The Case Against Financial De-Regulation
The Reagan-Thatcher revolution started an era of financial de-regulation, in adherence to free market ideology, which continues to this day. This is true despite the hundreds of major and minor financial crises which testify to the inherent instability of the financial system, and the necessity for effective regulation. Regulation and supervision of private commercial banks is the responsibility of Central Banks. To understand this debate in depth, it is useful to study the historical “Evolution of Central Banking“. This is the goal of an ongoing online course, which aims to go through a book by Charles Goodhart on this topic. About 100+ students are registered in the online course, and we have recently finished going through Goodhart Chapter 1 Evolution of Central Banks. In this post, we provide a summary of the six Reader’s Guides numbered RG1, …, RG6, which have been posted about Chapter 1. We will start our study of Chapter 2 one week later. This is an opportunity for latecomers to join, since they can easily go through the reading of one chapter, together with accompanying readers guides, in one week. Fill out the Google Form Evolution of Central Banking to register for an email discussion group for the course, and to get access to a downloadable copy of the complete book.
This 0-th post provides a general introduction to the online course. Economic theories cannot be understood outside their historical context (which includes transitions between nomadic, agricultural, feudal and market societies). History is of great value in understanding the nature of central banking also, because the way money works has also changed radically several times over the twentieth century (i.e. gold standard, gold exchange standard, floating currencies). Money is at the HEART of economics and we need to understand its role in the economy. To understand the role of money, it is essential to understand how this has been evolving and changing over time. As a result, a theory of money must also evolve and change, and even attempt to predict the next change that may emerge in the role and function of money. No universal invariant theory of money can be correct.
Goodhart worked as economic advisor at Bank of England for 17 years. As part of a general trend towards free market thinking launched by the Reagan-Thatcher revolution, he encountered increasing discussions about whether Central Banks were necessary, if so, what their role should be. He finds the new free market theories very much out of line with reality. He wrote this book in order to show the failure of these theories, and to show how the role of Central Banks emerged naturally from historical necessities. Seeing how Central Banks evolved to respond to needs of the financial system shows both how they are essential to the functioning of the system, and also exactly what the needed functions of Central Banks are
Charles Goodhart rehearses the main arguments against Central Banks, in order to show why they are wrong. The novelty of his approach is his use of the historical experience to show why these theories are wrong. There are two separate lines of free market arguments corresponding to Hayek and Freedman. Hayek argues for complete elimination of Central Banks, leading to “free banking”. In contrast, Freedman would like to tie the hands of Central Banks to follow fixed rules. Three different arguments can be given to explain the harms of discretionary monetary policy: that is a Central Bank which is free to take whatever actions it see’s fit to correct all types of problems in the financial sector. After rehearsing these arguments, Goodhart goes on to discuss the origins and evolutions of Central Banking, and show how this history contradicts these arguments. Central Banks emerged naturally to fulfill a need with small private banks could not fulfill. Their large size naturally led them to step into dual roles of stabilizing the economy and regulation and supervision of smaller banks. Contrary to the free market views of government imposing regulation, the structure of Central Bank actually evolved out of the needs of the government as well as the needs of the private banking industry.
As Central Banks grow big and powerful, their actions affect the economy of the nation as a whole. Recognition of this power leads to the responsibility to exercise it with care, in the public interest. This is called the macro-management responsibility of the Central Bank, and this came into existence very slowly. Furthermore, the nature of this responsibility, and the actions it necessitates, has changed radically over time, corresponding to changes in the international financial architecture. In contrast to this, the micro-management responsibility of Central Banks has remained constant over time, despite radical changes in both domestic and international environments. This micro-management responsibility consists of supervision and regulation of the commercial banks. From this historical fact, Goodhart concludes that the primary function of the Central Bank is micro-management. The macro management function is built on top of, and emerges due to, this micro role of supervision and regulation. Economists only theorize about the macro management role. Free market theories which argue for elimination of Central Banks, or for tying the hands of Central Banks to fixed rules, ignore completely the central importance of the micro-management role.
The first four posts (RG0, RG1, RG2, RG3) cover Chapter 1 of Charles Goodhart’s book on the Evolution of Central Banking. The next two posts – RG4 and RG5 – provide some general information about methodology of economics, and the conflict between free market ideology and reality. Similarly, while RG6 makes a beginning on Chapter 2, it is mainly a general discussion of free market ideology
This post explains how economic theories are created to understand particular economics systems, within a given historical context. Economic systems keep evolving and changing, and so economic theories also must evolve and change with time. Very strangely, the methodology of modern economics does not accept this simple and obvious truth. Why is this so? Because economists wanted to imitate the methodology of Physics, and create laws of economics which would be universally valid, across time and space, just like the law of physics. This a-historical methodology has been a source of great harm, making economists blind to the importance of world historical events in the study of economics. For example, World War 1, World War 2, and the Vietnam War, all led to dramatic changes in the global monetary system, but economists are unaware of this because modern methodology excludes history, This is one important reason why we are study history of Central Bankings, because it leads to insights not available to orthodox economists, who exclude history from economic theory.
It is easy to see that economic systems have evolved over time. The economic systems of hunter-gatherer societies differed radically from those of agricultural communities. It is also easy to see that the economic system affects political and social organization, as well as the patterns of interaction with our habitat, the planet earth. Treating economic theory as a science, a collection of universal invariant laws, blinds economists to all of these connections. This post traces the impact of the industrial revolution, which allowed creation of massive amounts of surplus, on social norms, politics, colonization, consumption, environment, and other dimensions of our existence. The evolution of economic systems, and the corresponding need for the evolution of economic theory adapted to the system, as well as the inter-connections of economic with politics, society, and environment, are all blind spots of modern economics. Studying the evolving economic system within its historical, cultural, and geographic context gives us deep insights into economics not available from the mainstream orthodox perspective on economic theory and methodology.
The debate about the responsibility of Central Banks for the recent Global Financial Crisis of 2007 continues to this day. Did they cause the crisis, destroying the lives of millions, or did they save the world from a financial disaster? The debate today mirrors debates which have been going on for more than a century. The strong support for financial de-regulation is built on the foundations of a free-market ideology. In fact, it is easy to prove, both theoretically and empirically, that the free market ideology is wrong. Vast numbers of economic crises created by free markets provide the empirical evidence. Theoretical evidence shows the presence of externalities, imperfect information, transaction costs, monopolies, and many other problems, all of which prove the failure of free markets. Despite huge theoretical and empirical evidence, the argument for the efficiency of free markets occupies the central position in modern economics textbooks. WHY does this extremely bad argument continue to dominate the discourse? The post explains that the top 1% do not have sufficient power to implement policies favorable their interests by brute force. Instead, they must convince the bottom 90% to go along of their own free will. This requires creating theories which give the appearance of being good for all, while actually promoting the interests of the top 1%.
The next post – RG7 – will make a start on Chapter 2 of Goodhart’s Evolution of Central Banks. This is due to be published on 8th May 2020.