Readers Guide: p1-3 of Goodhart on CB

This is the first readers guide RG1 of our online Reading Course: Central Bank History Here are a few questions to ponder while reading the introductory chapter of Goodhart. In addition to the 5 questions, an explanation of some theoretical material which is covered very briefly in the Goodhart book is given after the questions.  Dont worry if you cannot follow the theoretical material. Most of the book is a historical argument against the free market theories. The history is of great value in understanding the nature of Central Banking, and not just as an argument against certain false free market ideology based theories. These questions and explanations cover only the first 3 pages. Next post will start from top of page 4: “To return to the main theme, however, …”

1. What is Charles Goodhart’s motivation for writing this book?
2. What is “Free Banking”? This is not explained in text but taken for granted. You might read Wikipedia article on Free Banking to get the basic gist.
3. Walter Bagehot, author of Lombard Street, supports Free Banking theoretically, but not practically. What does this mean? That is, why does he have inconsistent position, with conflict between theory and practice?
4. The issue has been foreclosed – That is, there is unanimous agreement on government control of money supply via Central Banks – but proponents of free banking disagree, and think we should consider alternatives. Think about emerging bitcoins, FB Libra, community based local currencies, and other types on non-government issued currencies, and relate these to free banking. FORMULATE the QUESTION that modern critics of Central Banking would want to ask regarding these emerging privately issued currencies.
5. Friedman and Hayek are both free market ideologues. They believe that governments should not interfere with the workings of the free market. However, the two have a difference of opinion regarding Central Banks. What is this difference? Explain how both positions strongly restrict role of government policy but in rather different ways.

EXPLANATORY NOTES: Some of the material which follows covers rapidly a lot of literature – it is not worth asking questions about this because answers would only be possible for someone who knows the literature. Rather, I provide some explanations of what is a very condensed presentation of a rather extensive literature.

Supporters of of free banking for creation of money have done research from two angles – One is the theoretical side, based on rational expectations – for example King, Robert G. “On the economics of private money.” journal of Monetary Economics 12.1 (1983): 127-158., The second is an empirical side, based on analyzing historical experiences of eras where there was free banking. The gist of this research is that the theoretical analysis supports the possibility of free market creation of money leading to efficient outcomes. Also the analysis of historical experience suggests that it was not too bad (contrary to previous research, which said that it was a complete disaster, which is why Central Banks were necessary). The author Goodhart wants to argue AGAINST these positions, and show that Central Banks are needed.

Free market ideologues make comparisons between Free Banking versus Central Banks. Central Banks can be analyzed under Gold Standard, or under a fixed monetary policy rule, such as Friedman’s rule. In both cases, the options of the Central Bank are limited to following rules (like the Taylor Rule). Both of these scenarios are compatible with free market ideology, because the government is forced to follow free market discipline. However, a Central Bank following a DISCRETIONARY monetary policy is NOT compatible with free market ideology. Discretionary monetary policy MEANS that the government intervenes to fix problems with free markets, and is an admission of failure of the free market.

Another, rather different, line of criticism of Central Banking comes from work starting with Public Choice theorist Buchanan. In general, this line takes the view that governments cannot act in ideal ways to help the public because of incentive problems. The Central Bank is an AGENT carrying out orders but the motivation of the agent is not the same as that of the PRINCIPAL. The governor of the state bank is motivated by salary and reputation (which allow him to get future jobs), and this is not the same as doing the best possible action in the interest of the general public. This Principal-Agent literature has had a practical impact on conduct of monetary policy, as we shall see. Governments have tried to devise contracts which provide incentives to the Central Bank to keep inflation low and employment high. Suggestions have been given, and even implemented occasionally, where the salary and job of the governor of the state bank has been made to depend on monetary stability. From the free market ideology point of view, the point of this literature is to show that government interventions will lead to WORSE results compared to the free market. This is a NEW line of argument, and a NEW defense of free markets. It is admitted that free market can fail and can produce bad results. BUT, government attempts to fix the problem will make the problem even worse.

This whole line of thinking is a produce of free market ideology, and seriously flawed because of its ideological roots. Nonetheless, if we want to understand how Central Banks work today, we have to study some aspects of this theory, because it has been very influential in shaping policy making all over the world. It is NOT very important to understand this theory for the purposes of this book. In fact, one of the goals of this book is to show that history does not support the ideas of the free market ideologues. But to understand the book as a counter-argument to free market ideology, we have to understand what the ideology is.

This summary covers up to the bottom of page 3, the paragraph which ends at the top of page 4. The next post covers the first 5 pages: RG2: Goodhart on Central Banks.

OPTIONAL ADDITIONAL READINGS TO BUILD BACKGROUND KNOWLEDGE AND UNDERSTANDING

Wikipedia Articles on:

Regulatory Capture: Government attempts to regulate public enterprises. But the regulatory agency is captured by the enterprises that it wishes to regulate. Instead of acting in public interest, it acts on behalf of the private interests of the profit making firms at expense of the public.

Public Choice: A theory about how governments/bureaucracies behave when they try to interfere in the free market for the sake of the public interest.

James Buchanan: One of the leading public choice theorists who exercises a lot of influence on shaping public policy

Date posted: April 20, 2020
Author: Asad Zaman
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