Thursday, 18 October 2012

Central banks: reform or abolish?

This is the title of a new working paper by Gerald P. O’Driscoll at the Cato Institute. The abstract reads:
Advocates of central bank reform must examine why central banks emerged and what forces sustain them. They did not arise in an institutional vacuum, and will not be reformed in an institutional vacuum. The historical origins of central banks explain how they came into existence.  The forces sustaining and feeding their growth may differ from those explaining their origin.

Plans to abolish central banks constitute an extreme reform. It is doubtful that such plans can succeed without broader institutional change, occurring either first or simultaneously. That is likely true regardless of the strength of evidence on central bank performance. I examine these issues in what follows.
In his conclusion O'Driscoll argues that we have two intertwined systems, the fiscal and the monetary. They must be reformed together. In part O'Driscoll's conclusion reads,
I have suggested that the rise of the central bank coincides with the rise of nation states, whose spending commitments exceed their capacity to finance those commitments. Historically, wars were the chief source of fiscal embarrassment to monarchs. Early central banks, like the Bank of England, were not conceived as monetary institutions, but banks to the king. Even the Federal Reserve was not conceived as a monetary authority. “The responsibilities originally assigned to the Fed did not need to include, and in fact did not include that of managing the stock of money or the price level” (Selgin et al., 2010: 36). It did not arise for fiscal reasons, but became indispensable to a growing federal government both in wartime and peacetime. Standard economic justifications do not take adequate account of historical reality. Consequently, they are theoretically naïve.

Wars are still expensive, but most governments no longer fight major wars. The United States is a conspicuous exception. The modern welfare state with its vast array of entitlements drives government finances into deficit (Buchanan and Wagner 1977). Currently, the European Union is suffering an acute financial crisis. Its economies grow too slowly to generate the tax revenues to finance the benefits promised the citizens of those countries. The governments borrow chronically to help pay for ordinary, current expenses. Unforeseen events, like recessions, or housing bubbles bursting, throw the governments deeper into deficit. The modern European sovereign finds himself in much the same situation as his 18th century predecessor.

The European Union is an interesting case because its own central bank is limited in its ability to finance government deficits. So the commercial banking system has become a huge holder of sovereign debt. Partly that reflects the favorable treatment given to government securities under the Basel rules (Basel II). Banks do not need to hold reserves against the sovereign debt of OECD members. Since all such debt was preferred by regulators, bankers choose to hold the highest‐yielding and riskiest sovereign debt, e.g., that of Greece instead of  Germany. Governments also pressured their own banks to hold sovereign debt to keep funding costs down. That pressure is being very much felt today. So the EU banking system is in crisis along with their governments.

We Americans should not cultivate schadenfreude at the plight of Europe. The United States is not far behind Europe on its fiscal trajectory to default, or what amounts to the same thing, high inflation. We benefit temporarily because, relatively speaking, U.S. assets offer a safe haven for investors. If that changes, and global capital repositions elsewhere, borrowing costs for everyone, including the federal government, will rise. That by itself could produce a fiscal crisis here. A U.S. fiscal crisis is being postponed but not avoided.

It is institutionally impossible to end central banking in this environment. I certainly do not mean that it should not be discussed. But, as they have always been in the history of central banking, monetary and fiscal institutions are linked. Monetary reform will need to go hand‐in‐hand with fiscal reform.

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