Ooh, see the fire is sweepin
Our very street today
Burns like a red coal carpet
Mad bull lost its way
--Rolling Stones

UMV152:  A Counter View of Central Banks (Updated 04/20/2007 03:57 PM)

Introduction

The conventional belief about central banks, such as the Federal Reserve, is that they are necessary institutional components of financial systems.  However, a counter view argues that we'd be better off without central banks, and that their interventions do more harm than good. 

Effective market participants are aware of the counter view of central banking.

What is a Central Bank?

A central bank is generally in charge of 'monetary policy' for a country or group of countries.  Central banks enact monetary policy through activities such as setting inter-bank lending rates, establishing banking rules such as minimum reserve ratios, printing and issuing currency, and market purchase/sale of securities. 

The Federal Reserve functions as the central bank for the United States.  Other well known central banks include the Bank of Japan (BOJ), European Central Bank (ECB), and People's Bank of China (PBC). 

History

The first central bank was the Bank of England which was established in 1694.  Since then, virtually every country on the planet has created, or is linked to, a central bank. 

Prior to the advent of central banks, market forces exerted direct control over monetary systems.  Interest rates, for example, were determined by supply and demand in the market rather than by bureaucratic manipulation.  Moreover, most currencies were backed by gold or silver, which restrained governments from printing currency by 'fiat' (Mises, 1934).

Central banking in the United States was not institutionalized until 1913.  The Federal Reserve was the product of nearly twenty years of joint planning between industry leaders, academics, and government officials (Rothbard, 2002).  Few people realize that the Federal Reserve is not part of the US government.  Instead it is privately owned.

Conventional View

The conventional view of central banks, and the one expressed in most economic textbooks, is that these institutions are necessary instruments of smooth economic functioning (e.g., Frank & Bernanke, 2007; Hubbard & O'Brien, 2006).  By implementing policies that ease or tighten the supply of money and credit, central banks purportedly help smooth the peaks and valleys in economic cycle. 

In this regard, the Federal Reserve pursues a mission related to sustainable economic growth, stable prices, and maximum unemployment.

Counter View

The utility of central banks is contestable, however, and some believe that central banks do more harm than good over the long run.  Here are some of the critics' arguments.

Socialism.  When central bankers set monetary policy such as level of interest rates, they are essentially fixing the price of money.  The likelihood that a group of bureaucrats are more intelligent than markets in determining prices is remote (Mises, 1944).  Centralized decision-making and the government-owned assets that result from central bank decisions resemble socialism--an approach that history has largely proven ineffective from an economic standpoint.  

Currency destruction.  Since the advent of central banks, currencies have been weaned from the 'hard backing' of precious metals such as gold or silver.  Currently, currencies are printed by bureaucratic 'fiat' with no material backing.  This approach is inherently inflationary.  It invites excessive debt accumulation and destroys the purchasing power of a currency over time (Rothbard, 1990).  This graph reflects such an effect--remember the Fed was created in 1913.

Moral hazard.  Central bank intervention in times of market crisis creates a moral hazard.  During times of trouble, market participants believe that central banks will protect them against downside risk and therefore take more risk than they should (Miller, Weller & Zhang, 2002).  

Constitutional issues.  In the United States, it is questionable whether the Federal Reserve is a legal entity since the US constitution granted monetary authority exclusively to Congress.  

Exaggerated economic cycles.  A primary argument for creating central banks has been to make supply of money and credit more 'elastic' during recessionary periods, thus muting the cyclical nature of economic activity (Rothbard, 2002).  Yet, evidence suggests that the length and magnitude of economic cycles have been extended since the institutionalization of central banks (Anderson, 1949; Rothbard, 1963).

Summary

Central banks are widely accepted institutional elements of modern financial system functioning.  However, a counter argument is that central banks are essentially bureaucracies engaged in central planning and intervention.  Such practices are inconsistent with free market systems.

While you may discount this perspective and deem it unimportant or insignificant in the course of your financial affairs, it is important that you are at least aware of the counter view of central banks and the proposed negative consequences on market behavior and outcomes.  As such, you'll be a more informed market participant. 

References 

Anderson, B.M. (1949). Economics and the public welfare. New York: D. Van Nostrand Co.

Frank, R.H. & Bernanke, B. (2007). Principles of Economics, 3rd ed. New York: McGraw Hill.

Hubbard, R.G. & O'Brien, A.P. (2006). Macroeconomics. Upper Saddle River, NJ: Prentice Hall.

Miller, M., Weller, P. & Zhang, L. (2002). Moral hazard and the US stock market: Analysing the 'Greenspan Put.' The Economic Journal, 112: 171-186.

Mises, L. (1934). The theory of money and credit. London: Jonathon Cape Ltd.

Mises, L. (1944). Bureaucracy. New Haven: Yale University Press.

Rothbard, M.N. (1963). America's great depression. Princeton, N.J.: D. Van Nostrand Co.

Rothbard, M.N. (1990). What has government done to our money? Auburn, AL: Praxeology Press.

Rothbard, M.N. (2002). A history of money and banking in the United States. Auburn, AL: Ludwig von Mises Institute.

Quick Quiz...

152.1) The central bank of the United States is known as:

1. US Treasury
2. Bank of America 
3. Federal Reserve
4. US Bank

152.2) Central banks enact monetary policy by each of the following EXCEPT:

1. setting inter-bank lending rates
2. backing currencies with gold
3. establishing bank reserve requirements
4. purchasing securities via open market operations

152.3) A primary argument in favor of central banks is that central banks help reduce the duration and magnitude of economic cycles.

1. true
2. false

152.4) Each of the following is an argument against central banks EXCEPT:

1. central banks maintain price stability
2. central banks destroy the purchasing power of currencies
3. central banks are consistent with socialism
4. central banks invite moral hazard and extreme risk taking

Answers: 152.1) c 152.2) b 152.3) a 152.4) a

Copyright© 1999-2009 Matthew W. Ford.