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Up for grabs again

Central banking has undergone drastic changes during the last 100 years that are often unappreciated today. Before World War I, most central banks were partly or entirely privately owned. They were not expected to spur economic growth or smooth business cycles. Rather, they defined their goals more narrowly as adhering to the gold standard and earning modest profits for their shareholders in normal times. True, during wars they were expected to lend heavily to the government, temporarily suspending the gold standard if need be, and during financial crises they were expected to act as lenders of last resort to solvent but illiquid financial institutions. War between the major powers was viewed as improbable, though.

World War I struck like a thunderclap. Browse through old issues of the Commercial and Financial Chronicle, which in 1914 was the leading U.S. business publication, and you will see that in the month leading up to the war, European politics received little ink, as if the assassination of Archduke Franz Ferdinand were of no more world importance than the man who fired shots at the U.S. embassy in Sarajevo today. Then war came and within a week, more than half the world was embroiled in it, because Europe’s colonies were involved also.

By the war’s end, the central banks of the belligerent countries had created so much inflation to finance the war that returning to prewar exchange rates was either painful or impossible. Although the gold standard in principle remained the goal, the war had planted the idea that monetary policy could be “mobilized” in peacetime somewhat as it had been in wartime. The brief return of many countries to the gold standard in the late 1920s occurred in an intellectual climate where the standard no longer enjoyed its former unquestioned, and largely unquestioning, support. The Great Depression and World War II finished the job. By 1945, almost all central banks were government owned institutions whose primary goal was macroeconomic management, not profit seeking. There was a kind of gold standard — the Bretton Woods agreement had been signed and the signatories were working towards implementing it — but it was a gold standard in most cases hedged about by exchange controls, and without the depth of commitment of the pre-World War I gold standard. In the early 1970s that, too, ended.

As all readers who are at least middle-aged will remember, a generation of turbulence followed. Inflation in the rich countries in the 1970s, the Third World debt crisis of the 1980s, inflation in postcommunist countries and the emerging market financial crises of the 1990s. Finally, in the last decade, there were some quiet years, when it was plausible to think that the main practical problems of central banking been largely solved. Now it’s all up for grabs again.

  • RickDiMare

    Kurt, central bank policy that involves the "profit seeking" you mention is where I think the main problem lies. It would be irresponsible to entirely "end the Fed" or to consider a wholesale replacement for the central banking model without first identifying the specific central bank functions that are problematic. For example, there's nothing wrong with the central bank acting as "fiscal agent" of the Treasury Department, but it's really not the central bank's place to keep acting like a privately-owned profit-seeking corporation. Even if a free banking model were adopted one day, I suspect the central bank would still have a significant supervisory role.

  • Paul Marks

    It is true that Central Banking was not always as bad as it is now. It used to be a matter of playing at the margin – giveing big bankers (and those connected with them) a bit of an edge in life (a little help from time to time). Much as I despise people like Walter Bagehot – compared to modern "economists" (who seek to use monetary expansion to control the entire economy) Bagehot and co were saints.

    However, the principles of Central Banking were always wrong. Bankers should not get special help (even small amounts of special help, which is all they got before the First World War) and govenrments should not be able to borrow on special terms – they just should not (period) even if they are not borrowing much (by modern standards).

    As for now…..

    The entire financial system is bound up with the flow of funny money from the Central Banks. Both the banks and the leading corporations. I am not "anti banker" (at least I am not anti people who loan money for interest – I think rather differently of people who think they CREATE money) and I am certainly not "anti corporation" (indeed I have defended the right of people to create or to trade with limited liablity enterprises – if that is what they choose to do). However, the existing "finance economy" (and the leading corporations who have got wound up in it) is going to go – it will fall apart.

    There is no way that such a collapse can not have negative effects (at least in the short term), the real question is…. "what happens then?"

    Will people move to full collectivism (either under the open name of socialism or the deception of communal "anarchism"), or will people be allowed to build honest enterprises (including honest banks and honest corprorations) free from the drip feed of subsidy from government Central Banks.

    And the only way to really be free of such a drip feed of hidden subsidies (which turns, over time, into a vast flood of subsidies – totally corrupting the economy) is to NOT HAVE CENTRAL BANKS.

    Of "Currency Boards" or any other such thing.