Sunday, December 16, 2012

George Selgin’s odd claim that central banks are destabilising.

I have a plenty of respect for George Selgin, despite the fact that he advocates fractional reserve banking while I advocate full reserve. He knows a lot about the history of banking, plus (unlike many academics) everything he writes is clear, precise, waffle-free and informative.
But he had an off day when writing this article which claims that central banks are destabilising.

His basic argument is thus. First, central banks can create money willy nilly (true). Second, in a gold standard environment that freedom to create excessive amounts of money can lead to a general excess supply of money which leads to inflation, which in turn leads to gold being drained out of the country (true). And that in turn can lead to the central bank suddenly realising it is short of gold (true). So it suddenly brings the money supply expansion to a halt or reverses it, which results in a depression (very plausible).
Most readers will presumably have noticed the big flaw in that argument: no country is now on the gold standard! And as far as a balance of payments deterioration goes, that is dealt with nowadays by exchange rate adjustments (except of course within the Eurozone).
Selgin’s encyclopedic knowledge of the history of banking has got the better of him!
But that’s not to say central banks cannot be sources of instability: the lender of last resort function can be a source of instability. However that source of instability is ruled out in a full reserve environment. 


Is the commercial bank system stable?
The first weakness in his argument comes where he claims that the commercial bank system is inherently stable. His argument is that no one bank can expand too fast, else it loses reserves to other banks (true). Therefore the entire commercial bank system cannot expand too fast. As he puts it, “This routine note-exchange and settlement process imposes strict limits on credit expansion by individual note-issuing banks and, hence, by the banking system as a whole…”
Incidentally the reason for the phrase “note exchange” is that he assumes a system in which each commercial bank can issue its own banknotes. Strange as it may seem to 21stcentury folk who have spent their entire lives under a system where only central banks can issue notes, that assumption does not influence the argument one way or the other: it’s no big deal.
Of much more relevance is the historical fact that (contrary to Selgin’s above argument) commercial banks behave like lemmings. That is, while no individual bank can expand much faster than its rivals, the fact is that, for example, British banks loaned money into existence like there was no tomorrow prior to the recent crisis. The chart below shows commercial bank money expanding much faster than central bank money in the three years prior to the crisis.

So that rather dents Selgin’s claim that the commercial bank system is inherently stable.

Central banks promote instability under the gold standard.
The next problem with Selgin’s argument is that he assumes a gold or “specie” standard. As he puts it “I assume that banks, whether enjoying exclusive privileges or not, are obliged to redeem their notes on demand in specie—that is, in gold or silver coin.” Moreover, he assumes a WORLDWIDE gold standard.
He then points out, correctly, that given central bank privileges, central banks are under nowhere near the same constraints as commercial banks. That is, they can print money almost willy nilly, and if they do, that enables commercial banks to expand in a similarly irresponsible manner. And that according to Selgin leads to inflation and a movement of gold out of the relevant country.
As a result, in Selgin’s words, “The central bank consequently finds itself in danger of imminent default and proceeds to save itself by aggressively contracting credit. The contraction reduces commercial banks’ reserves, forcing them to contract as well and thus triggering a general credit crunch.”
Now there is nothing wrong with that argument, given Selgin’s assumptions. But there is just one whapping great and totally unrealistic assumption, namely the gold standard assumption. That is, no country nowadays is on the gold standard! That is, the “loss of gold” or “specie” point is plain irrelevant for 21stcentury purposes. Thus Selgin’s argument falls to pieces.
Put another way, central banks nowadays are free to print their way out of trouble, and as to currencies, they float relative to each other.

Central banks can nevertheless be destabilising.
But that is not to say that central banks cannot be destabilising. For example the idea that Argentina’s central bank is a source of stability is a joke (particularly when, as is normally the case, the bank is under the control of Argentine politicians.)
One important reason why central banks can be destabilising nowadays is actually one that Selgin points to. It’s the “lender of last resort” function that those banks perform.
If central banks abided by Walter Bagehot’s prescription and lent to problem banks at penalty rates and in exchange for first class collateral, there wouldn’t be a problem. But of course the reality is that (thanks to political and populist pressures) that function has degenerated into lending at zero or near zero rates of interest and on the basis of some very dodgy collateral.
And that just fuels credit expansion based on NINJA mortgages and other questionable bits of paper.

Full reserve comes to the rescue.
But this is where full reserve banking comes to the rescue. Under full reserve, commercial banks just don’t have any reason to go running to central banks for assistance. Under full reserve, commercial banks perform just one basic and very simple function (with a possible second function thrown in).
The first or basic function is to act as what might be called depositories. That is banks accept deposits and do nothing with the relevant money – or at most, they invest in ultra-safe securities like government debt. So that part of commercial banks cannot fail.
As to the second function, granting loans and making investments, that function is carried out (at least under the version of full reserve advocated by Laurence Kotlikoff) by entities that amount to the same as unit trusts (mutual funds in the US). Again, there is no reason for commercial banks to go  running to central banks any more than existing unit trusts go running to central banks. That is, if a series of loans or investments made by a bank’s “unit trust” division go wrong, then those who have invested in the unit trust find the value of their holding declines, just as is the case with existing unit trusts.
In contrast to Kotlikoff, other advocates of full reserve don’t propose unit trusts playing a big role, but they do advocate other ways of achieving what Kotlikoff aims to achieve with his unit trusts: that’s to make sure that depositors who want their money invested carry some or all the losses when those investments go bad.

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