Monday, December 6, 2010

End the Fed?

Why do we have a central bank, asks Gerald O'Driscoll of the Cato Institute? It's not actually necessary for a modern financial system. The US didn't have a true central bank until 1913. Canada didn't have one at the beginning of the Great Depression, and its banks sailed through the crisis without failure (But the Canadians legislated one in 1935).

The simple answer is that a central bank is really convenient for the government. It helps to get the government out of a jam and it helps the government to market its debt.

In wartime, a central bank is invaluable, because it helps the government commandeer the nation's resources for the struggle. And in a financial crisis it can act as lender of last resort to help financial institutions facing liquidity problems, i.e., a run on the bank.

After the Bank of England got started in the 1690s, it became evident that there was another benefit of a central bank, provided it was combined with sensible government fiscal policies. Government debt became highly regarded collateral, and rock-solid debt is the foundation of a well-functioning financial system. That was the basis of Alexander Hamilton's successful launch of the US National Debt in the first Washington administration.

The problem is that the government abuses the advantages of a central bank. The ease of floating debt creates a temptation to float more of it. Then the day comes when market actors wonder just how solid the government's debt is. Then they start to demand higher interest rates. Then the government gets into a sovereign debt crisis. Then the government defaults on its debt. Given this vicious cycle, maybe it is best to get rid of the central bank and get rid of the temptation for bad behavior.

The thing about debt comes down to the old saw about banks. The bank will only lend money if you don't need it. When you are in trouble, the bank will demand outrageous guarantees and collateral.

Well, of course. Credit works when everyone knows you are good for it. That means that you keep your debt levels low enough that you can always meet your obligations, even in the middle of a financial crisis. Financial crises, large and small, occur when debtors get in a jam. The solution to financial crises is for every actor to keep debt and equity properly balanced and keep risk capital and working capital clearly separate.

(That's easy to say, of course. In real life, consumers and businesses make mistakes and they put off doing something about it. Then, all of a sudden, it's too late, you are underwater, and you are facing bankruptcy.)

OK, so what should we do about the Fed? In my view we need to limit the Fed to the one job that central banks do well, and that is acting as the government's banker.

But it is time to move away from the temptations. Lender of last resort? Maybe, but the financial system should not rely on that. Printing money? Maybe, but we have seen that central banks can't be trusted to maintain the value of money. There has to be a better way, and I suspect we will see another way develop with the new ETFs for gold and other commodities.

The one thing we must stop is the failed policy of goosing the economy with the central bank and easy money. That is pure inflation, and that is wrong. Economies that need goosing are economies that have been distorted by bad government programs. Getting the central bank to paper over the government's failed subsidies and privileges doesn't solve anything.

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