their sandbox filled with imaginary toy models? Opinions diverge radically on this issue, which is quite embarrassing from both the scientific and the political point of view.

Instead of joining this debate, we take the second option as a given: economics is an intellectual game that economist play with toy models. We are interested in the meta-question of how did this become possible? What are the trends in history of thought which allowed the development of models completely divorced from reality?

A book length detailed treatment of the answer to this question has been provided by Manicas (1987) in “A history and philosophy of the social sciences.” The central thesis of this “embarrassingly ambitious” book challenges the very notion of “social science”, suggesting that it was built on the wrong foundations. A very brief outline of the central ideas of this book is as follows.

  1. The practices of the modern sciences which emerged in the sixteenth and seventeenth centuries were incorrectly characterized. For various historical reasons, this remained unrecognized in the more refined and sophisticated ‘philosophies’ of science which subsequently came to be articulated.
  2. Social sciences took their modern shape in the early 20th Century as the result of a deliberate attempt to apply the ‘scientific method” to the production of knowledge about human societies. But the understanding of the scientific method was deeply flawed. As a result, the “methodology” adopted for use in social science was also deeply flawed.

According to Manicas, “The upshot is the possibility of a thoroughgoing revolution in the received ideas of science, natural and social. It allows us to ask whether there is a huge gap between the ideology of science and practices in the physical sciences, and whether, more disastrously, the social sciences have been ideologically constituted in the sense that they were based on a misconception about what the physical sciences are.”

In a commentary on Rodrik’s (2015) defence of economic methodology, Maki (2018) writes that “The portrait of economics offered by philosophers of economics… (is)… too refined for practicing economists, but the degree of refinement… (in understanding economic methodology)… currently held by practicing economists is often too low.” The message of Manicas (1987) is central to understanding current methodology of social science, and leads to the possibility of a thoroughgoing revolution. However, reading and understanding this book requires background in history and philosophy which very few economists have. As a partial remedy, I have attempted to provide a coarse-grained and crude summary of some of the highbrow philosophical ideas which have driven the development of methodologies in the social sciences in general, and economics in particular. The goal is to explain how it became possible to think that it is reasonable to develop models without connecting them to external real world structures. We begin with a rough description of what this methodology is, based on an experiential view, rather than a theoretical perspective.

To read remainder of paper, see https://ssrn.com/abstract=3591782

The Reagan-Thatcher revolution started an era of financial de-regulation, in adherence to free market ideology, which continues to this day. This is true despite the hundreds of major and minor financial crises which testify to the inherent instability of the financial system, and the necessity for effective regulation. Regulation and supervision of private commercial banks is the responsibility of Central Banks. To understand this debate in depth, it is useful to study the historical “Evolution of Central Banking“. This is the goal of an ongoing online course, which aims to go through a book by Charles Goodhart on this topic. About 100+ students are registered in the online course, and we have recently finished going through Goodhart Chapter 1 Evolution of Central Banks. In this post, we provide a summary of the six Reader’s Guides numbered RG1, …, RG6, which have been posted about Chapter 1. We will start our study of Chapter 2 one week later.  This is an opportunity for latecomers to join, since they can easily go through the reading of one chapter, together with accompanying readers guides, in one week. Fill out the Google Form History of Central Banks to register for an email discussion group for the course, and to get access to a downloadable copy of the complete book.

RG0: Introduction to Online Course

This 0-th post provides a general introduction to the online course.  Economic theories cannot be understood outside their historical context (which includes transitions between nomadic, agricultural, feudal and market societies). History is of great value in understanding the nature of central banking also, because the way money works has also changed radically several times over the twentieth century (i.e. gold standard, gold exchange standard, floating currencies). Money is at the HEART of economics and we need to understand its role in the economy. To understand the role of money, it is essential to understand how this has been evolving and changing over time. As a result, a theory of money must also evolve and change, and even attempt to predict the next change that may emerge in the role and function of money. No universal invariant theory of money can be correct.

RG1: Readers Guide to Goodhart on Central Banking

Goodhart worked as economic advisor at Bank of England for 17 years. As part of a general trend towards free market thinking launched by the Reagan-Thatcher revolution, he encountered increasing discussions about whether Central Banks were necessary, if so, what their role should be. He finds the new free market theories very much out of line with reality. He wrote this book in order to show the failure of these theories, and to show how the role of Central Banks emerged naturally from historical necessities. Seeing how Central Banks evolved to respond to needs of the financial system shows both how they are essential to the functioning of the system, and also exactly what the needed functions of Central Banks are

RG2: Arguments against Central Banks

Charles Goodhart rehearses the main arguments against Central Banks, in order to show why they are wrong. The novelty of his approach is his use of the historical experience to show why these theories are wrong. There are two separate lines of free market arguments corresponding to Hayek and Freedman. Hayek argues for complete elimination of Central Banks, leading to “free banking”. In contrast, Freedman would like to tie the hands of Central Banks to follow fixed rules. Three different arguments can be given to explain the harms of discretionary monetary policy: that is a Central Bank which is free to take whatever actions it see’s fit to correct all types of problems in the financial sector. After rehearsing these arguments, Goodhart goes on to discuss the origins and evolutions of Central Banking, and show how this history contradicts these arguments. Central Banks emerged naturally to fulfill a need with small private banks could not fulfill. Their large size naturally led them to step into dual roles of stabilizing the economy and regulation and supervision of smaller banks. Contrary to the free market views of government imposing regulation, the structure of Central Bank actually evolved out of the needs of the government as well as the needs of the private banking industry.

RG3: Micro-Management Responsibilities of the Central Bank

As Central Banks grow big and powerful, their actions affect the economy of the nation as a whole. Recognition of this power leads to the responsibility to exercise it with care, in the public interest. This is called the macro-management responsibility of the Central Bank, and this came into existence very slowly. Furthermore, the nature of this responsibility, and the actions it necessitates, has changed radically over time, corresponding to changes in the international financial architecture. In contrast to this, the micro-management responsibility of Central Banks has remained constant over time, despite radical changes in both domestic and international environments. This micro-management responsibility consists of supervision and regulation of the commercial banks. From this historical fact, Goodhart concludes that the primary function of the Central Bank is micro-management. The macro management function is built on top of, and emerges due to, this micro role of supervision and regulation. Economists only theorize about the macro management role. Free market theories which argue for elimination of Central Banks, or for tying the hands of Central Banks to fixed rules, ignore completely the central importance of the micro-management role.

The first four posts (RG0, RG1, RG2, RG3) cover Chapter 1 of Charles Goodhart’s book on the Evolution of Central Banking. The next two posts – RG4 and RG5 – provide some general information about methodology of economics, and the conflict between free market ideology and reality. Similarly, while RG6 makes a beginning on Chapter 2, it is mainly a general discussion of free market ideology

RG4: History, Methodology and Economic Theory

This post explains how economic theories are created to understand particular economics systems, within a given historical context. Economic systems keep evolving and changing, and so economic theories also must evolve and change with time. Very strangely, the methodology of modern economics does not accept this simple and obvious truth. Why is this so? Because economists wanted to imitate the methodology of Physics, and create laws of economics which would be universally valid, across time and space, just like the law of physics. This a-historical methodology has been a source of great harm, making economists blind to the importance of world historical events in the study of economics. For example, World War 1, World War 2, and the Vietnam War, all led to dramatic changes in the global monetary system, but economists are unaware of this because modern methodology excludes history, This is one important reason why we are study history of Central Bankings, because it leads to insights not available to orthodox economists, who exclude history from economic theory.

RG5: Evolution of Economic Systems

It is easy to see that economic systems have evolved over time. The economic systems of hunter-gatherer societies differed radically from those of agricultural communities. It is also easy to see that the economic system affects political and social organization, as well as the patterns of interaction with our habitat, the planet earth. Treating economic theory as a science, a collection of universal invariant laws, blinds economists to all of these connections. This post traces the impact of the industrial revolution, which allowed creation of massive amounts of surplus, on social norms, politics, colonization, consumption, environment, and other dimensions of our existence. The evolution of economic systems, and the corresponding need for the evolution of economic theory adapted to the system, as well as the inter-connections of economic with politics, society, and environment, are all blind spots of modern economics. Studying the evolving economic system within its historical, cultural, and geographic context gives us deep insights into economics not available from the mainstream orthodox perspective on economic theory and methodology.

RG6: The Misleading Case for Free Markets

The debate about the responsibility of Central Banks for the recent Global Financial Crisis of 2007 continues to this day. Did they cause the crisis, destroying the lives of millions, or did they save the world from a financial disaster? The debate today mirrors debates which have been going on for more than a century. The strong support for financial de-regulation is built on the foundations of a free-market ideology. In fact, it is easy to prove, both theoretically and empirically, that the free market ideology is wrong. Vast numbers of economic crises created by free markets provide the empirical evidence. Theoretical evidence shows the presence of externalities, imperfect information, transaction costs, monopolies, and many other problems, all of which prove the failure of free markets. Despite huge theoretical and empirical evidence, the argument for the efficiency of free markets occupies the central position in modern economics textbooks. WHY does the extremely bad argument continue to dominate the discourse? The post explains that the top 1% do not have sufficient power to implement policies favorable their interests by brute force. Instead, they must convince the bottom 90% to go along of their own free will. This requires creating theories which give the appearance of being good for all, while actually promoting the interests of the top 1%.

This sequence of posts goes through Charles Goodhart’s book on Evolution of Central Banking. Previous post is: RG5 Evolution of Economic Systems

Chapter 2 opens with a discussion of the views of Walter Bagehot (pronounce as badge-it), author of Lombard Street, which has received a lot of recent acclaim as masterpiece on central banking. After the Global Financial Crisis, Martin Wolf asked “Doesn’t what has happened in the past few years simply suggest that [academic] economists did not understand what was going on?”. Larry Summers responded by naming Lombard Street (1873). There are many articles which examine how a 150 year old book provides insights into the financial crisis which modern economists do not understand!. See, for example, Brad De-Long’s This Time is Not Different. (For a more realistic and clear-sighted appraisal of Bagehot for modern Central Banking, see Misreading Walter Bagehot.)

As also discussed in the first chapter, Walter Bagehot supported free banking as a normative ideal, but recognized that it would not be practical or possible to create the radical changes required to move from Central Banking towards that ideal. Why then is it worth going over dead arguments of a dead economist from 150 years ago? As in a game of whack-a-mole, these arguments keep getting whacked down, and they keep popping up again and again. In practice, today, the shadow banking industry is close to a re-creation of the free banking idea. So, it is worth going over these ideas from their origins. In this post, we will discuss the general arguments for “laissez-faire” – let everyone do whatever they want to do – which is at the heart of many arguments for free banking. The general idea is that all type of regulations tie the hands of free markets and lead to less than optimal outcomes. The best system is a free market system without any regulation, where everyone is free to do whatever they want. In fact, this idea is disastrously wrong, and this can easily be proven theoretically, and backed up by many many empirical examples where free markets have led to major disasters like the Great Depression and the Global Financial Crisis. So ,question is: Why does this hopelessly bad argument keep popping up over and over again, like the whack-a-mole puppets, impervious to any number of blows? In this post, we attempt to provide an answer.

All economic policies hurt some classes and help others. No class has by itself sufficient power to control the outcomes. Thus, powerful classes must depend on persuasion to convince other classes that actions they want to take are in the common interest of all. Karl Marx said that capitalism depends on the willing compliance of the laborer with his own exploitation. Why do the bottom 90% strongly support a system which generates increasing inequality and siphons more than 50% of economic gains into the pockets of the top 1%? Their willing consent is based on the dominance of deficient economic theories (See ET1% Blindfolds Created by Economic Theory). To see how this works, we start with an example from ancient times.

Mazdak was an ancient Persian philosopher who preached against private property, and argued in favor of communal ownership of all resources. This would obviously appeal to the poor, who would thereby acquire a share of ownership in the palaces, wealth, and luxuries of the rich. However, the practical effect of the philosophy was the opposite of this egalitarian dream. The rich and powerful were able to defend their properties, and also were able to occupy and take over the property – including wives and children – of the poor, because they had the power to enforce their will upon others. The philosophy provided a cover for their actions because it deprived the poor of their rights to their own property. This is exactly how ET1% works: by appealing to the poor, while working against their interests.

Among the most powerful of the theories of the top 1% is the idea of “freedom” – let everyone be free to pursue his/her dreams. This matches the individualist and hedonistic spirit of the age, and appeals to everyone. Milton Friedman’s book “Free to Choose” has been a popular bestseller, and defends capitalism by selling dreams of freedom. The essential trick to selling these dreams is by creating a phantom enemy. The bottom 90% is initimately familiar with being oppressed – this is part of the life experience of the labor class. However, very few have understanding of the causes of this oppression. Therefore, free market demagogues can provide a simple enemy. For example, Trump appealed to the oppressed masses by telling them that it is the “immigrants” who are taking away your jobs and wealth. Similarly, free market economists blame everything on big government. They sell the “Horatio Alger” dream to the masses – if we move to a free market system, there will prosperity for all, and everyone will have a chance to become a millionaire. The reality of very low social mobility is hidden from sight. If you are born poor, you live poor, you have poor children, and you die poor. Of course, there are always a few who break free, and these people are glamorized and celebrate to create the dream that this is possible for everyone, and the only obstacle to the realization of this dream is the big government.

If you can successfully sell these dreams, as Trump did, you can make the masses focus on the wrong enemies, like immigrants, WMD of Saddam Hussein, Islamic terrorism, or the demon-of-the-month. That way, the people being exploited by the system do not recognize what is going on and are unable to unite to fight their common enemy. (See my post on “The Shifting Battleground” for more details about this analogy.). Over the course of the 20th Century, there has been revolution in techniques of persuasion – the selling of dreams. Our minds are shaped by the “hidden persuaders” in ways we are largely unaware of.

The fundamental structural flaws in the global economy have not been addressed after the 2008 global crisis.  Monopoly-finance capital became increasingly dependent on bubbles that, both in credit and capital markets, proved to be globally the sources of endogenous financial fragility. This process was reinforced, in a vicious circle, by a concentration of income, wealth and power. By negatively influencing labour and working conditions, it became increasingly difficult for effective demand to reach the level of full employment. In response to this situation, credit policies fostered consumers to expand their spending through increasing debt. While public spending on social and infrastructural objectives was severely restricted, it expanded in other areas, sustaining the income and the demand of powerful groups.   Considering this background, in the last two years, serious concern arises that a new global economic crisis of unprecedented magnitude could still happen.

At the beginning of 2020, the outbreak of COVID 19 in Europe and Latin America put in question the dynamics of neoliberal capitalism and its global governance. Moreover, the global health crisis will certainly have negative implications for economic growth and democratic institutions since its evolution is deeply affecting social cohesion and political stability. When taking into account the trade-off between the so called efficient strategies for re-opening the economies and the recommendations on social distancing, the former ones might be only possible in societies that tolerate more inequalities.

Ten years after the 2008 global financial crisis, the commodification of health, the spread of fiscal austerity programmes, deep social marginalization and climate change challenges revealed that health issues are “vital matters” that economists should address. Moreover, the outcomes of the coronavirus crisis call for a reflection on the contemporary threatens related to individual freedom, control on individuals and insecurity in social interrelations.

After the  global financial crisis, central banks in the US and European Union focused on lender-of-last-resort program extensions and dealt with multiple challenges: how to prevent a recessionary downturn, how to avoid asset and credit bubbles and inflationary pressures. The unprecedented actions of the Federal Reserve, European Central Bank and the Bank of England, for example, suggested the need to rethink the traditional scope of the lender of last resort. The scope of the central banks’ interventions was expanded in order to include not only the provision of liquidity as lender of last resort, but also to include the expansion of repurchase agreements as buyer of last resort and the supply of liquidity to specific markets as market maker of last resort.

In the current COVID-19 scenario, the lack of global joint actions reveals that the world increasingly lacks supranational solutions to supranational or transnational problems. Nevertheless, there is no global authority to assume these political decisions. Recalling Eric Hobsbawm´s words in the book Globalisation, Democracy and Terrorism: “The only effective actors are states”.

At the core of this global and fagmented setting, there is the “trade” dispute between China and the U.S.  It is worth remembering that, according to Yanis Varoufakis, the “Global Minotaur” has a crucial weaknes  because of the global asymmetries that resulted from the global architecture built after the 1970s. the maintenance of the U.S. supremacy requires global permanent unbalances.

The “failure of the market mechanisms” to cope with the outcomes of COVID-19 calls for a reflection on new  issues of power, politics and finance. Indeed, the coronavirus crisis relates to a socio-cultural process that is provoking changes in  subjectivities, behaviours and modes of governance.  New power mechanisms that rely on behavioural data are deeply interconnecting surveillance states, personal devices and corporations in a global context where democratic institutions are being threatened.

 

 

 

 

As discussed in previous post (RG4: History, Methodology, & Economic Theory), economic systems have changed and evolved through history. The purpose of this post is to go over, very briefly, how the economic system has changed over time, to arrive at the capitalist economic system that we all live in today.

Evolution of Economic Systems

Economic systems evolve, sometimes under external dynamic and sometimes under internal dynamics. As they evolve, economic theories co-evolve, however their can be (often are) lags in understanding – so theories relevant to one system are applied to another, with disastrous results.

Human beings started out with tribal societies, and spent the longest period of history in this form. They societes were egalitarian and communal. They were not market oriented. Production and  distribution was done by consensus of the community. Communities were self-sufficient, producing or acquiring basic needs for all members, without any markets or trade. For more details, see “Hunter-Gatherer Societies”.  An essential point to understand is that the economic system shaped the nature of the society – the need for cooperation to survive in a harsh environment shaped social norms. This is again in contrast with the story told by economists that evolution has shaped us to be greedy and competitive, as this is necessary for survival. For the opposite point of view, see “Does Altruism Exist?” by D. S. Wilson, which uses latest findings of evolutionary biology to show that the opposite is true. Evolution has shaped human beings to be cooperative and generous.

In light of these understandings, it is very important for us to study the great transformation in European societies during which traditional societies based on cooperation, social responsibility, and community, were replaced by market societies with competition, individualism, and hedonism. This is because our own identities have been shaped by living in market societies.

Industrial Revolution Allows Production of Massive Surplus: New patterns of crop rotation and livestock utilization paved the way for better crop yields, a greater diversity of wheat and vegetables and the ability to support more livestock. These changes impacted society as the population became better nourished and healthier. The Enclosure Acts, passed in Great Britain, allowed wealthy lords to purchase public fields and push out small-scale farmers, causing a migration of men looking for wage labor in cities. The availability of surplus food, surplus labor, and technological innovations, combined to create the Industrial Revolution, which permitted production of massive amounts of surplus.

The ability to produce massive amounts of surplus led to dramatic changes in economics, politics, and social systems. Some of these changes are listed below:

  1. Surplus needs to be marketed to consumers. This led to creation of a consumer economy. When domestic demand proved insufficient, colonization of the globe was done to provide more consumers for the surplus.
  2. Massive productive capacity provided the material wealth, power, and weapons to enable colonization. This process had to destroy self-sufficient societies throughout the globe, in order to create consumers. This led to the emergence of the theory of “comparative advantage”, which argued that colonized lands should only produce raw materials, while the colonizers produced manufactured goods to sell back to the colonized lands.
  3. Creation of a large labor force was required to support industrial production processes. This led to the gradual normalization of the idea the hours of our lives could be brought and sold for wages on the market. This cheapened human lives by reducing them to resources and valuing lives by what they were worth on the marketplace.
  4. Money acquired central importance as a much more efficient way to store the surplus value created by goods. Money allowed trading of goods across time, and became the means to purchase all things – human lives, entire nations and colonies, political power, and educational systems to indoctrinate masses to capitalist ways of thinking. As Karl Marx noted, capitalism exploits workers not by force, but by their willing agreement. A similar statement holds for colonization.
  5. Thinking shifted from the C-M-C’ mode, where commodities are valued and traded by using money, to the M-C-M’ mode, where money is used to produce commodities and to sell them for even more money. This shift changed social goals and markers of social status from land and property to monetary wealth. This shift was of monumental importance in changing society.
  6. One of important impacts was the change in the nature of the relationship between man and our habitat – The Mother Earth. Instead of the natural symbiotic relationship, our planet provides all resources we need for our comforts, and we protect and preserve it, land became a commodity for sale on the market.

For a large number of reasons – repeated crises, increasing inequality, environmental collapse, even the ongoing COVID crisis – the current mode of capitalism seems to be self-destructing.  Continuing rape of the planet and massive destruction of plants and animals has led to loss of habitat and increased unusual interactions between humans and animals. The process continues, making further crises like this eminently likely.  If our planet and humanity survive the death-throes, we may expect a new system to emerge out of the ashes. There are large numbers of successful alternative models which have been used to organize societies in the past, and perhaps some of these may be useful as templates for the future.

To connect this with our current study of Central Banking, it is worth noting that we are studying the evolution of the monetary system associated with Central Banks. But all realms of our lives – social, political, and environmental – are connected and changes in one sphere affect all others.

LINKS to related Materials:

  • Introduction to Reading Course: bit.ly/iw2gh
  • Readers Guide (RG1) to Goodhart on Central Banking: bit.ly/gh2rg
  • RG2: Free Market objections to Central Banks bit.ly/we0rg1
  • RG3: Macro & Micro Monetary Management by CBs bit.ly/we0rg3
  • RG4: History, Methodology, & Economic Theory bit.ly/wp0rg4

This is the 4th Readers Guide to Goodhart’s book on Evolution of Central Banking. See: Reading Course on Central Banking for more details about this online Reading Course. We have completed Chapter 1, and before beginning Chapter 2, I would like to add some notes on the importance of History for Economic Theory – !4m video is followed by a detailed writeup.

It is an Obvious Truth that economic theories analyze specific historical economic systems.

In nomadic societies, there is no production. Economics would be about finding plants, game, and moving according to seasons.

In agricultural societies, private property becomes important. Those who plant need to have rights to harvest their plantings.

Feudal Societies are mostly self-sufficient in commodities and operate without money. These are barter societies. Money is not a goal, but only a means to get more goods. Karl Marx explained this via the formula: C – M – C’  which means that Commodities are sold for money, which is used to get different commodities.

Market societies: people sell labor for wages to produce commodities. Money is used for purchase. Money is main driver of society. Laborers sell their lives for money. Producers start with money, use money to produce commodities, and sell commodities for more money: M – C – M’  – This inversion of goals is tremendously important in understanding market societies. Both laborers and producers are driven by the desire to make money – not to consume goods. It is important to note the modern economic theory does not recognize this, and treats market societies like barter societies. It is only because of this failure to recognize the motivations that economic theories treat money as a veil, and say that money is neutral.

All of this discussion is to make a very simple point: Economic theories cannot be understood outside their historical context.

To understand Keynes, we must study the Great Depression. What were the theories which failed, and how was Keynes driven to find a new theory? How did his theory explain the Great Depression?

To understand Minsky’s Financial Fragility Theory, we must study the repeated banking crises that occurred since the 1970’s. These led Minsky to think about the causes of these crises, and come up with a theory which explained them.

To understand Mercantilism, we must understand European history driven by wars, and the necessity for accumulating gold to finance them. For modern economies, it make no sense to accumulate gold, but in the 18th Century, gold was of central importance to finance wars.

It is of great interest to understand that the opposite is also true. Just as we cannot understand economic theory without the historical context, so we cannot understand history without understanding economic theory. This is because history is shaped by theories. Economic problems continuously arise, and these problems are solved in light of dominant economic theories – whether they are right or wrong. This makes it important to study wrong economic theories because these theories shape policy, and economic policies shapes history. We give some examples of this process.

When the Great Depression occurred there were two economic theories about what should be done. The free marketeers (Hayek) said that governments should not interfere. Keynes said that free markets can create unemployment, and governments must intervene to create full employment. Following Keynesian theories led to shortening of the Great Depression. Had Hayek been followed, the Great Depression would have lasted much longer, and disastrous effects on millions of live. In the post World War 2 era, rapid growth and full employment was achieved via Keynesian Demand Management Policies based on Keynesian theory. Stagflation caused by oil embargo in the 1970’s led to rejection of Keynesian theories and the rise of Chicago School of free market economics. According to the Chicago school, there was a Natural Rate of Unemployment. Since the 1970’s this theory, which leads to the Expectations Augmented Phillips Curve has dominated policy. This theory is touted as a great success by free market economists, because it has led to control of inflation all over the world. However, they do not mention the enormous cost that has been paid for this low inflation in terms of growth and unemployment.

It is a great puzzle to understand WHY Economists REJECT these Obvious Truths?

This is a long and complicated story. See Emergence of Logical Positivism for a more detailed account. Very briefly, there was a battle of Science and Christianity in Europe. This led to a victory of Science. As a result, Science was accepted as the new religion. The philosophy emerged (and continues to dominate European thought) that SCIENCE is the ONLY source of certain knowledge. The natural methods for humanities are based on qualitative and historical approach. However, because of European worship of science, the Battle of Methodologies (methodenstreit) in 1890’s replaced this natural method by a mathematical, quantitative, scientific approach, applying methods suitable for physics to the study of human beings and societies.

Logical Positivism was a philosophy of science which was based on a deep misunderstanding of the scientific method. This philosophy became wildly popular early in the 20th Century.  The emergence of “Social Science” in early 20th Century. Founded on Logical Positivism, a misunderstanding of scientific method – This misunderstanding was applied to create foundations of economics. Even though Logical Positivism was later rejected by philosophers, economists never went back to correct the foundations on which the discipline is based.

Implications of “Scientific” approach to economics:

The so-called “scientific” approach to economics has led to major problems. Physics works with particles which have the same behavior in all circumstances. Accordingly, economists developed a theory of human behavior which must be the same for all people, regardless of time and place. Another consequence of the rejection of God and Afterlife, was the development of the religion of pleasure-seeking behavior. Utilitarianism was developed by Jeremy Bentham who saw himself as a prophet of a new religion, developed to replace Christianity. The God of this religion is “Rationality” which means rejecting all things for which there is no empirical evidence (like God, Angels, Afterlife). In fact, behavioral economists have learnt that human beings are not pleasure seekers in the way that economists suppose – see “Behavioral Vs. Neoclassical Economics”.

Economists want to look for scientific laws, which are universal invariants. They must hold across time and space, in the same way, in all cultures. The fact that there are no such laws has led to creation of many “ economic laws” which hold only in the imaginary world of economic models, and have no contact with reality. See Quotes Critical of Economics for documentation.  As just one example, the economic theory of International Trade is same for any pair of countries, at any time. It should be obvious that trade of England with China after the opium wars, was of an entirely different nature, and subject to different rules than that of England with France, or that of Pakistan with India. Power, Politics, and Wars, play a tremendous role, which is completely ignored by economists because of their search for pseudo-scientific laws. Geoffrey Hodgson has written a book entitled How Economics Forgot History which discussed the ‘methodenstreit’. Economic methodology consists of the search for universal TRUTHs. Economists do not understand that economic truths keep changing as economic systems evolve in time. This is one of the things that will become clear when we study the evolution of Central Banking system in the present book.

The Global Financial Crisis of 2007 made the complete failure of economic theory plain for all to see – see Romer’s Trouble with Economics for more details about this failure. Because they ignore history, and are based on a misconception regarding scientific methodology, economic theories are disastrous failures. To see just one example of why we must consider history, note that WW1 led to breakdown of Gold Standard, WW2 led to Bretton-Woods and Vietnam War led to the Nixon Shock in 1971. All three wars led to major changes in the international financial system. We cannot understand economics without understand wars and their impact on economies, for starters. History, Culture, Institutions, Environment, and many other factors not part of the “science” of economics, play a very important role in economics.

This creates a Golden Opportunity for us. We must study how economic theory originates from history. We must improve methodology by studying the match between theories and history – this is precisely one of the goals of this study of history of Central Banking. This will allow us to create better theories based on deeper knowledge of history. Because modern economic theory has forgotten history, so this is relatively unexplored territory. Because it is a new area, there are many low hanging fruits – theories we can develop with relatively small amount of effort. There is a problem with this historical approach. These ideas are not acceptable to mainstream  orthodox economists. However, in these times, there are many alternative Journals. Furthermore, the historical approach makes a lot of sense (unlike the equations of economic theory) and this leads to HIGH acceptability by general public as well as by policy makers.

Previous Posts in this sequence: Reading Course: Central Banking, Readers Guide: Goodhart on Central Banks, RG2: Goodhart on Central BanksRG3: Goodhart On Central Banks Next Post RG5 Evolution of Economic Systems.

[bit.ly/we0rg3] This continues from previous post RG2: Goodhart on Central Banks of our online READING Course on the Evolution of Central Banks by Charles Goodhart. This post (Readers Guide 3) covers  pages 6-11, or the last half of Chapter 1. Writeup is given following the 10m video lecture.

Central Banks were not designed for macro and micro management roles. Rather, as they acquired power and strength, they came to the recognition of responsibility that this status gave them.

As Central Banks became big and powerful, they realized that they could not act competitively, just like other banks. They needed to support other banks in times of crisis. Also, they needed to pay attention to macro responsibilities. These responsibilities were in conflict with the role of a private sector competitive profit maximizer

Two Types of Monetary Management responsibilities emerged naturally from the institutional structure:

  • Macro Management: State of Economy, Employment, Exchange Rates, Stability of Currency.
  • Micro Management: Regulation and Supervision of the Banking System

Over time, the macro management responsibilities changed greatly, but the micro management responsibilities remained constant. This suggests that the primary role of Central Banks is the micro management of the financial system.

Evolving Nature of (Macro) Responsibilities

Gold Standard until 1914 (World War 1):  Ensure stability of money by keeping adequate gold reserves for stability and convertibility of currency.

Post WW1 (inter-war chaos): Gold Standard broke down due to excessive war expenditures by Central Banks, chaotic change of system. Post-war, complete ruin of the economy led to prioritization of the needs of domestic economy over the stability of currency for international trade. For detailed discussion of this, see  International Financial Architecture, Part II.

Post WW2: Bretton-Woods: created Gold-Exchange Standard based on dollars. CB Responsibility shifted to defending exchange rates and keeping domestic economy healthy.

Post Nixon Shock in 1971: New regime of floating exchange rates – major change in conceptualization of CB responsibilities.

Throughout these major changes in macro management responsibilities, Central Bank responsibility for smooth operation of Financial System remained constant. This suggests that the main function of Central Banks is to ensure that people can pay for goods produces, deposit money, transfer money from reliably. It is only SECONDARILY, the macro management functions emerge.

This is opposite of textbook picture, according to which the main function of Central Banks is the conduct of monetary policy. As Goodhart writes, micro functions – supervision and regulation of banks and financial system are main reason for Central Banks. This is not taken into account by current theoretical debate about functions of Central Banks which looks only at macro management, and not at the micro management functions.

An important issue that emerges from this analysis is the role of Interactions between Micro and Macro Management functions. In fact, there is a close connection between the two aspects, but this is not dealt with adequately in theoretical or empirical literature. The reason for the connection is explained below:

Central Banks act as lender of last resort; this provides some level of insurance to private banks. Insurance creates Moral Hazard: a tendency for risky behavior, because insurance protects against big losses. High levels of insurance will generate Macro financial crisis because banks will gamble with depositors money. If they win, they increase profits, if they lose, the Central Bank picks up the losses. Because of this connection between regulation and financial crises, there is need to connect the two functions – Supervision and Regulation of Commercial Banks, and Macroeconomic Management. It is worth noting that post Global Financial Crisis, “Macro Prudential Regulation” became a hot topic; see my talk on “Regulation of Financial Markets: An Islamic Perspective”.

How did Experience lead to abandonment of commercial and competitive role, and transition to a  supervision and regulatory role for Central Banks?

The 1844 Bank of England Act was actually a step backwards. It divides BoE into two parts – One is responsible for issue of currency, maintaining Gold Standard. Other is a private commercial bank. It was not clear at that time that Central Banks cannot act as private commercial banks. This is simply becausea bank which is lender of last resort CANNOT be a competitor; it must cooperate with banks in distress. There is a conflict of interest between the supervision and regulation role and the private commercial bank role.

Goodhart goes through an analysis of historical experience to establish how this conflict was realized in several European countries, and how this led to change in the role of Central Banks. Central Banks often started out as just one big bank, like others, in competition with other private commercial banks. This led to unpleasant outcomes, when financial systems collapsed because the Central Banks refused bailouts to competitors. This led to the realization that CBs cannot act as a competitive profit maximizing private entity. This led to re-organization where CBs abandoned private banking and became solely a banker’s bank.

European history shows a large number of different trajectories and also a large number of different structures regarding the supervisory and regulatory responsibilities of CBs in European experience. There is no single best institutional structure, and many different ways to arrange management of macro and micro responsibilities.

The questions of interest which emerge from this preliminary discussion are the following:

Should we separate Supervision & Regulation (Micro Management) from Monetary (Macro) Management? If so how? If not, how best to merge them? This is NOT explored in the book.

Rather, the book focuses on the theoretical & empirical reasons for existence of Central Banks. The 19th Century discussion of this issue concerned the question that: “Would a Central Clearinghouse be sufficient to create a stable monetary system?” A central clearinghouse is one of the important functions of Central Banks where daily clearing of all checks written on the entire banking system takes place. History provides a clear answer to this question. A system of private banks without any supervision and regulation leads to wild and chaotic system with regular and frequent crises. This is why the 20th Century Discussion of this question has moved on to: the Role of Asymmetric Information, Risk, Moral Hazard, and how Central Banks can reduce these market failures.

The next two posts provide a general methodological discussion of how historical context of economic theories matters, and what we can learn by studying history. These posts are: RG4: History, Methodology, & Economic Theory, and RG5 Evolution of Economic Systems

RG2 (Reading Guide 2) – Continues from previous posts on Reading Course: Central Banking and Readers Guide: Goodhart on Central Banks. Writeup is given following the ten minute video:

 

Goodhart starts by discussing discontent with Central Banking System. He wrote this book well before the GFC 2007 -8, which has created much greater discontent. There are two different lines of attack on Central Banking: One calls for eliminating Central Banks completely, while the other asks for tying the hands of Central Banks to follow some fixed rules.

  1. Free Banking: Private Creation and Provision of Money. Today, this idea would find shape in large scale private creation of money via bitcoins, FB Libra, community money, and many other innovative ideas for creation of money without governments being involved.
  2. Regulated Central Banks: Banks should follow specified rules, like Friedman’s rule of 6% monetary growth, or Taylor rule, or certain other rules. This line of thinking emerges from a rational expectations approach, and will be discussed in greater detail later

Free Market Ideology does not accept Discretionary Monetary Policy. This happens when the Central Bank looks at economic situation, and make decisions on monetary policy according to the circumstances – this is nearly universal practice today. The reason free market ideologues do not like this is because this means that free markets do not necessarily lead to good outcomes, and the state must intervene to fix problems created by free markets. This was the main argument of Keynes in his famous book on the General Theory of Unemployment. He said that free markets will not eliminate unemployment (contrary to classical and neoclassical economic theory) and the government must intervene to do so.

The first line of attack, complete elimination of Central Banks, and creation of a free banking system, will be discussed later. For the second line of attack, in order to force Central Bank to follow rules, we must show that allowing them to act freely causes harm to the public interest. We consider below three different free-market arguments which support this position by showing that discretionary monetary policy  will cause harm. if these arguments are correct, then Central Banks should be prevented from acting freely, as they see fit, to correct emerging problems, to prevent financial instability, and to protect the financial system from different kinds of crises and failures. It is worth noting the empirically, nearly all Central Banks of the world do operate freely in this manner, so the theory conflicts with observed realities. The three lines of theoretical argument against free action by Central Banks are as follows:

  1. The first line of attack say that unregulated markets work best, and any interference via regulations or government interventions always causes harm. In particular, Discretionary Monetary Policy causes long term harm, while appearing to do short term good. This line is represented by the Expectation Augmented Phillips Curve, which is taught in standard textbooks. According to this theory, If the Central Bank follow a loose monetary policy, it can lower unemployment in the short run. In the long run, unemployment will move back to its natural rate, but the inflation rate will increase, causing long run damage to the economy. Thus efforts to improve the economic situation actually cause harm in the long run.
  2. The second line of attack says that discretionary policies may work, but we cannot achieve them because governors of Central Banks will act in their private interest, instead of taking actions in the public interest. This is called the Principal Agent approach:  Instead of assuming that Governors will work for the public interest, this line of thinking assumes that they will act for their private interests – salaries, careers – rather than look out for the public good. The recommendation that emerges out if this line is that we should change incentive structure, by penalizing the governor for failing to meet policy targets.
  3. The third line of attack says that the industry being regulated (banking sector in this case) is rich and powerful. The industry can CAPTURE the regulator in many ways. Regulatory Capture occurs in many different ways.  For example, people who run Central Banks retire and go on to jobs with high salaries at private banks. Or banks can use their money to lobby for regulations favoring them, instead of the public. Thus, Central Banks may come to serve the interests of the private banks rather than the people. It is clear that this happened in the Global Financial Crisis. The regulatory agencies spent trillions bailing out the corrupt and failed banks, and did not spend any money bailing out the people who lost their homes.

After discussing these free market theories, Goodhart turns to the central topic of his book: “What does history tell us about functions of Central Banks?”

The first thing we learn is that these were NOT formed to regulate money supply. In fact, the original purpose of creation of Central Banks was to provide funding for wars. For more details, Origins of Central Banking. Central Banks were created as to provide loans to the State on easy terms, often to finance wars or colonization. They were quite GOOD at this function. Historian Peter Kennedy in his Rise and Fall of Great Powers argues that ability to finance wars was the source of power. Noting the efficiency of Central Banks at providing finance led to widespread imitation, and creation of Central Banks all over Europe.

A side-benefit of this was also the regulation of chaotic system of money creation by private banks. But again, this was not the main purpose – regulation of private banks was done both for stability and also to earn revenue for the state and for the central bank.

ONCE Central Banks were established, other functions of CBs evolved naturally CBs were large, and politically well-connected, hence, FAR SAFER than any other banks. As a result, commercial banks started keeping large portions of their reserves with CB. They also relied on CBs for loans in times of financial distress.  By DEFAULT, not by DESIGN, CB became the bankers bank. Initially, CBs did not see themselves as bankers bank, but were just one bank like others – but bigger and more powerful. They saw smaller banks as COMPETITORS.

This led to an unintentional transition into what we recognize today as Central Banking. To be more precise, once established, Central Banks had:

  • political power,
  • substantial gold reserves
  • ability to create money by re-discounting

NOTE ON RE-DISCOUNTING: Banks lend money and take IOU NOTES from private parties, which are promises to pay back the loan. These notes are called bills of exchange. In times of crisis, banks need cash, but all they have is promises in these notes. They can sell them, or they can give them as security to the Central Bank, and borrow on the strength of this NOTE as a collateral for the loan. This process is called re-discounting.

The financial strength of the Central Bank naturally led them to become bankers bank. Private Banks had no option but to go to the Central Banks for loans and re-discounting in times of crisis. This led to a situation where all small private commercial banks held reserves in Central Bank. This centralization of power, which occurred naturally, made it possible for Central Banks to make monetary policy.

Reading for this session ends with the following passages (see page 6 of Goodhart Book).

Their privileged legal position, as banker to the government and in note issue, then brought about consequently, and, naturally, a degree of centralization of reserves within the banking system in the Central Bank, so it became a bankers’ bank. Il was the responsibility that this position was found to entail, in the process of historical experience, that led Central Banks to develop their particular art of monetary management.

Such management has had two (interrelated) aspects, a macro function and responsibility relating to the direction of monetary conditions in the economy at large, and a micro function relating to the health and well-being of the (individual) members of the banking system.

For next post, see: RG3: Goodhart On Central Banks

A copy of Chapter 1 – which we are in process of reading – is attached below

GoodhartCh01

POSTSCRIPT: One reader was confused about re-discounting, so here is some further explanation: When a lender borrows $1000 from a bank, and promises to pay $100 per month for a the next year, the written promise given to the bank is called the “debt instrument” or a NOTE or a Bill-of-Exchange. The bank will get $1200 in return for paying out cash of $1000 right now, so it receives the (loan) NOTE at a DISCOUNT – it pays $1000 only for a NOTE worth $1200. Now suppose for some reason the bank needs to raise cash. It can sell this note (worth $1200 over the year) for any lesser amount, thereby RE-DISCOUNTING the original loan note. A particular form of this occurs when the bank borrows from the Central Bank using this NOTE as a collateral for the loan. The Bank can borrow any amount upto the face value of the NOTE ($1200) from the Central Bank at the standard rediscount rate which is set in the Monetary Policy. The loan NOTE is held as collateral to secure the loan, and is returned to bank when the loan is paid off.

See also the INVESTOPEDIA article on this term: Rediscounting