I have a
plenty of respect for George Selgin, despite the fact that he advocates
fractional reserve banking while I advocate full reserve. He knows a lot about
the history of banking, plus (unlike many academics) everything he writes is
clear, precise, waffle-free and informative.
But he had
an off day when writing this article which claims that central banks are
destabilising.
Summary.
His basic
argument is thus. First, central banks can create money willy nilly (true).
Second, in a gold standard environment that freedom to create excessive amounts
of money can lead to a general excess supply of money which leads to inflation,
which in turn leads to gold being drained out of the country (true). And that
in turn can lead to the central bank suddenly realising it is short of gold
(true). So it suddenly brings the money supply expansion to a halt or reverses
it, which results in a depression (very plausible).
Most readers
will presumably have noticed the big flaw in that argument: no country is now
on the gold standard! And as far as a balance of payments deterioration goes,
that is dealt with nowadays by exchange rate adjustments (except of course
within the Eurozone).
Selgin’s
encyclopedic knowledge of the history of banking has got the better of him!
But that’s
not to say central banks cannot be sources of instability: the lender of last
resort function can be a source of instability. However that source of
instability is ruled out in a full reserve environment.
____________
Is the commercial bank system stable?
The first
weakness in his argument comes where he claims that the commercial bank system
is inherently stable. His argument is that no one bank can expand too fast,
else it loses reserves to other banks (true). Therefore the entire commercial
bank system cannot expand too fast. As he puts it, “This routine note-exchange
and settlement process imposes strict limits on credit expansion by individual
note-issuing banks and, hence, by the banking system as a whole…”
Incidentally
the reason for the phrase “note exchange” is that he assumes a system in which
each commercial bank can issue its own banknotes. Strange as it may seem to 21st
century folk who have spent their entire lives under a system where only
central banks can issue notes, that assumption does not influence the argument
one way or the other: it’s no big deal.
Of much more
relevance is the historical fact that (contrary to Selgin’s above argument)
commercial banks behave like lemmings. That is, while no individual bank can
expand much faster than its rivals, the fact is that, for example, British
banks loaned money into existence like there was no tomorrow prior to the
recent crisis. The chart below shows commercial bank money expanding much
faster than central bank money in the three years prior to the crisis.
So that
rather dents Selgin’s claim that the commercial bank system is inherently
stable.
Central
banks promote instability under the gold standard.
The next
problem with Selgin’s argument is that he assumes a gold or “specie” standard.
As he puts it “I assume that banks, whether enjoying exclusive privileges or
not, are obliged to redeem their notes on demand in specie—that is, in gold or
silver coin.” Moreover, he assumes a WORLDWIDE gold standard.
He then
points out, correctly, that given central bank privileges, central banks are
under nowhere near the same constraints as commercial banks. That is, they can
print money almost willy nilly, and if they do, that enables commercial banks
to expand in a similarly irresponsible manner. And that according to Selgin
leads to inflation and a movement of gold out of the relevant country.
As a result,
in Selgin’s words, “The central bank consequently finds itself in danger of
imminent default and proceeds to save itself by aggressively contracting credit.
The contraction reduces commercial banks’ reserves, forcing them to contract as
well and thus triggering a general credit crunch.”
Now there is
nothing wrong with that argument, given Selgin’s assumptions. But there is just
one whapping great and totally unrealistic assumption, namely the gold standard
assumption. That is, no country nowadays is on the gold standard! That is, the
“loss of gold” or “specie” point is plain irrelevant for 21st
century purposes. Thus Selgin’s argument falls to pieces.
Put another
way, central banks nowadays are free to print their way out of trouble, and as
to currencies, they float relative to each other.
Central
banks can nevertheless be destabilising.
But that is
not to say that central banks cannot be destabilising. For example the idea
that Argentina’s central bank is a source of stability is a joke (particularly
when, as is normally the case, the bank is under the control of Argentine
politicians.)
One
important reason why central banks can be destabilising nowadays is actually
one that Selgin points to. It’s the “lender of last resort” function that those
banks perform.
If central
banks abided by Walter Bagehot’s prescription and lent to problem banks at
penalty rates and in exchange for first class collateral, there wouldn’t be a
problem. But of course the reality is that (thanks to political and populist
pressures) that function has degenerated into lending at zero or near zero
rates of interest and on the basis of some very dodgy collateral.
And that
just fuels credit expansion based on NINJA mortgages and other questionable
bits of paper.
Full
reserve comes to the rescue.
But this is where
full reserve banking comes to the rescue. Under full reserve, commercial banks
just don’t have any reason to go running to central banks for assistance. Under
full reserve, commercial banks perform just one basic and very simple function
(with a possible second function thrown in).
The first or
basic function is to act as what might be called depositories. That is banks
accept deposits and do nothing with the relevant money – or at most, they
invest in ultra-safe securities like government debt. So that part of
commercial banks cannot fail.
As to the
second function, granting loans and making investments, that function is
carried out (at least under the version of full reserve advocated by Laurence
Kotlikoff) by entities that amount to the same as unit trusts (mutual funds in
the US). Again, there is no reason for commercial banks to go running to central banks any more than
existing unit trusts go running to central banks. That is, if a series of loans
or investments made by a bank’s “unit trust” division go wrong, then those who
have invested in the unit trust find the value of their holding declines, just
as is the case with existing unit trusts.
In contrast
to Kotlikoff, other advocates of full reserve don’t propose unit trusts playing
a big role, but they do advocate other ways of achieving what Kotlikoff aims to
achieve with his unit trusts: that’s to make sure that depositors who want
their money invested carry some or all the losses when those investments go
bad.
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