Fedophilia (love of central banks).

Congratulatons to George Selgin, the world’s leading and very articulate Fedophobe, for coining the word.

Selgin advocates what he calls “free banking”: that’s a system in which there is no central bank, and commercial banks are free to issue their own banknotes, as they did in England prior to 1844. And given the mess made by central banks and politicians who think they can frame bank regulations that improve on the free market, he has a point.

Examples of government or central bank mistakes that he cites include:

1. The fact that mistakes by the Fed in the 1930s did at least as much to prolong that recession as to cure it. 2. Failure by the authorities to regulate banks prior to the recent crisis, and failure to deflate the property price bubble that preceeded it. 3. The fact that Walter Bagehot regarded central banks as dangerous institutions. 4. The fact that it was PRECISELY bank regulations that lead to the thousands of bank failures in the U.S. in the 1930s, as compared to Canada, where there was no effective central bank till 1935, and where the bank system was much nearer Selgin’s “free banking” system, and which experienced no bank failures. (For 3 and 4, see respectively p.492 and 494 here)

However there are two weaknesses in Selgin’s arguments, as follows.

1. He argues here (under the heading “The Principle of Adverse Clearings”) that any attempt by one bank to expand faster than others results in its becoming indebted to others. And that constrains the bank concerned. Therefor free banking is a stable system.

My first answer to that is: “Northern Rock”. That is a bank which DID EXPAND faster than others. And yes – it became indebted to other banks, or other institutions. But it thought it could get away with it, and it would have, if wholesale money markets had not frozen.

Second, even if an INDIVIDUAL BANK cannot expand faster than others, that does not stop the commercial bank system AS A WHOLE going mad and expanding like there is no tomorrow. Look at the expansion of commercial bank money / lending in Britain in the three years prior to the crunch.

2. In arguing (as mentioned above) that central banks OUGHT TO HAVE deflated the property bubble that preceeded the recent crisis, Selgin could be taken to be arguing FOR central bank or government control of some sort.

So what’s the solution?

I agree with Selgin to some extent: that is, I agree that some of the functions of central banks ought to be dispensed with. E.g. interest rate adjustments by central banks are a farce for reasons set out here.  Also see Werner.

As to the lender of last resort function, that would be OK if it were carried out as per Bagehot’s prescription: lending at penalty rates and so on. In practice, and due to political pressures, it has degenerated into totally unjustified subsidies for supposedly “commercial” banks.

So the lender of last resort function should be dispensed with. Instead, and with a view to making banks genuinely commercial rather than relying on taxpayer support, ALL CONCEIVABLE LOSSES in the banking industry should be born by banks and those involved with banks: shareholders, depositors, borrowers, etc. And a system of that sort is advocated by Laurence Kotlikoff.

To summarise, we should dispose of the interest rate adjusting function of central banks and the lender of last resort function. That’s central banks reduced to a shadow of their former selves, which is consistent with Selgin’s Fedophobia.

However Kotlikoff’s system equals full reserve banking: a system under which commercial banks do not create money: only central banks do. And on the face of it, that is inconsistent with Selgin’s ideas.

Well it’s not strictly speaking inconsistent with Selgin’s ideas on banks as such. That is, the idea that the central bank / government machine should create and spend money into the economy when required is really just Keynsianism. That’s the idea that the authorities should counteract recessions when they occur.

AS IT HAPPENS, Selgin is not too keen on Keynsianism. So there is a clash there. But, to repeat, there is not much of a clash between Selgin’s ideas on banks as such and some of the main ideas proposed by advocates of full reserve.