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 central bank 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 Selgin
Department of Economics
University
of Georgia
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
February 1999, Vol. 49, No. 2.
Yourname@libertyhaven.com
