We Need a Global Fed?

Central Banks Cater to Political Interests

Some economic pundits see every instance of economic disorder as proof of the defects of capitalism and of the need for more extensive government regulation of the economy. It never seems to cross their minds that government regulations might even destabilize markets. A recent example of such thinking comes from Jeffrey E. Garten, dean of Yale’s School of Management, who in the September 23, 1998, New York Times, urged creation of a global central bank to stabilize the world economy.

Garten begins with a summary of U.S. financial history that would make any economic historian blush. From the Civil War to the 1930s, Garten writes, the American economy “was an uncontrollable Darwinian process” marked by frequent booms and busts and “countless bank failures.” Then, to every right-thinking citizen’s vast relief, the federal government stepped in, creating the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, and “most important, the Federal Reserve.” The “harsh, invisible hand of Adam Smith” was thus moderated, and the business cycle brought under control.

So America’s financial system was unregulated before 1930? It just ain’t so! In truth, Civil War legislation nearly wiped out the antebellum state banking industry, setting up new national banks that were forced to back their notes with government bonds. Eligible bond collateral became increasingly scarce during the last quarter of the nineteenth century. Over the course of any year, such banks were prevented from meeting seasonal peaks in currency demands. The result was an inelastic stock of national bank currency, which gave rise to serious “currency shortages” in 1884, 1893, and 1907. Government regulation thus played a key role in the “destructive business cycles” that Mr. Garten so unhesitatingly blames on the invisible hand.

In addition to setting unnatural limits to the stock of currency, the government also prohibited national banks from setting up branch networks. This resulted in the proliferation of thousands of under-diversified and failure-prone banks. In Canada, where chartered banks were free to issue notes and to branch nationwide, bank failures were few and far between, and not a single bank failed during the Great Depression. In the United States, by contrast, several thousand banks failed during the 1930s alone, and almost all of them were “unit” banks lacking any branches.

Canada, it should be noted, established a central bank in 1935. Economic historians still wonder why, since its monetary system had withstood the depression better than those of other nations having central banks, including the U.S. system. Mr. Garten suggests that central banks such as the Fed prevent business cycles. But the United States suffered a serious downturn in 1921 and its most serious depression of all starting in 1929, notwithstanding the Fed’s establishment in 1913. The years since World War II have not witnessed another Great Depression, but the business cycle has hardly disappeared, and secular inflation has become an additional problem.

The truth is that in combating financial crises, central banks have proven to be highly costly and unreliable substitutes for structural improvements in the banking industry, namely, branch banking, competitive note issuance, and foreign bank entry. Central banks have all too often undermined the solvency of private financial firms. The U.S. savings and loan industry became insolvent in the early 1980s mainly because of Fed-sponsored inflation, which dissolved the value of long-term home mortgages negotiated a decade or more before. The S&L mess was worsened by the perverse effects of deposit insurance, administered in this case by the Federal Savings and Loan Insurance Corporation, which subsequently failed. So much for the stabilizing effects of “progressive” New Deal financial regulations.

According to a recent study by Kurt Schuler, central banks have done a poorer job historically at promoting low inflation, exchange-rate stability, open exchange markets, and economic growth than non-central banking arrangements, including free banking and currency boards. Indeed central banks offer only one clear advantage over these other arrangements: the ability to print money for their sponsoring governments. And that is one advantage the public can live without.

Seemingly unaware of the role national central banks have played in generating financial turmoil around the world, Mr. Garten can think of no better solution to the world’s financial troubles than a global central bank. He does not appreciate the link between central-bank pegged exchange rates and speculative currency runs like those recently experienced in Southeast Asia (runs to which noncentral-bank arrangements, such as currency boards, are invulnerable); he does not consider the possibility that Japan’s present slump may be the payback for its aggressively expansionary monetary policy during the 1980s; and he doesn’t contemplate the fact that Russian bank depositors might not have to watch their savings gradually erode were they free to do business with foreign banks. Worse still, Mr. Garten somehow imagines that the errors of national central bankers would somehow be avoided by an international bank, as if ignorance and short-sightedness were unable to transcend national boundaries.

Take Russia as a case in point. From June to October 1992, Russia’s central bank tripled its lending to commercial banks. Most of this credit was in turn re-lent, at a loss, to the banks’ own state-enterprise owners! The losses were then made up for by Russia’s finance ministry In the meantime, genuinely private Russian firms went begging for funds.

Eventually, the massive flows of centralbank credit began to reduce the value of the ruble, undermining Russian banks’ ability to pay their foreign debts and rendering them that much more insolvent. And how has Russia’s central bank proposed to resolve the crisis? By lending still more credit to commercial banks that should have been declared insolvent long ago!

Would a global central bank help? Not at all. On the contrary, such a bank would merely encourage Russian authorities to continue their perverse policies, by forcing citizens of other countries to bail out an essentially corrupt system.

Instead of performing their self-assigned task of stabilizing national financial markets, central banks have routinely attempted to prop up unsound banking systems with easy money. Jeffrey Garten believes that the cure for this failure is a bigger, better central bank, capable of acting as a world “lender of last resort,” when in fact loans from such an institution would only make it easier for national governments to delay needed financial market reforms. Perhaps Mr. Garten believes that a global central bank would rise above domestic politics, resisting any pressure to bail out insolvent banks. But the record of existing central banks, and of the IMF and World Bank for that matter, provides no grounds for such optimism.

On the contrary, experience suggests that a global central bank would quickly be captured by international banking interests and that it would serve those interests (rather than the interest of the general public) by rushing to guarantee their loans even when doing so would be tantamount to rewarding irresponsible government policies and banking practices.

So Mr. Garten, kindly spare us a world central bank: your quaint belief that, when it comes to regulating financial markets, governments can never go too far, just ain’t so.

—George A. Selgin

Department of Economics

University of Georgia

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