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CENTRAL BANKING- WHY NOT?

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As an Economics students with fervent Austrian beliefs, the authors of this presentation are thrilled at even hearing the word “central”, whether it is applied in the context of politics, banking, or philosophy.

Central banking is based on a major misconception that knowledge is circumscribable. Embracing Hayek’ theory as it is exposed in the familiar to any cognizable student paper “The Use of Knowledge in Society” http://www.jstor.org/view/00028282/di950315/95p0423m/0 , we endorse the conception that absolute knowledge is an oxymoronic expression. Knowledge is dispersed among innumerable individuals and only in their multifaceted interactions can knowledge be transmitted. Any exterior intervention, whether it is called government, institution or Federal Reserve Board of Governors, is a carrier of manipulative forces that only lead to misbalance. The fundamental starting point of our critique of the central banking theory is not only that perfect knowledge of the vicissitudes of the economy is a surrealistic concept but also that, were its existence to be possible, savoir would still not have been collectible by a single institution of human minds. As Hayek put it in “Constitution of Liberty” (1960),

"No human mind can comprehend all the knowledge which guides the actions of society" F. A. Hayek

Our belief in the inability of the Fed to integrate the economy as a function of the consumers’ preferences is supported by real examples of wrong assumptions of the Fed that have led to severe states of the economy. We exemplify this with a familiar case: cost- push inflation caused by targeting high employment. This is a good illustration of how interventionism leads to more and more interference and the Fed’s attempts to correct its mistakes are actually aggravating them. Also, targets are often inconsistent with each other, and it is usually not unequivocal which target is to be preferred.

Mishkin, Frederic. "The Economics of money, banking, and financial markets". Mishkin Economics, Inc.: 1992.pg. 673, fig.28.5

This kind of accomodating policy reflects the reaction of the Fed to workers' desire for higher wages. By constantly shifting out the aggregate demand, activist policymakers create inflation.

Unfortunately, the mistakes of the Fed cannot be encompassed in a brief undergraduate presentation but are rather subject to graduate dissertation.

Another criticism that we would like to address to the central banking system’ s (mal)functioning is the pure focus on ex ante state of the economy without taking into account ex post conditions that are in fact incorporated into agents expectations, and thus affect their present behavior. Path-dependent strategies are anything but smart and unavoidably distress the economy.

Last but not least, we would like to use Selgin as a reference and list some of the most recurrent mistakes of the Federal Reserve’s control on the money supply. These mistakes are mainly due to the motivation hidden behind these changes, namely:

• To stabilize some index of prices

Our criticism: prices reflect relative scarcity of resources worldwide, and hence, they are the only trustworthy mechanism of information transmission. If prices fluctuate, this is due to a change in the availability of a resource. Intervening to stabilize their movement is a crude attempt to manipulate data and misinform the public

• To peg an interest or discount rate

Our criticism: Similarly, interest rates are “prices” of loans, and reflect most veraciously their private and public demand. Manipulation of the interest or discount rates would mislead entrepreneurs and push them into risky projects, or prevent them from engaging into successful investments that could lead to expansion of the economy.

Example: When the US joined WWII in 1941, military government expenditure went up tremendously. To finance it, the Treasury issued bonds, and the Fed pegged their interest rates at very low values (2.5 on long term t-bonds). Thus, the Fed was serving the political purposes of the government. After the Korean War of 1950, the pegging policy brought about detrimental results, giving rise to inflation and raising CPI by more than 8% for one year.

• To attain full employment

Our criticism: Again, we do not accept “full” (employment), “absolute” (power), “complete” (knowledge) as economically adequate terminology, all these terms indicating over-determination, which is in sharp contrast with our veneration of the perfectly competitive market. (Here, the authors risk contradicting their basic anti-absolutistic linguistic approach but the educated reader will not ignore the fact that even Adam Smith assumes some minimum intervention of the government in his invisible hand theory).

How is the “natural” rate of unemployment to be determined? Economists have not reached an affirmative conclusion on this question. This is why we doubt the precision with which the Fed can determine it, if all the experts in the world are still leading zealous debates on this question.

• To achieve a fixed percent rate of growth of MB or some other money aggregate

Our criticism:Once more, we face the transingent belief of the Fed that they can determine what the most desired condition of the economy is. This mistake is sharpened by the notion that the economy’s development should follow any change in monetary aggregates. If the money aggregates followed the natural interactions in the economy, and thus changed in response to actual processes, they would be useful as a reliable indicator of the economic situation. There is no justification of the Fed transforming the banking system into an absolute monarchy under its omnipotent governance.

FREE BANKING SYSTEM- CHAOS OR HARMONY?

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“Government failure might be worse than market failure” Milton Friedman and Anna Schwartz

After carrying out a substantial research on the history of the American banking system, prominent economists such as Milton Friedman and Anna Schwartz claim in their book “A Monetary History of the United States” that often “turning to the government as an alternative was a cure that was worse than the disease.” Do self- interested actions create a stable or unstable equilibrium in the monetary market? Before advocating the mechanisms of efficient functioning of the free banking system, a brief description of its structure merits deliberation. As Milton Friedman verbalizes his discontent with the Fed’s actions, “The failure of government to provide a stable monetary framework has thus been a major if not the major factor for our really severe inflations and depressions.” (Friedman 1960)

What is free banking?

“Free banking developed naturally, out of a pure specie monetary system, which had developed naturally out of barter” (White, Free Banking as an Alternative Banking System) Free banking is a system of money exchange with no central bank and no governmental intervention. It is characterized by the fact that it is self-adjustive, and interest rates adjust to agents’ demand for funds. Thus, deposits, loans, and credits’ supply is also uncontrolled. The only laws these banks would then obey are the laws of the free competitive market. Once there is no government, there is not a required reserve ratio, and all reserves and capital are free to be put to the best use of the economy. In the free banking system exchange rates and money supply are determined by the public’s demand for money and the real purchasing power of specie.

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There are several characteristics of free banking that we would like to emphasize:

• Free communication between lenders and borrowers • A new kind of markets evolves: the market of short-term credits. It opposes the credit- rationing model by providing opportunities to anyone to receive a loan and engage in a no-matter-how risky investment, as long as the loan is to be repaid shortly after it has been given out. This solves the problem of excess supply of reserves ( banks can invest them), as well as the problem of excess demand for loanable funds. We can see how this kind of market leads to a naturally clearing money market. • Currencies are perfectly competitive and banks are not limited as to their issuance. • Last but not least, it is assumed that notes are exchanges per se, i.e. that for every agent demanding a note, there is one who is willing to supply it. In “Emergence of Money” Carl Menger explains how this happens through infinite number of transactions, considered to be costless in the model of free banking.

Our recent history has not witnessed a free banking economy, and since free banking system is only an economic model, we should not even expect to observe it in its pure form. Sieglin suggests that this system should be analyzed in the context of an “imaginary, unregulated society” that he calls Ruritania. (Sieglin, 16)