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«8 CENTRAL AND FREE BANKING THEORY T his chapter contains a theoretical analysis of the arguments raised for and against both central and free banking ...»

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(Hayek, The Constitution of Liberty, p. 336) 83The various systems and agencies designed to “insure” created deposits in many western countries tend to produce an effect which is the exact opposite of that intended when they were established. These “deposit guarantee funds” encourage less prudent and responsible policies in private banking, since they give citizens the false assurance that their deposits are “guaranteed” and thus that they need not take the effort to study and question the trust they place in each institution.

These funds also convince bankers that ultimately their behavior cannot harm their direct customers very seriously. The leading role deposit guarantee or “insurance” systems played in the eruption of the American bank crisis of the 1990s is covered in, among other sources, The Crisis in American Banking, Lawrence H. White, ed. (New York: New York University Press, 1993). It is therefore disheartening that the process of harmonizing European banking law has included the approval of Directive 94/19 C. E. of May 30, 1994, with respect to deposit guarantee systems. This directive establishes that each member state must officially recognize a deposit guarantee system and requires each European credit institution to affiliate itself to one of the agencies created for this purpose in each country. The directive also establishes that guarantee systems will insure coverage of up to 24,000 ecus on all deposits made by any one depositor, and that the European Commission will revise this figure every five years.

Central and Free Banking Theory and particularly difficult to obtain in the financial sector.

Hence it is painfully obvious that the central bank cannot possibly acquire all the information it would need to act in a coordinated manner, and its inability to do so is one more illustration of the theorem of the impossibility of socialism, in this case applied to the financial realm.

Knowledge of the different components of the supply of and demand for money is never available for objective accumulation. On the contrary, it is of a practical, subjective, diffuse nature and is difficult to articulate. Such knowledge arises from economic agents’ subjective desires, which change constantly and depend largely on the evolution of the money supply itself. We already know that any quantity of money is optimal. Once any changes in the money supply have exerted their effects on the relative-price structure, economic agents can take full advantage of the purchasing power of their money, regardless of its absolute volume. It is when the quantity and distribution of money changes, via the expansion of loans (unbacked by saving) or the direct spending of new monetary units in certain sectors of the economy, that a serious disturbance occurs and widespread maladjustments and discoordination appear in the behavior of the different economic agents.

Therefore it is unsurprising that the central-bank system of our analysis is marked by having triggered the most severe intertemporal discoordination in history. We have seen that the monetary policies adopted by central banks, especially that of England and the Federal Reserve of the United States, with the purpose of “stabilizing” the purchasing power of the monetary unit, encouraged a process of great credit and monetary expansion throughout the “roaring” twenties, a process which led to the most acute economic depression of the last century. Following World War II, economic cycles have been recurrent, and some have approached even the Great Depression in severity: for example, the recession of the late seventies and, to a lesser extent, that of the early nineties. These events have occurred despite many political declarations concerning the need for governments and central banks to conduct a stable monetary policy, and despite the massive efforts made, in terms of human, Money, Bank Credit, and Economic Cycles statistical, and material resources, to realize this objective.

Nevertheless the failure of such efforts could not be more obvious.84 It is impossible for the central bank, as a financial centralplanning agency, to somehow carry out the exact function private money would fulfill in a free market subject to legal principles. The central bank not only lacks the necessary information, but its mere existence tends to amplify the distorting, expansionary effects of fractional-reserve banking, giving rise in the market to severe intertemporal discoordination which, in most cases, not even the central bank is able to detect until it is too late. Even central-bank defenders, like Charles Goodhart, have been obliged to admit that, contrary to the implications of their equilibrium models, and despite all efforts made, in practice it is almost impossible for central-bank officials to adequately coordinate the supply of and demand for money, given the highly changeable, unpredictable, seasonal behavior of the multiple variables they work with. For it is exceedingly difficult, if not impossible, to manipulate the so-called “monetary base” and other aggregates and guides, such as the price index and rates of interest and exchange, without instigating erratic and destabilizing monetary policies. Furthermore Goodhart acknowledges that central banks are subject to the same pressures and forces that influence all other bureaucratic agencies, forces 84Thus the monetary-policy error which most contributed to the appearance of the Great Depression was that committed by European central banks and the American Federal Reserve during the 1920s. It was not, as Stephen Horwitz indicates and Milton Friedman and Anna Schwartz did before him, that the central bank, following the stock-market crash of 1929, failed to properly respond to a 30 percent decrease in the quantity of money in circulation. As we know, the crisis erupted because prior credit and monetary expansion caused distortions in the productive structure, not because the corresponding reversion process invariably brought deflation with it. Horwitz’s error in interpretation, along with his defense of the arguments invoked by members of the modern FractionalReserve Free-Banking School, appear in his article, “Keynes’ Special Theory,” in Critical Review: A Journal of Books and Ideas 3, nos. 3 and 4 (Summer–Autumn, 1989): 411–34, esp. p. 425.

Central and Free Banking Theory which have been studied by the Public Choice School.

Indeed central-bank officials are human and are affected by the same incentives and restrictions as all other public officials. Therefore they may be somewhat swayed in their decision-making by groups with a vested interest in influencing the central bank’s monetary policy. These include politicians eager to secure votes, private banks themselves, stock-market investors and numerous other special interest groups.

Goodhart concludes:

There is a temptation to err on the side of financial laxity.

Raising interest rates is (politically) unpopular, and lowering them is popular. Even without political subservience, there will usually be a case for deferring interest rate increases until more information on current developments becomes available. Politicians do not generally see themselves as springing surprise inflation on the electorate.

Instead, they suggest that an electorally inconvenient interest rate increase should be deferred, or a cut ‘safely’ accelerated. But it amounts to the same thing in the end.

This political manipulation of interest rates, and hence of the monetary aggregates, leads to a loss of credibility and cynicism about whether the politicians’ contra-inflation rhetoric should be believed.85 Acknowledgment of the harmful behavior (analyzed by the Public Choice School) of central-bank officials and of the “perverse” influence politicians and interest groups exert on 85Charles A.E. Goodhart has written an accurate summary of the insurmountable theoretical and practical difficulties the central bank encounters in implementing its monetary policy. See his article, “What Should Central Banks Do? What Should be their Macroeconomic Objectives and

Operations?” published in Economic Journal 104 (November 1994):

1424–36. The above excerpt appears on pp. 1426–27. Other interesting

works by Goodhart include: The Business of Banking 1891–1914 (London:

Weidenfeld and Nicholson, 1972), and The Evolution of Central Banks.

Thomas Mayer also referred to the inevitable political influences exerted on the decisions of central banks, even those banks most independent of the executive branch from a legal standpoint. See Mayer’s book, Monetarism and Macroeconomic Policy (Aldershot, U.K.: Edward Elgar, 1990), pp. 108–09.

Money, Bank Credit, and Economic Cycles them has led to the consensus that central banks should be as “independent” as possible of the political decisions of the moment and that this independence should even be incorporated into legislation.86 This constitutes a small step forward in the reformation of the financial system. However, even if rhetoric for the independence of central banks finds its way into legislation or the constitution itself, and even if it is effective in practice (which is more than doubtful in most cases), many public-choice arguments regarding the behavior of central-bank officials would remain unrefuted. Moreover, and more importantly, the central bank would continue to generate massive, systematic intertemporal maladjustments even when appearing to pursue a more “stable” monetary policy.87 Oddly enough, the controversy over the independence of central banks has provided the context for the discussion on which structure of incentives would best motivate central-bank officials to develop the correct monetary policy. Thus, in connection with the “financial central-planning agency,” the sterile debate about incentives has revived, a debate which in the 1960s and 1970s prompted theorists from the economies of the former Eastern bloc to expend a veritable river of ink. In fact the proposal of making the salary of central-bank officials conditional upon their performance with respect to set goals of price stability is strongly reminiscent of the incentive mechanisms which were introduced in socialist countries in an unsuccessful attempt to motivate the managers of state companies to act more “efficiently.” Such proposals for reforming the incentive system failed, just as the latest, similar, well-intentioned 86A helpful overview of the different positions on this point and of the most recent related literature has been prepared by Antonio Erias Rey and José Manuel Sánchez Santos in “Independencia de los bancos centrales y política monetaria; una síntesis,” Hacienda Pública Española 132 (1995): 63–79.

87On the positive effect which the independence of the central bank has on the financial system, see Geoffrey A. Wood et al., Central Bank Independence: What is it and What Will it Do for Us? (London: Institute for Economic Affairs, 1993). See also Otmar Issing’s book, Central Bank Independence and Monetary Stability (London: Institute for Economic Affairs, 1993).

Central and Free Banking Theory propositions regarding the central bank are bound to fail. They will be unsuccessful because from the start they ignore the essential fact that the officials responsible for government agencies, whether state-owned companies or central banks, cannot in their daily lives escape from the bureaucratic environment in which they work, nor can they overcome the inherent ignorance of their situation. János Kornai makes the following appropriate, critical comments concerning attempts to develop

an artificial incentive system to make the behavior of functionaries more efficient:

An artificial incentive scheme, supported by rewards and penalties, can be superimposed. A scheme may support some of the unavowed motives just mentioned. But if it gets into conflict with them, vacillation and ambiguity may follow. The organization’s leaders will try to influence those who impose the incentive scheme or will try to evade the rules.... What emerges from this procedure is not a successfully simulated market, but the usual conflict between the regulator and the firms regulated by the bureaucracy.... Political bureaucracies have inner conflicts reflecting the divisions of society and the diverse pressures of various social groups. They pursue their own individual and group interests, including the interests of the particular specialized agency to which they belong. Power creates an irresistible temptation to make use of it. A bureaucrat must be interventionist because that is his role in society; it is dictated by his situation.88 (b) A banking system which operates with a 100-percent reserve ratio and is controlled by a central bank In this system the distortion and discoordination which arise from the central bank’s systematic attack on the financial market would be lessened, since private banks would no longer enjoy the privilege of functioning with a fractional reserve. In this sense bank loans would necessarily reflect 88János Kornai, “The Hungarian Reform Process,” Journal of Economic Literature 24, no. 4 (December 1986): 1726.

Money, Bank Credit, and Economic Cycles economic agents’ true desires with regard to saving, and the distortion caused by credit expansion (i.e., unbacked by a prior increase in real, voluntary saving) would be checked.

Nevertheless we cannot conclude that all discoordination generated by the central bank would disappear, since the mere existence of the central bank and its reliance on systematic coercion (the imposition of legal-tender regulations and a set monetary policy) would still have a damaging effect on the processes of social coordination.

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