RG2: Goodhart on Central Banks

RG2 (Reading Guide 2) – Continues from previous posts on Reading Course: Central Banking and Readers Guide: Goodhart on Central Banks. Writeup is given following the ten minute video:

Goodhart starts by discussing discontent with Central Banking System. He wrote this book well before the GFC 2007 -8, which has created much greater discontent. There are two different lines of attack on Central Banking: one calls for eliminating Central Banks completely, while the other asks for tying the hands of Central Banks to follow some fixed rules.

  1. Free Banking: Private Creation and Provision of Money. Today, this idea would find shape in large scale private creation of money via bitcoins, FB Libra, community money, and many other innovative ideas for creation of money without governments being involved.
  2. Regulated Central Banks: Banks should follow specified rules, like Friedman’s rule of 6% monetary growth, or Taylor rule, or certain other rules. This line of thinking emerges from a rational expectations approach, and will be discussed in greater detail later

Free Market Ideology does not accept Discretionary Monetary Policy. This happens when the Central Bank looks at economic situation, and make decisions on monetary policy according to the circumstances – this is nearly universal practice today. The reason free market ideologues do not like this is because this means that free markets do not necessarily lead to good outcomes, and the state must intervene to fix problems created by free markets. This was the main argument of Keynes in his famous book on the General Theory of Unemployment. He said that free markets will not eliminate unemployment (contrary to classical and neoclassical economic theory) and the government must intervene to do so.

The first line of attack, complete elimination of Central Banks, and creation of a free banking system, will be discussed later. For the second line of attack, in order to force Central Bank to follow rules, we must show that allowing them to act freely causes harm to the public interest. We consider below three different free-market arguments which support this position by showing that discretionary monetary policy  will cause harm. if these arguments are correct, then Central Banks should be prevented from acting freely, as they see fit, to correct emerging problems, to prevent financial instability, and to protect the financial system from different kinds of crises and failures. It is worth noting the empirically, nearly all Central Banks of the world do operate freely in this manner, so the theory conflicts with observed realities. The three lines of theoretical argument against free action by Central Banks are as follows:

  1. The first line of attack say that unregulated markets work best, and any interference via regulations or government interventions always causes harm. In particular, Discretionary Monetary Policy causes long term harm, while appearing to do short term good. This line is represented by the Expectation Augmented Phillips Curve, which is taught in standard textbooks. According to this theory, If the Central Bank follow a loose monetary policy, it can lower unemployment in the short run. In the long run, unemployment will move back to its natural rate, but the inflation rate will increase, causing long run damage to the economy. Thus efforts to improve the economic situation actually cause harm in the long run.
  2. The second line of attack says that discretionary policies may work, but we cannot achieve them because governors of Central Banks will act in their private interest, instead of taking actions in the public interest. This is called the Principal Agent approach:  Instead of assuming that Governors will work for the public interest, this line of thinking assumes that they will act for their private interests – salaries, careers – rather than look out for the public good. The recommendation that emerges out if this line is that we should change incentive structure, by penalizing the governor for failing to meet policy targets.
  3. The third line of attack says that the industry being regulated (banking sector in this case) is rich and powerful. The industry can CAPTURE the regulator in many ways. Regulatory Capture occurs in many different ways.  For example, people who run Central Banks retire and go on to jobs with high salaries at private banks. Or banks can use their money to lobby for regulations favoring them, instead of the public. Thus, Central Banks may come to serve the interests of the private banks rather than the people. It is clear that this happened in the Global Financial Crisis. The regulatory agencies spent trillions bailing out the corrupt and failed banks, and did not spend any money bailing out the people who lost their homes.

After discussing these free market theories, Goodhart turns to the central topic of his book: “What does history tell us about functions of Central Banks?”

The first thing we learn is that these were NOT formed to regulate money supply. In fact, the original purpose of creation of Central Banks was to provide funding for wars. For more details, Origins of Central Banking. Central Banks were created as to provide loans to the State on easy terms, often to finance wars or colonization. They were quite GOOD at this function. Historian Peter Kennedy in his Rise and Fall of Great Powers argues that ability to finance wars was the source of power. Noting the efficiency of Central Banks at providing finance led to widespread imitation, and creation of Central Banks all over Europe.

A side-benefit of this was also the regulation of chaotic system of money creation by private banks. But again, this was not the main purpose – regulation of private banks was done both for stability and also to earn revenue for the state and for the central bank.

ONCE Central Banks were established, other functions of CBs evolved naturally CBs were large, and politically well-connected, hence, FAR SAFER than any other banks. As a result, commercial banks started keeping large portions of their reserves with CB. They also relied on CBs for loans in times of financial distress.  By DEFAULT, not by DESIGN, CB became the bankers bank. Initially, CBs did not see themselves as bankers bank, but were just one bank like others – but bigger and more powerful. They saw smaller banks as COMPETITORS.

This led to an unintentional transition into what we recognize today as Central Banking. To be more precise, once established, Central Banks had:

  • political power,
  • substantial gold reserves
  • ability to create money by re-discounting

NOTE ON RE-DISCOUNTING: Banks lend money and take IOU NOTES from private parties, which are promises to pay back the loan. These notes are called bills of exchange. In times of crisis, banks need cash, but all they have is promises in these notes. They can sell them, or they can give them as security to the Central Bank, and borrow on the strength of this NOTE as a collateral for the loan. This process is called re-discounting.

The financial strength of the Central Bank naturally led them to become bankers bank. Private Banks had no option but to go to the Central Banks for loans and re-discounting in times of crisis. This led to a situation where all small private commercial banks held reserves in Central Bank. This centralization of power, which occurred naturally, made it possible for Central Banks to make monetary policy.

Reading for this session ends with the following passages (see page 6 of Goodhart Book).

Their privileged legal position, as banker to the government and in note issue, then brought about consequently, and, naturally, a degree of centralization of reserves within the banking system in the Central Bank, so it became a bankers’ bank. Il was the responsibility that this position was found to entail, in the process of historical experience, that led Central Banks to develop their particular art of monetary management.

Such management has had two (interrelated) aspects, a macro function and responsibility relating to the direction of monetary conditions in the economy at large, and a micro function relating to the health and well-being of the (individual) members of the banking system.

Use link to view/download Chapter 1 of Goodhart, which is currently under study.

POSTSCRIPT: One reader was confused about re-discounting, so here is some further explanation: When a lender borrows $1000 from a bank, and promises to pay $100 per month for a the next year, the written promise given to the bank is called the “debt instrument” or a NOTE or a Bill-of-Exchange. The bank will get $1200 in return for paying out cash of $1000 right now, so it receives the (loan) NOTE at a DISCOUNT – it pays $1000 only for a NOTE worth $1200. Now suppose for some reason the bank needs to raise cash. It can sell this note (worth $1200 over the year) for any lesser amount, thereby RE-DISCOUNTING the original loan note. A particular form of this occurs when the bank borrows from the Central Bank using this NOTE as a collateral for the loan. The Bank can borrow any amount upto the face value of the NOTE ($1200) from the Central Bank at the standard rediscount rate which is set in the Monetary Policy. The loan NOTE is held as collateral to secure the loan, and is returned to bank when the loan is paid off.

The next post in this sequence covers the last half of chapter 1, p6-11 of  Evolution of Central Banking by Charles Goodhart: RG3: Goodhart on Central Banks


Date posted: April 21, 2020
Categories: Blogs

Comments (5 responses)

  • Uzma says:

    Very interesting read, and lead me to think how central banks, which were initially formed to financed wars, pose as an important entity to regulate the economy. In colonial times, central banks were created to finance wars, and even now it is serving government interest by providing easy funding to the government.
    secondly the idea of endogenous money supply, also raise question on the role of the central bank. if banks can create money even out off thin air, then what is the role of the central bank left?

    if we are saying we don’t need to have central banks, then what is the role of monetary policy? we need to see how monetary policy actually work, there is a lot of literature on the transmission mechanism of monetary policy, Is it really relevant? Does monetary policy actually follow these mechanisms? if monetary transmission mechanism are actually functional, then we are safe with all what we have learned in the monetary economics courses, but if they are not functional, then what’s up?
    these are the questions that arise in my mind while reading this book and listening to the video of Respected Dr. Asad Zaman. I hope all these questions will be answered as we move forward in this reading course.

  • Muhammad Rafiq says:

    Sir from the presentation of this section, I deduce that initially legal status of the central banks had no other defined functions than the printing of money to finance governments war expanses. In this context, one direct question comes to mind that why government needed a central bank for this purpose whereas it had the authority and power to print money directly for that purpose.

    • Asad Zaman says:

      For the answer to this deep and important question, read carefully my post linked below:

      • Farhan Arif says:

        Keeping in perspective the history of the formation of the Bank of England and the Federal Reserve, don’t you think that this book by Goodhart paints a very benign picture of Central Banks? I know its early times as we have only finished the introduction, but what do you think we will gain in studying this book while we know that things were not that benign.

        • Asad Zaman says:

          We must KNOW the history before we can acquire opinions about the history — I try to keep an open mind and learn about the subject matter from different perspectives

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